Problem Set 7 Solutions

Problem Set 7 Solutions - Economics 3213 Answers to Problem...

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Economics 3213 Answers to Problem Set 7: Pocahontas Prof. Xavier Sala-i-Martin 1. Ratcliffe A. The costs of transacting between money and financial assets are any direct and indirect costs that consumers incur when transferring their interest-bearing financial assets, such as bank accounts, bonds, etc., into money, which they need for purchases. Direct costs include bank fees, broker fees, transportation costs to get to the bank, etc. Indirect costs include time spent to go to the bank or to make transactions, which represents forgone wages or forgone leisure. B. The introduction of ATMs makes it easier to convert interest-bearing assets, such as saving accounts, into money. Transaction costs are reduced, so consumers can afford to make more frequent transactions and keep less money in their pockets. Aggregate money demand is reduced. C. The model of money demand discussed in class assumes that people need money for purchases but would like to keep their wealth in interest-bearing assets. Consumers incur a cost each time they convert assets into money. Optimal money demand is found as a "compromise" between the desire keep as little money as possible and earn interest and the opposing desire to make as few transactions as possible and save on transaction costs. The introduction of ATMs lowers the transaction cost, so that consumers can afford to make more frequent transactions, keep less money at any point in time, and earn more interest. Aggregate money demand decreases. 2. Grandmother Willow A. The Walras Law does not say that the output market is in equilibrium all the time. If consumers are not optimizing, i.e. they are not exhausting their budget constraint, their demand for consumption may be less than the supply of output. Real consumption will be less than real output, and the goods market equilibrium condition C t = Y t will not hold. The problem here is that the budget constraint does not hold with equality. B. Neither does the Walras Law say that all markets are in equilibrium all the time. Take the three markets that we saw in class: output, money, and bonds. Suppose that the output market is in equilibrium but that the excess supply of money (money supply minus money
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