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Econ 154a Problem Set 7 Solution

# Econ 154a Problem Set 7 Solution - Problem Set 7 Problem 1...

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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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Econ 154a Problem Set 7 Solution - Problem Set 7 Problem 1...

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