Econ303 Homework Assignment 3 Fall 2014
Econ303 Homework Assignment 3 Fall 2014 Due Thursday October 23 Name: Section: 1. Suppose a country has a money demand function , where k is a constant parameter. The money supply grows by 12 percent per year, and the real income grows by 4 percent per year. a. What is the average inflation rate? b. How would inflation be different if real income growth was higher? Explain. c. How do you interpret the parameter k? What is its relationship to the velocity of money? d. Suppose, instead of a constant money demand function, the velocity of money in this economy was growing steadily because of financial innovation. How would that affect the inflation rate? Explain.2 2. Suppose that the money demand function takes the form a. If output grows at rate g, at what rate will the demand for real balances grow (assuming constant nominal interest rate)? b. What is the velocity of money in this economy? c. If inflation and nominal interest rates are constant, at what rate, if any, will velocity grow?3 3. In each of the following scenarios, explain and categorize the cost of inflation. a. Because inflation has risen, the L.L. Bean Company decides to issue a new catalogue quarterly rather than annually. b. Grandma buys an annuity for $100,000 from an insurance company, which promises to pay her $10,000 a year for the rest of her life. After buying it, she is surprised that high inflation triples the price level over the next few years. c. Maria lives in an economy with hyperinflation. Each day after being paid, she runs to the store as quickly as possible so she can spend her money before it loses value. d. Warren lives in an economy with an inflation rate of 10 percent. Over the past year, he earned a return of $50,000 on his million dollar portfolio of stocks and bonds. Because his tax rate is 20 percent he paid $10,000 to the government. e. Your father tells you that when he was your age, he worked for only $3 an hour. He suggests that you are lucky to have a job that pays $7 an hour.4 4. Use the model of small open economy to predict what would happen to the trade balance, the real exchange rate, and the nominal exchange rate in response to each of the following events. a. A fall in consumer confidence about the future induces consumers to spend less and save more. b. A tax reform increases the incentive for businesses to build new factories. c. The introduction of a stylish line of Toyotas makes some consumers prefer foreign cars over domestic cars.5 d. The central bank doubles the money supply. e. New regulations restricting the use of credit cards increase the demand for money. 5. Consider an economy described by the following equations: 6 a. In this economy, solve for national saving, investment, the trade balance, and the equilibrium exchange rate. b. Suppose now that G rises to 1,250. Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find. c. Suppose now that the world interest rate rises from 5 to 10 percent. (G is again 1,000.) Solve for national saving, investment, the trade balance, and the equilibrium exchange rate. Explain what you find.7 6. You read in a newspaper that the nominal interest rate is 12 percent per year in Canada and 8 percent per year in the United States. Suppose that international capital flows equalize the real interest rates in the two countries and that purchasing-power parity holds. a. Using the Fisher equation, what can you infer about expected inflation in Canada and in the United States? b. What can you infer about the expected change in the exchange rate between the Canadian dollar and the U.S. dollar? c. A friend proposes a get-rich-quick scheme: borrow money from a U.S. bank at 8 percent, deposit the money in a Canadian bank at 12 percent, and make a 4 percent profit. What’s wrong with this scheme?