Problem Set 7
Problem 1
. Endogenous Money Supply
1. Revisit model with exogenous money supply  Analyze the e
ff
ect of an
increase in A.
Remember that the procedure to evaluate the impacts in the economy
consists of the following steps:
fi
rst, determine what happens in the real side
of the economy, i.e., what happens to real interest rate; second, determine
how the equilibrium in the future asset markets is a
ff
ected;
fi
nally, given
the
fi
rst and second steps, evaluate what happens with current asset market
equilibrium.
Let’s
fi
rst determine what happens to r.
Figure 1:
Since
S
d
(
r/A, K, G, G
f
) is a
ff
ected positively by A, the savings increase,
so that for each level of r we have now a higher level of savings which is
represented by the shift of S to the right. The equilibrium is given by
S
=
I
,
so the new equilibrium real interest rate decreases, as can be seen in the
fi
gure above.
The second step is to determine how the future asset market equilibrium
is a
ff
ected.
We have that:
P
f
=
M
s,f
L
(
Y
f
)
=
M
s,f
L
(
A
f
F
(
K
f
(
r
)
,
)
N
f
)
1
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Since we have a higher level of investment,
K
f
increases, which implies
that
Y
f
increases, increasing the demand for future real balances. Since the
supply of future real balances is kept constant this implies that
P
f
has to
decrease. The intuition for this is that with a higher income in the future
period there is a higher demand for real balances but the supply of money
does not change. So the only way the supply of real balances (
m
s,f
=
M
s,f
P
f
)
increases is when the prices decrease.(so,
P
f
decreases).
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 Fall '07
 BjoernBruegemann
 Macroeconomics, Inflation, Supply And Demand, Procyclical Procyclical Procyclical Countercyclical Countercyclical Procyclical Acyclical Countercyclical Af Procyclical, Procyclical Procyclical Procyclical Acyclical Procyclical Procyclical Procyclical

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