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Correct_Midterm_II_Econ_110_Spring_2010_Solutions_with_all_graphs

# Correct_Midterm_II_Econ_110_Spring_2010_Solutions_with_all_graphs

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1 In signing the following, I am pledging to uphold the Duke University honor code. Signature: _____________________ Name: _____________________ Duke University Professor Michelle Connolly Department of Economics Spring 2010 Econ 110D: Intermediate Macroeconomics Midterm II Make sure to use a different exam book for parts I and II. The exam has a total of 100 points. I. Inflation. (55 pts) a. (7 pts) Consider the Inflation Laffer Curve. What is seignorage and how does the rate of money growth affect the revenue maximizing level of seignorage? The government prints money as a source of revenue. Revenue from seignorage is t t t t t t t t t t P M P M M M M P M M = = + + µ 1 1 Therefore seignorage is tax of money holdings at rate, µ . People who hold money pay the tax since printing decreases the purchasing power of the money held by the people. For given money balances, M/P, as the tax rate, µ , increases so do revenues. So at low rates of money growth, the government can increase seignorage revenues by increasing the rate of money growth. However, as µ becomes large, people respond by decreasing their money holdings, M/P, and thereby decrease the seignorage revenue. For parts b-g, assume that r* and Y* are given and fixed. Seignorage Tax Revenues = µ·M/P 0 µ * µ Tax rate As µ ↑, M/P ↓. So at low values of µ as µ ↑ (µ·M/P) ↑ implying that government revenues ↑. After µ * , any further ↑ in µ is more than offset by ↓ in M/P implying a decrease in government revenues.

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2 b. (6 pts) Suppose that at time T 0 , the government unexpectedly increases the rate of money growth from 10% to 30%. What immediately happens to the price level at time T 0 ? What happens to the inflation rate? Use a GRAPH as part of your answer and explain why these things are happening. c. (3 pts) Is money superneutral? Why or why not? Money is not super neutral because changes in the growth rate of money affect the level of real money demand. Only if it had no effect on real variables would it be superneutral. d. (8 pts) Now suppose that at time T 0 , the government announces that at time T 1 , it will increase the rate of money growth from 10% to 30%. What will immediately happen to the price level at time T 0 ? What will happen to the inflation rate at time T 0 ? What will happen to the price level and the inflation rate at time T 1 ? Are the inflation rate and the rate of money growth equal between T 0 and T 1 ? Use a GRAPH as part of your answer and explain why these things are happening. T 0 T 1 t There is a discreet jump up in P since π e immediately => Φ(·) ↓. As approach T 1 , π e ↑ even further since π e continues to ↑ → Φ(·) ↓ even further so that at T 1 there is no jump in P just a further ↑ in π. Between T 0 and T 1 , π > µ. I.e. just knowing that money growth will increase in the future is enough to start increasing inflation today.
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