Edouard Schaal

Spring 2016
Econ-UA 12: Intermediate Macroeconomics
Problem Set 5

This problem set is due Wednesday, April 13th in class at the end of the lecture. You are allowed
to discuss the problems with your classmates. It is, however, in your best interest to try to solve
these problems by yourself first.

Part A. ABC Exercises

Chapter 4. Analytical problem 1. Use the saving-investment diagram to analyze the eects of
the following on national saving, investment, and the real interest rate. Explain your reasoning.
1. Consumers become more future-oriented and thus decide to save more.
2. The government announces a large, one-time bonus payment to veterans returning from a war.
The bonus will be financed by additional taxes levied on the general population over the next
five years.
3. The government introduces an investment tax credit (oset by other types of taxes, so total
tax collections remain unchanged).
4. A large number of accessible oil deposits are discovered, which increases the expected future
marginal product of oil rigs and pipelines. It also causes an increase in expected future income.
Chapter 7. Numerical problem 5. Consider an economy with a constant nominal money supply,
a constant level of real output Y = 100, and a constant real interest rate r = 0.10. Suppose that
the income elasticity of money demand is 0.5 and the interest elasticity of money demand is -0.1.
[Hint: please read section 7.5, pp.268-269 in ABC].
1. By what percentage does the equilibrium price level dier from its initial value if output
increases to Y = 106 (and r remains at 0.10)?
2. By what percentage does the equilibrium price level dier from its initial value if the real
interest rate increases to r = 0.11 (and Y remains at 100)?
3. Suppose that the real interest rate increases to r = 0.11. What would real output have to be
for the equilibrium price level to remain at its initial value?

Part B. Corporate Taxation

We study the eect of corporate taxation on investment. Let us consider the basic model of investment that we studied in class. Firms choose their investment and their future level of capital stock
to maximize their profits. We now assume that a government imposes a tax on firms: they have to
pay a fraction t of their total output in taxes. Their future real profits can now be written as:
f = (1

t)Af K f

0.5

Nf

0.5

ucf .K f

wf .N f .

Assume that the price of capital is constant over time pK = pfK = 1. The interest rate, r, equals 5%
and the depreciation rate, d, equals 15%. In addition, assume that future total factor productivity,
Af , equals 1 and the initial capital stock, K, equals 10.
1

1. Assume for now that future labor, N f , is fixed, so that we can ignore the terms related to
labor. Discuss the eect of tax t on the desired future capital stock on a graph with K f on the
x-axis. Explain the economic intuition behind this result. [Hint: The graph should be similar
to what we studied in class: you will plot the net sales of the firm for two cases, one in which
t = 0 and one in which t > 0, as well as the total cost of using capital ucf .K f ]
2. We will now verify this result analytically. Derive the first-order condition that characterizes
the optimal choice of future capital K f . [Do not solve yet]
3. For t = 0 and N f = 2, compute numerically the optimal future capital stock and level of
investment.
4. For t = 10% and N f = 2, compute numerically the optimal future capital stock and level of
investment.
5. Are your answers to questions (3) and (4) consistent with the result obtained in question (1)?
6. We have assumed so far that N f remains fixed. This will not be true in equilibrium. Using
what you have learned about labor markets, what would be the eect of the corporate tax on
N f ? How would this aect your answer to question (4)? [No derivation necessary, just explain
with words what would happen]

Part C. Cagans Model of Seignorage

Consider an economy in which the money demand function is given by
M
= L(Y, r + e ) = Y e
P

a(r+ e )

where Y is real income, r is the real interest rate, e is the expected rate of inflation and a > 0
a constant parameter that describes how quickly the money demand reacts to interest rates. We
focus on the case where prices move much faster than Y and r, so we will treat the latter two as
constant. Our objective in this exercise is to understand why some countries can experience high
rates of inflation and why governments choose policies that lead to such situations.
There are dierent reasons why inflation may sometimes be desirable from the point of view of
a government. The explanation we consider here is that government use the inflation tax to raise
revenue. Printing money is indeed a rather quick and easy way for the government to raise revenue
without increasing taxes. We call seignorage the revenue generated by money creation. We can
write the real revenue from seignorage as
M
P

S=
where

M is the increase in the money supply.

1. Assume the money supply increases at a constant rate g = MM . For simplicity, let us also
assume that inflation expectation are fixed at e = 0 for now. What would be the rate of
inflation in this economy? How does it relate to the growth rate of money supply g?
Now, the assumption that expectations of future inflation are fixed may be fine in the short run, but
certainly not in the long run. At some point, people should come to realize that there is inflation
and should adjust their expectations.

2. Assume that people have adaptive expectations and that their expectations converge to the
actual rate of inflation in the long run. Assume, in addition, that the actual long run rate of
inflation is constant:
e ! .
What is the only long run rate of inflation consistent with these beliefs? How does it relate to
the growth rate in the money supply g?
3. How does your answer in (2) dier from (1)? Do your answers seem consistent? What needs
to adjust between question (1) and (2) to ensure that the equilibrium is reached in the money
market? [Hint: the inflation rate is only determined in the long run; in the short run, prices
are free to adjust in a specific way to be consistent with both questions.]
4. The government chooses the growth rate of the money supply to maximize seignorage revenue.
Write the real seignorage revenue as
S=

M
M
=

P
|M
{z }
=g

M
.
P
|{z}

=Y e

a(r+)

Substitute in the above expression the value you found for the long run inflation rate as
a function of g. Derive the first order condition with respect to g. What is the level of
money creation that maximizes real seignorage revenue for the government? What is the
corresponding optimal inflation rate? Is it positive?
The temptation of printing money to generate seignorage revenue is great in countries with fiscal
problems. This explains why we often observe high rates of inflation in countries with large budget
deficits. This, of course, can be quite dangerous, since governments do not necessary internalize the
negative impact that inflation could have on the economy the most dramatic consequence being
a hyperinflation. To prevent such problems, most industrialized economies have made their central
banks independent from the government.