452 OVS Intermediate Macroeconomics II
VSE, Spring 2009
Ex. session #2
Eva Hromdkov
Exercise session #2 - Consumption; Money and ination
Problem 1 - Eect of increase in interest rate for net borrower
In the lecture, we have used Fisher model to explain the eect of an increase in
the interest rate for the consumer who was net saver. Suppose that consumer is a net
borrower. How does this alter the analysis. What can you tell about the dierences in
the income and substitution eect between the two types of consumers?
Problem 2
Gurgen and Marek both obey the two-period Fisher model of consumption. Gurgen
earns $100 in the rst period and $100 in the second period. Marek earns nothing in
the rst period and $ 210 in the second period. Both of them borrow or lend at interest
rate r.
You observe both Gurgen and Marek consuming $100 in the rst period and $100
in the second period. What is the interest rate r?
Suppose the interest rate increases. What will happen to Gurgen's consumption
in the rst period? Is Gurgen better o or worse o then before the interest rate
rise?
What will happen to Marek's consumption in the rst period when the interest rate
increases? Is Marek better o or worse o then before the interest rate increase?
Problem 3
We have seen the analysis for the case when consumer can save and borrow at the same
interest rate r. Consider now that consumer can save at rate rs and borrow at rate rb
where rs < rb .
What is the consumer's budget constraint in the case that he consumes less than
his income in period one?
What is the consumer's budget constraint in the case that he consumes more than
his income in period one?
Graph the two budget constraints and nd all the combinations of rst-period and
second-period consumption the consumer can choose.
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Add consumer's indierence curves. Show three possible outcomes - one in which
the consumer saves, one in which the consumer borrows and one in which he neither
saves or borrows.
What determines rst period consumption in each of the three cases?
Money demand models - micro level: in general macro level
M
P
D
= L(Y, r + e )
How to model demand for money on micro level?
2 out of 3 functions of money create the demand:
1. Portfolio theories of money demand: money as store of value
people choose to hold money as a part of their portfolio of assets (money oers
safe return compared to bonds or stocks)
MD
= L(rs , rb , e , W )
P
where rs is expected return on stock, rb is expected return on bond, e is
expected ination and W is stock of wealth
basic equation = simplication, as Y W and i = rb + e
relevance depends on measure of money analyzed: no useful for M1 - low or
no return, applicable on M2 or M3
2. Transaction theories of money demand: money as medium of exchange
people hold money in order to be able to make purchases
Baumol - Tobin model of cash benet management:
of holding money - convenience
cost of holding money - foregone interest on deposits
formal derivation on exercise session
microeconomic justication for
M
P
2
D
= L(Y, i)
Questions for review:
Lecture 3: Consumption:
What were Keynes's three conjectures about the consumption function?
Write down the formal notation of consumption function that satises all three
Keynes's conjectures.
Explain dierences among cross-section, time series and panel data (give an exam-
ple of each).
Describe empirical evidence that was consistent with Keynes's conjectures.
Describe empirical evidence that was inconsistent with Keynes's conjectures.
How would you dene intratemporal and intertemporal budget constraint?
What is the eect of change in income within the framework of Fisher model?
What is the eect of change in interest rate within the framework of Fisher model?
Explain income eect.
Explain substitution eect.
How does life-cycle model explain contradictory evidence concerning consumption
behavior?
Explain dierence between permanent and transitory income. Which one deter-
mines the level of consumption and why?
How does permanent-income model explain contradictory evidence concerning con-
sumption behavior?
What is random walk (give denition or simple explanation)?
Why are changes in consumption unpredictable if consumers act according to per-
manent income hypothesis and have rational expectations?
Give an example in which somebody exhibits time-inconsistent preferences (other
than on the lecture).
Summarize determinants of the current level of consumption.
Lecture 4: Money and ination
Dene money.
What are the three main functions of money?
What are the two basic types of money?
How did money evolved in the historic context (very short :-))?
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Who regulates money supply in the Czech republic?
Dene monetary aggregate M 1. Would you say it satises all functions of money?
Dene monetary aggregate M 3. Would you say it satises all functions of money?
What are the reserves? What is their role in the regulation of money supply in the
economy?
How can banks create money?
Based on the simple model presented at lecture, what are the main determinants
of money supply in the economy (+ who are the agents)?
What is monetary base?
State three basic instruments of monetary policy. Can you state some more?
Write down quantity equation and explain what it represents.
What does the assumption of constant income velocity of money imply?
What is Fisher eect?
List all the costs of ination and rank them according to their severity (in your
opinion).
Who pays the taxation tax?
Explain the role of monetary and scal policy in causing and ending hyperination.
What is seignorage?
Dene real variables and nominal variables, give example.
Explain the concept of neutrality of money.
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