Test Question 1:
a. Since growth rates of the money supply and price levels are measured in
compounded annual amounts, on a normal scale the money supply and price
levels would both increase exponentially…even with constant growth rates. Since
logarithms and exponential functions are inverses of each other, making the
vertical axis a log. (proportional) scale takes the exponential increase out of the
graph and replaces it with a linear increase. The slope of the M and P lines then
represents the growth rates.
b.
dashed line = M; solid line = P
c. The amount of money that people want to hold (their demand for money) for
transaction purposes decreases as the cost of holding money increases and
increases as the cost of holding money decreases. One element in the cost of
holding money is the nominal interest rate. So, as the money supply goes from
growing at 5% to 2% (as in (i)), the amount of money that people want to hold
suddenly jumps from the amount desired when the interest rate includes a 5%
expected inflation to a greater amount desired when the interest rate includes 2%
expected inflation. So, right at time T, people suddenly want to hold more money
and do so by suddenly curtailing their purchases until they achieve the desired
higher level of money balances. Though the decrease in demand will cease as
soon as peoples’ desired money balance holding are restored, the transitional
effect will be for prices to fall (jump) to clear the immediate inventory glut. In (ii),
in a deflation, people are willing to hold much more money than in an inflation,
so as we move from deflation to inflation, people attempt to suddenly decrease
their money holdings…by spending it. That transitional spending is manifested
by a suddent (but short-lived) increase in demand…which causes prices to
“jump” up. In (iii) We know that doubling the money supply doubles prices, so
the “jump” takes place when that occurs regardless of the growth rates of M
before and after the jump in M.
Test Question 2:
The VAT is a consumption tax. A tax on consumption will raise the effective price; it
will now take (1+c) to purchase consumer goods. The household budget constraint can
be written as:
(1+c)C+(1/P)B+K=(w/P)Ls+r(B/P +K) + V-T
The tax on consumption (but not on leisure) reduces the effective opportunity cost of
leisure in terms of current (and future) consumer goods. This caused the substitution
away from labor and into leisure. In other words, the labor supply would decrease by
the substitution effect. The reduction in the labor supply would reduce the marginal
product of capital services. Capacity utilization rates and real interest rates would fall.
Decreases in L and K (utilization rates in the short and long runs; actual capital over the long
run) will cause real income, Y, to fall. The decrease in interest rates induces intertemporal
substitution effects. Current consumption is less expensive than future consumption, so
current consumption increases relatively and real savings decreases.
Test Question 3:
a.
The price level increases. The pandemic does not destroy money, but causes the
demand to hold money to decline. As survivors try to reduce their real money
balances, price levels increase. Both labor and capital utilization falls. The pandemic is
also an external shock to the system (can be treated as a reduction in technology, A). In
any case, real income falls, but because decreasing marginal returns to both labor and
capital, the decrease in Y is less than proportional to the decrease in population, so per
capita real income increases among survivors. [Note: do not try to determine the price
level in the market for consumption goods, C; we have learned that market is affected
by relative prices, not the price level.]
b.
The pandemic reduces the labor force causing labor supply to decrease. MPL
(curve, not level) is basically unchanged (rebound effect decreases it a bit) so real wages
increase and income per laborer increases.
c.
The decrease in labor causes the MPK curve to decrease (shift down and to the
left). This causes R/P to decrease and capital utilization rates to decline. Though
depreciation declines, it does not fall as much as R/P. Since r = (R/P)*k – depreciation,
the real interest rate falls. Since the price level increase is a one-time occurrence, the
nominal interest rate falls with the real rate (no long-term inflation).
d.
Capital utilization rates decline (since there is less labor and the amount of
capital in initially unchanged). Over the longer term, the capital stock will decline
slightly as savings rates fall (due to the decrease in the real interest rate and the smaller
population base of savers) though depreciation also declines. This is because you do
not need as much capital to sustain the reduced level of GDP.