ECO 3355-001: Money and Banking

Southern Methodist University

Exam 1

Answer Key
Total Points 100

1. (50 points) Consider the following overlapping generations economy where

1. Each person is endowed with y1 when young and y2 when old. Note that y2 is
sufficiently small that everyone wants to consume more than y2 in the second
period of life.

2. Population is constant, n = 1;

3. Money stock is constant, z = 1;

4. The government finances the entire amount of government purchases (Gt= Ntgt)
through lump-sum taxation. A fixed tax of τ goods is collected from each young
person such that τ = g.

(a.) (10 points) Find the feasible constraint for central planners.

The number of young population at time t is Nt, each of them has endowment
y1. The number of old population at time t is Nt-1, and each of them has
endowment y2. There exist the government purchases of g goods per young
person in every period.

Total amount of consumption good at time t = Nty1 + Nt-1 y2.

N t c1,t + N t −1c 2,t + N t g ≤ N t y1 + N t −1 y 2 .

Dividing through both sides of this equation by Nt,

⎡N ⎤ ⎡N ⎤
c1,t + ⎢ t −1 ⎥ c 2,t + g ≤ y1 + ⎢ t −1 ⎥ y 2 .
⎣ Nt ⎦ ⎣ Nt ⎦

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Note that the population is constant, Nt = Nt−1, the feasible set under
stationarity is
c1 + c 2 + g ≤ y1 + y 2 .

(b.) (10 points) Set up the money-market clearing condition in period t and t+1
(supply of fiat money equals to demand for fiat money). Find the rate of return on
fiat money, υ t +1 / υ t .

Money stock at any particular time is M. M units of money can acquire υM

A group of people who wants to obtain money at any particular time is young
people at that given time. Old people no longer want to have money; instead,
they want to have consumption of goods. Therefore, the consumption good
available for trade is young people’s endowment minus their first-period
consumptions and tax expenditure.

At time period t: υ t M t = N t ( y1 − τ − c1,t ).

N t +1 ( y1 − τ − c1,t ) nN t ( y1 − τ − c1 )
υ t +1 M t +1 zM t n 1
= = = = = 1,
υt N t ( y1 − τ − c1,t +1 ) N t ( y1 − τ − c1 ) z 1
Mt Mt
due to stationarity, constant money stock and population growth.

(c.) (10 points) Find the budget constraint for individuals when young and old,
and then obtain the lifetime budget constraint. Use the solution in (b.) for your
equation.

Besides consumption and money holding young people have to pay part of
their endowment for taxes in the first period. They also have endowment y2
in their second period of life in addition to money that they have been
holding from the first period.

First – period constraint: c1,t + υ t mt ≤ y1 − τ .

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Solving for mt and substituting it back into the first period constraint, we will
get the lifetime budget constraint:

⎡υ ⎤ ⎡υ ⎤
c1,t + ⎢ t ⎥ c 2,t +1 ≤ y1 + ⎢ t ⎥ y 2 − τ .
⎣υ t +1 ⎦ ⎣υ t +1 ⎦

Using the solution we found in part (b) together with the fact that τ = g in
this problem, the lifetime budget constraint becomes

c1,t + c 2,t +1 ≤ y1 + y 2 − g.

(d.) (10 points) Draw a graph represents both the feasible set and the budget set
with c1 on the x-axis and c2 on the y-axis. Indicate intercepts on both axes. Show
arbitrary indifferent curves for the future generations, and label your equilibria.

y1+y2-g

y1+y2-g

(e.) (10 points) Does the monetary equilibrium attain the golden rule allocation?
Explain.

The monetary equilibrium attains the golden rule allocation because the
budget set is identical to the feasible set. This implies that individuals in the
monetary equilibrium will choose the same (c1*, c2*) combination as the one
which maximizes the utility of all future generations.

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2. (50 points) Consider an overlapping generations economy where individual lives
for two periods. Each person is endowed with y1 when young and nothing when
old. Endowment cannot be stored. Population is growing at the rate n > 1. The
government raises revenue by printing more money at the rate z > n.

(a.) (10 points) What is the role of money in the economy?

Money is a medium of exchange. It provides a means for people to acquire

(b.) (10 points) Is the rate of return on fiat money (υ t +1 / υ t ) constant, increasing
or decreasing? Give an intuitive interpretation of your answer.

The rate of return on fiat money is equal to n/z (see the calculation in
question 1, part b). We are given that n > 1, and z > n. Therefore, n/z < 1; the
rate of return on fiat money is decreasing. It tells us that if one unit of good is
sold for money in period t, that amount of money will get us less than a unit
of good in period t+1.

(c.) (10 points) We know that the budget set does not coincide with the feasible
set in this case. Give an intuitive explanation why the budget set line is flatter than
the feasible set line.

In this case, the fiat money stock is growing at the rate z > n, and the rate of
return on fiat money is decreasing. Inflation discourages the consumption of
the c2, which can be acquired by money, in favor of the consumption of c1,
which can be acquired without money. Therefore, inflation alters the graph
of the budget set and makes it flatter than the feasible set line.

(d.) (10 points) Is monetary equilibrium efficient in this problem? Why? Or why
not?

The monetary equilibrium is not efficient when there is inflation. Since the
budget set does not coincide with the feasible set, there exists the other
equilibrium (golden rule allocation) which is preferred by all to the monetary
equilibrium.

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(e.) (10 points) Are there any other policies for the government to raise the
revenue without distorting the budget set?

Yes. The government can raise the revenue through lump-sum taxation.
Under this policy, the money supply can be held constant, and the budget set
is not distorted.

Extra Credits (5 points)

What is the objective of this course? How do we approach our study?

The objective of this course is to understand the economy with the presence
of money; the behavior of people who hold money and consequences of their
actions on economic variables. We approach the monetary economies
through construction of a series of model economies that replicate essential
features of actual monetary economies.