U6301 Macroeconomics for International and Public Affairs Martsella Davitaya
Columbia University | SIPA
Problem Set #7
Suggested Solutions
_____________________________________________________________________________
Deadline. 11:59 pm April 9, 2024
Instructions. The electronic version (either scanned or typed up) of solutions must be uploaded to
CourseWorks by the indicated deadline. Solutions submitted after the deadline will receive 0 points.
Solutions submitted via email will receive 0 points. Solutions can be submitted individually or by a
group of up to 4 students. You can work in a group with students from sections 1, 2, 3, and 4 only. If
you work in a group, please indicate all names and UNI-s on top of the first page.
Problem 1. Pure Gold
Suppose the Federal Reserve decides to sell to the public $1 million worth of the gold sitting its vaults
in New York.
a) Illustrate this sale on the typical balance sheet of the Central Bank.
Assets Liabilities
• Monetary Base ↓
• Foreign Assets o Currency
o Gold ↓ o Commercial Banks’ Reserves
o Foreign currency • Deposits of Treasury
o Foreign securities
• Domestic Assets Net Worth
o Loans to commercial banks
o Treasuries
o Other domestic assets
b) How would the sale of gold affect the U.S. money supply?
This would reduce the money supply, just like the sale of government securities through open market operations.
Problem 2. Money Supply
Recall that money supply aggregate, M1, is defined as M1 = Currency + Deposits. All else being equal,
how would each of the following affect the M1? Explain.
a) The maximum number of checks per month that can be written on money-market funds is raised
from three to thirty. (Hint: A money market mutual fund account is considered an investment, and
it is not a savings or checking account, even though some money market funds allow you to write
checks.)
People would probably take money out of checking accounts (deposits) and put it into money market mutual
funds. Money market mutual funds are included in M2 but are not part of M1. The result is a decrease in M1.
b) Home equity lines of credit that allow homeowners to write checks against the value of their homes
are introduced.
This would reduce M1, as people would have reduced need for money in checking accounts, and home equity lines
of credit are not included in M1.
c) The stock market crashes, and further sharp declines in the market are widely feared.
If people fear a stock market collapse, they will want greater liquidity, so they will hold more money. Also, since
stocks are an alternative asset to money, and the expected return to stocks has fallen, money demand will increase.
Both effects will lead to people investing less in stocks and more in cash, checking accounts, and other items that
provide liquidity and safety, so M1 rises.
d) Banks introduce overdraft protection, under which funds are automatically transferred from
money-market funds to checking as needed to cover checks.
People would have less need for money in checking accounts and would put more in money-market mutual funds.
So M1 will decrease.
e) A crackdown reduces the illegal drug trade (which is carried out largely in currency).
If currency demand falls, this decreases M1.
Problem 3. Money Demand
The income elasticity of money demand is 2/3 and the interest elasticity of money demand is -0.1. Real
income is expected to grow by 4.5% over the next year, and the real interest rate is expected to remain
constant over the next year. The rate of inflation has been zero for several years.
a) If the central bank wants zero inflation over the next year, what growth rate of the nominal money
supply should it choose?
Since inflation has been zero and the real interest rate is expected to remain constant, 𝑔! = 0. Therefore,
"
𝜋 = 𝑔"! − 𝜀# " 𝑔#
" $
To keep inflation at zero, the Central Bank should set 𝑔"! = 𝜀# " 𝑔# = % 4.5% = 3%.
b) By how much will velocity change over the next year if the central bank follows the policy that
achieves zero inflation? (Hint: velocity is defined as V=PY/M)
𝑔& = 𝜋 + 𝑔# − 𝑔"! = 0 + 0.045 − 0.03 = 1.5%
Problem 4. IS-LM and Short-Run Equilibrium
Throughout this question, assume that EconLand is a closed economy. The government of EconLand
was expected to increase taxes in April 2024.
a) Could the increase in taxes (assuming that they are lump-sum) have had no effect on the
consumption in EconLand? Explain in no more than one sentence.
Yes; this would happen under the Ricardian equivalence. Individuals will not change their consumption because
they anticipate the resulting lower taxes in the future. The change in tax would have no effect on individuals’
after-tax PVLR.
Suppose that the EconLand Government increased lump-sum taxes in April 2024.
b) Assuming that the Ricardian equivalence does not hold, how would the increase in lump-sum taxes
have affected
i. national saving
ii. government saving
iii. consumption
in the short run?
Government saving increases, consumption decreases, private saving decreases but by less than increase in taxes,
so national saving increases.
c) Illustrate the short-run effects of this tax increase on the EconLand’s saving and investment graph.
Indicate with A and B the equilibria before and after this shock.
S
r S’
A
rOLD
rNEW B
I
I
S = I S’= I’ S, I
Suppose that in April 2024 the risk on EconLand’s Government bonds dropped.
d) How would this drop in risk, and this shock only, have affected the EconLand’s
i. consumption
ii. investment
in the short run?
Consumption and investment increase.
e) Illustrate the short-run effects of this drop in risk on the EconLand’s asset markets graph. Indicate
with A and B, respectively, the equilibrium before and after this shock.
MS/P
r
rOLD A
rNEW
B
L
L’
iFF,OLD
Ms/P M/P
Suppose that EconLand was affected by two shocks in April 2024:
i. an increase in lump-sum taxes (assuming that the Ricardian equivalence does not hold) and
ii. a drop in risk on bonds
f) Illustrate the short-run effects of these two shocks on the Japanese IS-LM-FE graph if the combined
shocks are contractionary in the short run. Indicate with A, B, and C, the equilibrium before the two
shock, the short-run equilibrium, and the long-run equilibrium. Assume that A is at full
employment.
C
g) Under these circumstances, can you predict whether investment increases or decreases in the short
run? Explain in no more than one line.
Yes, investment increases because the real interest falls.