Macroeconomics-1

Section 6-7

Philippova Diana

New Economic School, MAE

October 13, 2023

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 Money and Inflation

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Problem 1
G. Mankiw, Chapter 5, p. 128

In the country of Wiknam, the velocity of money is constant. Real GDP grows by 5 percent per
year, the money stock grows by 14 percent per year, and the nominal interest rate is 11
percent. What is the real interest rate?

Recall that from quantitative theory of money equation MV = PY :

∆M
M + ∆V
V =
∆P
P + ∆Y
Y

∆V ∆Y ∆M ∆P
Therefore, V = 0, Y = 5, M = 14. Hence, P =π =9

Also, from Fisher equation i = r + π:

11 = r + 9

r = 2 - real interest rate

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Problem 3
G. Mankiw, Chapter 5, p. 129

d
Suppose a country has a money demand function MP = kY , where k is a constant parameter.
The money supply grows by 12 percent per year, and real income grows by 4 percent per year.

(a) What is the average inflation rate?

M ∆M
In a equilibrium, P = kY and M − ∆P
P =
∆k
k + ∆Y
Y

∆P ∆M
Therefore, π = P = M − ∆Y
Y = 12 − 4 = 8

(b) How would inflation be different if real income growth were higher? Explain.

The inflation would be smaller. Indeed, higher income implies higher demand for real money
balances as people would like to spend more. However, the money supply growth remains the
same, thus, inflation becomes lower, as the supply side would not be able to meet the demand
side otherwise.

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Problem 3
G. Mankiw, Chapter 5, p. 129

(c) How do you interpret the parameter k? What is its relationship to the velocity of money?

The parameter k shows by how much an additional unit of output increases the demand for real
money balances (it is the sensitivity of the demand for money to the change in aggregate
output). In a equilibrium, k is the reciprocal of the velocity: k = V1 .

(d) Suppose, instead of a constant money demand function, the velocity of money in this
economy was growing steadily because of financial innovation. How would that affect the
inflation rate? Explain.

In this case, ∆M ∆V ∆P ∆Y
M + V = P + Y , therefore, the inflation would be growing faster whenever
there is a positive growth of the velocity. The growth of the velocity implies that the same
quantity of money is used more often to purchase goods and services. Thus, there is smaller
demand for real money balances, hence, prices must grow to compensate for the drop in
demand.

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Problem 5
G. Mankiw, Chapter 5, p. 129

Md Y
Suppose that the money demand function takes the form: P = L(Y , i) = 5i .

(a) If output grows at rate g, at what rate will the demand for real balances grow (assuming
constant nominal interest rates)?

∆M ∆P ∆Y
− = =g
M P Y
(b) What is the velocity of money in this economy?

In a equilibrium:
M Y
= ⇒ M · (5i) = PY
P 5i
Thus, V = 5i

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Problem 5
G. Mankiw, Chapter 5, p. 129

(c) If inflation and nominal interest rates are constant, at what rate, if any, will velocity grow?

Since velocity depends only on the nominal interest rate, it will not grow.

(d) How will a permanent (once-and-for-all) increase in the level of interest rates affect the
level of velocity? How will it affect the subsequent growth rate of velocity?

The velocity will increase five times more than the nominal interest rate: ∆V = 5∆i.
No other changes must happen to it.

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Problem 6
G. Mankiw, Chapter 5, p. 129
In each of the following scenarios, explain and categorize the cost of inflation.

(a) Because inflation has risen, the L.L. Bean Company decides to issue a new catalog quarterly
rather than annually.

L.L. Bean Company now spends more money issuing new catalogs, thus pays menu costs.

(b) Grandma buys an annuity for $100,000 from an insurance company, which promises to pay
her $10,000 a year for the rest of her life. After buying it, she is surprised that high inflation
triples the price level over the next few years.

Unexpected inflation made grandma receive much more than she was anticipating to receive, so
the insurance company pays the cost of unexpected inflation.

(c) Maria lives in an economy with hyperinflation. Each day after being paid, she runs to the
store as quickly as possible so she can spend her money before it loses value.

Maria pays the shoeleather costs as she could rather spend her time more productively rather
than run to the shop each day.
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Problem 6
G. Mankiw, Chapter 5, p. 129

(d) Warren lives in an economy with an inflation rate of 10 percent. Over the past year, he
earned a return of $50,000 on his million dollar portfolio of stocks and bonds. Because his tax
rate is 20 percent, he paid $10,000 to the government.

Due to inflation Warren has lost $100,000 and his capital gains are $50,000. After paying the
tax, he lost an additional $10,000, which is due to the tax costs of inflation (as the tax for
capital gains is not adjusted to account for inflation, and, thus, government requires to pay
taxes on the nominal gain).

(e) Your father tells you that when he was your age he worked for only $3 an hour. He suggests
that you are lucky to have a job that pays $7 an hour.

Due to the difference in probably 30 years, you are extremely unlucky to receive only $7 dollars
as the inflation must have risen considerably during this period.

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Problem 7
G. Mankiw, Chapter 5, p. 129

When Calvin Coolidge was vice president and giving a speech about government finances, he
said that "inflation is repudiation." What might he have meant by this? Do you agree? Why or
why not? Does it matter whether the inflation is expected or unexpected?

One way to understand Coolidge’s statement is to think of a government that is a net debtor in
nominal terms to the private sector. Let B denote the government’s outstanding debt measured
in U.S. dollars. The debt in real terms equals B/P, where P is the price level. By increasing
inflation, the government raises the price level and reduces in real terms the value of its
outstanding debt. In this sense we can say that the government repudiates the debt. This only
matters, however, when inflation is unexpected. If inflation is expected, people demand a higher
nominal interest rate. Repudiation still occurs (i.e., the real value of the debt still falls when
the price level rises), but it is not at the expense of the holders of the debt, since they are
compensated with a higher nominal interest rate.

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 Open Economy

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Problem 1
G. Mankiw, Chapter 6, p. 164

Use the model of the small open economy to predict what would happen to the trade balance,
the real exchange rate, and the nominal exchange rate in response to each of the following
events.

(a) A fall in consumer confidence about the future induces consumers to spend less and save
more.

As consumers save more now, the amount of private savings increases, thus, national savings
also grow up. Investment does not change as it only affected by the world interest rate that
does not change. Thus, S − I (r ∗ ) increases. The increased supply of dollars causes the
equilibrium real exchange rate to fall. Because the dollar becomes less valuable, domestic goods
become less expensive relative to foreign goods, so exports rise and imports fall. This means
that the trade balance increases. The nominal exchange rate falls following the movement of
the real exchange rate, because prices do not change in response to this shock.

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Problem 1
G. Mankiw, Chapter 6, p. 164

(b) A tax reform increases the incentive for businesses to build new factories.

Due to the tax reform businesses increase its investment, national savings do not change, thus,
S − I (r ∗ ) decreases. The increased demand for dollars causes the equilibrium real exchange rate
to rise. Because the dollar becomes more valuable, domestic goods become more expensive
relative to foreign goods, so exports decreases and imports increases. This means that the
trade balance falls. The nominal exchange rate rises following the movement of the real
exchange rate, because prices do not change in response to this shock.

(c) The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars over
domestic cars.

The introduction of a stylish line of Toyotas that makes some consumers prefer foreign cars
over domestic cars has no effect on saving or investment but it shifts the Nx(ε) schedule
inward. The trade balance does not change, but the real exchange rate falls. Because prices are
not affected, the nominal exchange rate follows the real exchange rate.

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Problem 1
G. Mankiw, Chapter 6, p. 164

(d) The central bank doubles the money supply.

An increase in money supply leads to a decrease in nominal interest rate, assuming prices to be
constant in short-run, real interest rate also decreases. But as investment depends only on the
world interest rate, and national savings do not depend on the interest rate at all, the
equilibrium values of trade balance, real exchange rate, and nominal exchange rate do not
change (country’s interest rate adjusts to the world’s interest rate).

(e) New regulations restricting the use of credit cards increase the demand for money.

An increase in the demand for money leads to a increase in nominal interest rate, assuming
prices to be constant in short-run, real interest rate also increases. But as investment depends
only on the world interest rate, and national savings do not depend on the interest rate at all,
the equilibrium values of trade balance, real exchange rate, and nominal exchange rate do not
change (country’s interest rate adjusts to the world’s interest rate).

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Problem 2
G. Mankiw, Chapter 6, p. 164

Consider an economy described by the following equations:

Y = C + I + G + Nx
Y = 5000
G = 1000
T = 1000
C = 250 + 0.75(Y − T )
I = 1000 − 50r
Nx = 500 − 500ε
r = r∗ = 5

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Problem 2
G. Mankiw, Chapter 6, p. 164

(a) In this economy, solve for national saving, investment, the trade balance, and the
equilibrium exchange rate.

S priv = (Y − T ) − C0 − mpc(Y − T ) = (5000 − 1000) − 250 − 0.75(5000 − 1000) = 750

S pub = T − G = 1000 − 1000 = 0

S nat = S priv + S pub = 750
I = 1000 − 50r ∗ = 1000 − 50 · 5 = 750
Nx = S − I (r ∗ ) = 750 − 750 = 0
Nx = 500 − 500ε = 0
ε1∗ = 1

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Problem 2
G. Mankiw, Chapter 6, p. 164

(b) Suppose now that G rises to 1 250. Solve for national saving, investment, the trade
balance, and the equilibrium exchange rate. Explain what you find.

S priv = (Y − T ) − C0 − mpc(Y − T ) = (5000 − 1000) − 250 − 0.75(5000 − 1000) = 750

S pub = T − G = 1000 − 1250 = −250

S nat = S priv + S pub = 500
I = 1000 − 50r ∗ = 1000 − 50 · 5 = 750
Nx = S − I (r ∗ ) = 500 − 750 = −250
Nx = 500 − 500ε = −250
ε2∗ = 1.5

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Problem 2
G. Mankiw, Chapter 6, p. 164
(c) Now suppose that the world interest rate rises from 5 to 10 percent (G is again 1 000).
Solve for national saving, investment, the trade balance, and the equilibrium exchange rate.
Explain what you find.

S priv = (Y − T ) − C0 − mpc(Y − T ) = (5000 − 1000) − 250 − 0.75(5000 − 1000) = 750

S pub = T − G = 1000 − 1000 = 0

S nat = S priv + S pub = 750
I = 1000 − 50r ∗ = 1000 − 50 · 10 = 500
Nx = S − I (r ∗ ) = 750 − 500 = 250
Nx = 500 − 500ε = 250
ε3∗ = 0.5

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Problem 3
G. Mankiw, Chapter 6, p. 164

The country of Leverett is a small open economy. Suddenly, a change in world fashions makes
the exports of Leverett unpopular.

(a) What happens in Leverett to saving, investment, net exports, the interest rate, and the
exchange rate?

When Leverett’s exports become less popular, its national saving does not change. Investment
also does not change, since investment depends on the world interest rate, and Leverett is a
small open economy that takes the world interest rate as given. Because neither saving nor
investment changes, net exports, which equal S – I, do not change either. The decreased
popularity of Leverett’s exports leads to a shift inward of the net exports curve. At the new
equilibrium, net exports are unchanged but the currency has depreciated. Even though
Leverett’s exports are less popular, its trade balance has remained the same. The reason for
this is that the depreciated currency provides a stimulus to net exports, which overcomes the
unpopularity of its exports by making them cheaper.

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Problem 3
G. Mankiw, Chapter 6, p. 164

(b) The citizens of Leverett like to travel abroad. How will this change in the exchange rate
affect them?

Leverett’s currency now buys less foreign currency, so traveling abroad is more expensive. This
is an example of the fact that imports (including foreign travel) have become more expensive —
as required to keep net exports unchanged in the face of decreased demand for exports.

(c) The fiscal policymakers of Leverett want to adjust taxes to maintain the exchange rate at
its previous level. What should they do? If they do this, what are the overall effects on saving,
investment, net exports, and the interest rate?

If the government reduces taxes, then disposable income and consumption rise. Hence, saving
falls so that net exports also fall. This fall in net exports puts upward pressure on the exchange
rate that offsets the decreased world demand. Investment and the interest rate would be
unaffected by this policy since Leverett takes the world interest rate as given.

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Problem 6
G. Mankiw, Chapter 6, p. 165

A Case Study in this chapter concludes that if poor nations offered better production efficiency
and legal protections, the trade balance in rich nations such as the United States would move
toward surplus. Let’s consider why this might be the case.

(a) If the world’s poor nations offer better production efficiency and legal protection, what
would happen to the investment demand function in those countries?

If poor nations offered better production efficiency and legal protections, the investment
demand function in those countries would increase.

(b) How would the change you describe in part (a) affect the demand for loanable funds in
world financial markets?

In this case, the demand for loanable funds in world financial markets would increase.

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Problem 6
G. Mankiw, Chapter 6, p. 165

(c) How would the change you describe in part (b) affect the world interest rate?

The world interest rate increases because of the increase in world investment demand.

(d) How would the change you describe in part (c) affect the trade balance in rich nations?

The increase in the world interest rate increases the required rate of return on investments in
our country. Because the investment schedule slopes downward, we know that a higher world
interest rate means lower investment.

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Problem 10
G. Mankiw, Chapter 6, p. 165

"Traveling in Mexico is much cheaper now than it was ten years ago," says a friend. "Ten years
ago, a dollar bought 10 pesos; this year, a dollar buys 15 pesos." Is your friend right or wrong?
Given that total inflation over this period was 25 percent in the United States and 100 percent
in Mexico, has it become more or less expensive to travel in Mexico? Write your answer using a
concrete example — such as an American hot dog versus a Mexican taco — that will convince
your friend.

Suppose that ten years ago, an American hot dog cost $1, while a Mexican taco cost 10 pesos.
Since $1 bought 10 pesos ten years ago, it cost the same amount of money to buy a taco in
both countries. Since total U.S. inflation has been 25 percent, the American hot dog now costs
$1.25. Total Mexican inflation has been 100 percent, so the Mexican taco now costs 20 pesos.
This year, $1 buys 15 pesos, so that the Mexican taco costs 20 pesos/[15 peso/dollar] = $1.33.
This means that it is now more expensive to purchase taco in Mexico than hot dog in the
United States.

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Problem 11
G. Mankiw, Chapter 6, p. 165

You read in a newspaper that the nominal interest rate is 12 percent per year in Canada and 8
percent per year in the United States. Suppose that international capital flows equalize the real
interest rates in the two countries and that purchasing-power parity holds.

(a) Using the Fisher equation, what can you infer about expected inflation in Canada and in
the United States?
i = r + πe
Fisher equation for Canada and United States:
e
12 = r + πCan
e
8 = r + πUS
This implies that expected inflation in Canada is four percentage points higher than in the
United States:
e e
πCan − πUS =4

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Problem 11
G. Mankiw, Chapter 6, p. 165

(b) What can you infer about the expected change in the exchange rate between the Canadian
dollar and the U.S. dollar?
PCan
ε nom = ε real ·
PUSA
The change in the nominal exchange rate:

∆ε nom ∆ε real
= real + πCan − πUSA
ε nom ε
We know that if purchasing-power parity holds, than a dollar must have the same purchasing
power in every country. This implies that the percent change in the real exchange rate is zero
because purchasing-power parity implies that the real exchange rate is fixed. Thus, changes in
the nominal exchange rate result from differences in the inflation rates in the United States and
Canada:
∆ε nom
= πCan − πUSA
ε nom

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Problem 11
G. Mankiw, Chapter 6, p. 165

Because economic agents know that purchasing-power parity holds, they expect this
relationship to hold. In other words, the expected change in the nominal exchange rate equals
the expected inflation rate in Canada minus the expected inflation rate in the United States:
∆ε nom e e
= πCan − πUSA =4
ε nom
(c) A friend proposes a get-rich-quick scheme: borrow from a U.S. bank at 8 percent, deposit
the money in a Canadian bank at 12 percent, and make a 4 percent profit. What’s wrong with
this scheme?

The problem with your friend’s scheme is that it does not take into account the change in the
nominal exchange rate between the U.S. and Canadian dollars. Given that the real interest rate
is fixed and identical in the United States and Canada, and given purchasing-power parity, we
know that the difference in nominal interest rates accounts for the expected change in the
nominal exchange rate between U.S. and Canadian dollars.

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Problem 11
G. Mankiw, Chapter 6, p. 165

In this example, the Canadian nominal interest rate is 12 percent, while the U.S. nominal
interest rate is 8 percent. We conclude from this that the expected change in the nominal
exchange rate is 4 percent.
εtnom = 1$Can /$US
nom
εt+1 = 1.04$Can /$US
Assume that your friend borrows 1 U.S. dollar from an American bank at 8 percent, exchanges
it for 1 Canadian dollar, and puts it in a Canadian Bank. At the end of the year your friend will
have $1.12 in Canadian dollars. But to repay the American bank, the Canadian dollars must be
converted back into U.S. dollars. The $1.12 (Canadian) becomes $1.08 (American), which is
the amount owed to the U.S. bank. So in the end, your friend breaks even. In fact, after paying
for transaction costs, your friend loses money.

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Problem 6. Long-run equilibrium with two types of consumers
Exam 2021, Part 2

Consider an economy with two types of consumers: patient and impatient ones. Patient
consumers have the following linear consumption function: C p (Y p − T p ) = c0 + c1p (Y p − T p ),
where Y p − T p denotes disposable income of patient consumers, c0 and c1p are constants.
Impatient consumers have higher marginal propensity to consume and their consumption
function is given by C im (Y im − T im ) = c0 + c1im (Y im − T im ) with c1im > c1p . Investment demand
function is given by I (r ) = i0 − i1 r .
Assume now that this economy is closed and c0 = 200, c1p = 0.6, c1im = 0.8, i0 = 450, i1 = 25,
Y p = Y im = 2500, T p = T im = 1000, G = 2200.

Assume now a small open economy model with the same parameters. The world real interest
rate is equal r ∗ = 4 and net export is given by the following function: NX (ε) = nx0 − nx1 ε,
where epsilon is a real exchange rate, nx0 = 200 and nx1 = 40.

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Problem 6. Long-run equilibrium with two types of consumers
Exam 2021, Part 2

(3) Compute saving of patient and impatient consumers, total private and public saving,
national saving, real interest rate, investment, net export and real exchange rate in this small
open economy when T p = T im = 1000. Illustrate using graphs.

From Section 4 we know that S p = 400, S im = 100, S priv = 500, S pub = −200, S nat = S = 300
Investment is determined by the world real interest rate: I = I (r ∗ ) = 450 − 25 · 4 = 350

Thus, Nx = S − I (r ∗ ) = 300 − 350 = −50

Nx(ε) = −50 = 200 − 40 · ε

ε1∗ = 6.25

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Problem 6. Long-run equilibrium with two types of consumers
Exam 2021, Part 2

(4) Now consider a small open economy with a new lump-sum tax and transfer, so T im = 1500
and T p = 500. Compute saving of patient and impatient consumers, total private and public
saving, national saving, real interest rate, investment, net export and real exchange rate for this
new equilibrium. Explain the differences with respect to closed economy. Illustrate using graphs.

From Section 4 we know that S p = 600, S im = 0, S priv = 600, S pub = −200, S nat = S = 400
Investment is determined by the world real interest rate: I = I (r ∗ ) = 450 − 25 · 4 = 350
Thus, Nx = S − I (r ∗ ) = 400 − 350 = 50

Nx(ε) = 50 = 200 − 40 · ε

ε2∗ = 3.75

Higher saving with constant investment means larger net outflow of capital, i.e. increasing
demand for foreign assets and foreign currency. That drives down real exchange rate.

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Problem 6. Long-run equilibrium with two types of consumers
Exam 2021, Part 2

Graphs for 3 (LHS) and 4 (RHS):

S − I (r ∗ ) S1 − I (r ∗ ) S 2 − I (r ∗ )
ε ε

Nx Nx

1 6.25 1
6.25
2
3.75

Nx Nx
−50 −50 50

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