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answers_1_3140 - York University Department of Economics...

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York University Department of Economics ECON 3140N Monetary Economics Professor Tasso Adamopoulos Answers to Problem Set 1 January 29, 2006 1. Answers to Exercises 1.1, 1.3, 1.4 from Champ and Freeman (Ch.1, pp.27-29), are at the end. 2. The problem for every young member of future generations is to find a way to acquire consumption goods in the second period of life. In a decentralized environment, such acquisitions can occur only through mutually beneficial bilateral trades. A currently young member of future generations can potentially trade with individuals alive in the current period, that is, other young individuals or the old individuals. No mutually beneficial trade can take place between young individuals of the same cohort because they are all alike and they are all trying to do the same thing, namely acquire goods in the future. Further, no mutually beneficial trade can take place between a young and a currently old individual because the young has what the old wants but the old does not have what the young wants. A currently young individual would want to trade with a young individual of the next period because that individual will have the goods the currently young wants. The problem, however, is that the young individual of the next cohort has no interest in trading with the current young because he is not around today. This lack of double coincidence of wants in cross-generational trades is what prevents trades and allows money to arise naturally as a medium of exchange. Thus, market incompleteness is the main friction in the overlapping generations model: markets between currently alive and future generations do not exist. 3. The statement is false. An infinite horizon (economy goes on forever) is a necessary condition but it is not sufficient for money to be valued. Why is it necessary? Suppose 1
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that it was known that the economy does not go on forever, i.e., there is some future period T in which the world would come to an end. Then money would not be valued today. To see this: in period T no one would be willing to give up something valuable in exchange for money because there is no period T +1 to use the money to trade. Thus money will be valueless in period T . Similarly, money will be worthless in period T - 1 because nobody will want to hold money into period T , in which we showed money would have no value. By a similar logic money will be worthless in all earlier periods up to the present. Why is the condition of an infinite horizon not sufficient? The reason is that people have to believe in money in order for money to get off the ground. So even if the economy goes on to eternity if is not complemented by an infinite structure of beliefs in the value of money, money will have no value today. If individuals believe that someone down the road in a sequence of trades, will not have faith in money and thus will not accept it in transactions, money will be valueless in all earlier periods.
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