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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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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 onetime 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 percapita 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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 Spring '08
 SchmittGrohe
 Macroeconomics, Inflation, Supply And Demand, money demand, real money demand

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