solutions exercise 4 - Monetary Macroeconomics Dr Pinar...

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Monetary Macroeconomics University of Zurich Dr. Pınar Ye¸ sin Spring 2008 Solutions to Exercise 4 1. Solve question 6 . 1 on pages 128 - 129 in your textbook. Suppose people in our overlapping generations model have the opportunity either to hold fiat money with complete safety or to lend to someone who may never repay the loan. The chance of such a default is 10 percent. Assume a stationary monetary equilibrium in which the population grows at a net rate of 8 percent and the fiat money stock is fixed. What real interest rate will be charged the borrower if people are risk neutral? What can you say about the level of the real interest rate if people are instead risk averse? First we calculate the gross rate of return of fiat money. In a stationary monetary equi- librium, it is equal to n z = 1 . 08 1 = 1 . 08. A risk neutral lender would be willing to make a loan if the expected real interest rate is equal to 1.08. Let r be the real interest rate that is paid when the loan is repaid. Then
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