HE2002 Tutorial 9

April 3, 2014
1. The government decides that the use of credit card is bad, and introduces a tax on credit card balances. That is, if a consumer or rm holds a credit card balance of X (in real terms), he or she is taxed tX , where t is the tax rate. Determine the effects on the equilibrium quantity of credit card balances, the demand for money, and the price level. Explain your results.

2. Suppose, in the Friedman-Lucas money surprise model, that there are monetary demand shocks and shocks to total factor productivity. Neither private sector economic agents nor the central bank can observe monetary demand shocks directly. Private sector economic agents cannot observe productivity shocks. However, the central bank can observe productivity shocks. How should the central bank conduct monetary policy? Discuss.

3. Assume that there are no surprises, with all economic agents and the central bank having full information about shocks that are hitting the economy. Suppose that the central bank adopts a nominal GDP target, and interpret this in the model as a goal of maintaining some constant level of nominal GDP. (a) Suppose that there is an increase in total factor productivity. What should the central bank do in response, given its goal? What are the effects on aggregate variables? Explain. (b) Now suppose that there is a positive shift in the money demand function. What should the central bank do? Determine the effects on aggregate variables. Explain. 4. Suppose that there is limited commitment in the credit market, but lenders are uncertain about the value of collateral. Each consumer has a quantity of collateral H , but from the point of view of lender, there is a probability a that the collateral will be worth p in the future period, and probability 1 a the collateral will be worthless in the future period. Suppose that all consumers are identical.
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(a) Determine the collateral constraint for the consumer, and show the consumers life-time budget constraint. (b) How will a decrease in a affect the consumers consumption and savings in the current period, and consumption in the future period? Explain your results. 5. Suppose that all consumers are identical, and also assume that the real interest rate r is xed. Suppose that the government wants to collect a given amount of tax revenue R, in present value terms. Assume that the government has two options: (i) a proportional tax of s per unit of savings, in that the tax collected per consumer is s(y c); (ii) a proportional tax u on consumption in the current and future periods, so that the present value uc of the total tax collected per consumer is uc + 1+ r . Show that option (ii) is preferable to option (i) if the government wishes to make consumers as well off as possible, and explain why this is so. 6. A consumer receives income y in the current period, income y in the future period, and pays taxes of t and t in the current and future period, respectively. The consumer can lend at the real interest rate r. The consumer is given two options. First, he can borrow at the interest rate r but can only borrow an amount x or less, where x < we y + t. Second, he can borrow an unlimit amount at the interest rate r2 , where r2 > r. Show which option the consumer chooses, and explain your results.