Fall 06 Midterm I Solutions

Fall 06 Midterm I Solutions - Midterm I: Suggested...

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1 Midterm I: Suggested Solutions Econ 110 Fall 2006 100 points USE DIFFERENT BLUE BOOKS FOR PARTS I AND II Good luck. Part I: 50 points 1. (5 points) What could lead to an increasing elasticity of money demand with respect to the interest rate? Explain. If there is a fixed cost to shifting money into interest bearing assets, then the elasticity of money demand with respect to the nominal interest rate is low when that rate is also low and higher when the nominal interest rate is high. 2. (5 points) The Fed has suggested that it should pay interest on Federal Reserve Deposits. Why? Why does Congress not enact this? If interest is paid on Federal Reserve Deposits, the costs of financial intermediation will decrease. This will increase the amount of financial intermediation, thus generating a positive shock in the economy. Congress does not enact this because they don’t want to loose the money. 3. (8 points) Is it true that in a closed economy with no investment, a permanent shock to the economy will always leave the interest rate unchanged? Does the moment in which the permanent shock occurs make any difference in the answer? The statement is false. A permanent shock occurring today would not affect the interest rate in this setup. However if the household anticipates a future permanent shock to the economy they will want to smooth consumption in anticipation. This could affect the equilibrium interest rate. 4. (8 points) How does the volatility of C d depend on the planning horizon of the household? Give specific examples and speak both about permanent and temporary changes in output. If the change in output is permanent, a marginal propensity to consume is equal to one, regardless of the planning horizon length. However, for temporary changes in output, the volatility of consumption demand will be higher the shorter the planning horizon is. A temporary change in output, coupled with the desire to smooth the consumption pattern, will imply a marginal propensity to consume less than one, in order to spread the gains over future periods. If the planning
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2 horizon is shorter, there is no need to save as much and consumption will adjust more in the current period. 5. (10 points) Suppose a plague leads to a one-time decrease in population. Those who survive are the same as those who died in terms of tastes. Money supply is unchanged. Assume that equilibrium MPL is exactly the same as before. What happens to aggregate output, Y, work effort, L, the real interest rate, r, and the price level, P? Since all people had the same productivity and tastes, no per-capita variables will change. That is, output per capita, work effort per capita, and real money demand per capita will remain the same. Since there are now fewer people, the aggregate level of each of these quantities will have fallen by the same proportion as did the population. Thus, if the population is x percent of the initial value, aggregate output, work effort, and real money demand are also now
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This note was uploaded on 05/22/2010 for the course ECON 110D taught by Professor Schmitt-grohe during the Spring '08 term at Duke.

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Fall 06 Midterm I Solutions - Midterm I: Suggested...

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