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In the context of the overlapping generation model, explain why if we allowed individuals to trade bilaterally (without money) there would be no trade? What is the friction that the introduction of money overcomes in the overlapping generation model? The problem for every young member of future generations is to find a way to acquire consumption goods in the second period of life. In a decentralized environment, such acquisitions can occur only through mutually beneficial bilateral trades.

A currently young member of future generations can potentially trade with individuals. No mutually beneficial trade can take place between young individuals of the same cohort because they are all alike and they are all trying to do the same thing, namely acquire goods in the future. Further, no mutually beneficial trade can take place between a young and currently old individual because the young has what the old wants but the sold does not have what the young wants.

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A currently young individual would want to trade with a young individual of the next period because the individual will have the goods the currently young wants. The problem, however, s that the young individual of the next cohort has no interest in trading with the current young because he is not around today. This lack of double coincidence of wants in cross-generational trades id what prevents trades and allows money to arise naturally as a as medium of exchange. Thus, market incompleteness is the main friction in the overlapping generations model: markets between currently alive and future generations do not exist.

Q Explain whether the following statement is true or false: “If the government has to finance a given stream of wasteful purchases of goods, then it should do so by renting money rather than raising lump-sum taxes because printing money is costless” The statement is false. Even though printing money at a constant rate has a low resource cost (the administrative cost of printing notes) in introduces a distortion on the activity of holding money. It causes inflation which erodes the real value of money (inflation tax).

The inflation tax induces people to change their behavior; they economies on their money holdings, and thus end up holdings less real money balance than is optimal for them (and less than they would hold in a world without inflation) Furthermore, the inflation tax is a proportional tax: the more money an individual holds, the more serve the loss in real value he will experience. A lump-sum tax, by definition takes away a fixed amount of goods from an individual, in a way that does not depend on any actions that the particular individual undertakes.

Thus the lump- sum tax does not induce people to alter their behavior. Under a lump-sum tax the welfare of future generations is maximized. Consequently the lump-sum tax is Q. Suppose that the dollar and the pound are perfect substitutes, and there are no reign currency controls between the two countries. Explain why the British government might have an incentive to inflate The value of a unit of money is determined by the total world money supply and not the money supply of the issuing nation.

Therefore, an increase in the stock of one money reduces the value of all money and not Just the money whose supply is expanded. This can occur because people, indifferent between currencies in the absence of foreign currency controls, treat the different currencies as simply different denominations of a world money free to circulate in all nations. Therefore, it does not matter which denomination (which nation’s money) is increased during an expansion of the world stock of money; all currencies will fall in real value.

A nation that expands its money stock acquires revenue by lowering the value of the outstanding money stock, in effect by taxing money holders. The tax revenue is called seignior-age. In the presence of foreign currency controls, seignior-age can be collected from the citizens of other countries. It now follows that the British government has incentive to inflate because it would tax not only its own citizens, but citizens of other countries. Q. Explain whether the following statement is true or false: “The data indicate that in periods in which inflation was high output was high too.

The policy lesson from this empirical observation is that the government should increase the rate of at money creation whenever it wants to stimulate the economy The statement is false. If fails to account for the Lucas critique: when policy changes, individuals change their behavior in response to that policy. Thus reduced form correlations such as the ones mentioned in the question are subject to change when the “rules of the Ames” under which people make decisions change.

When the monetary authority causes surprise inflation it can manage to increase output because individuals are confused about the true state of the world. They MIS-interpret the increase in the price level caused the money stock as an increase output in the demand for their product, and produce more. If the monetary authority tries t exploit this, by permanently switching to an inflationary policy, rational people will realize this and individuals will choose to produce less to avoid the implicit taxation. Thus if the monetary authority continues to innate it will end up reducing output rather than increasing it.

Q. Suppose people in our overlapping generations model have the opportunity either to hold fiat money with complete safety or to lend to someone who may never repay the loan. The chance of such a default is 20 percent. Assume a stationary monetary equilibrium in which the population grows at a net rate of 8 percent and the fiat money stock is fixed. What real interest rate will be charged the borrower if people are risk neutral? What can you say about the level of the real interest rate if people are instead risk averse?

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