Suggested Solution to Problem Set 5

Macroeconomics (Fall 2023)

Professor: Wonmun Shin

1 Nominal and Real Interest Rates

(a) Please refer to the lecture note for the detailed explanation.
i. (1 + r) units of goods
ii. You will receive Pt (1 + i) dollars from the bank. This amount of money makes you buy Pt
Pt+1 (1 + i) units
of goods.
iii.
Pt
1+r = (1 + i)
Pt+1

iv.
Pt+1 − 1 Pt+1
π= = −1
Pt Pt
Therefore, Pt+1 /Pt = 1 + π , and Pt /Pt+1 = 1
1+π .
v. By plugging the result in (iv) into the result in (iii):

(1 + i) = (1 + r) (1 + π)

(b) Since (1 + i) = (1 + r) (1 + π),

1+i
1+r =
1+π
1+i
→ r= −1
1+π

We know that i = 0.05 and π = 0.05. Therefore, the exact value of the real interest rate is:
1.05
r= −1=1−1=0
1.05
Real interest rate is zero.

(c) Since ination and the real interest rate are usually small (close to zero) for most countries, the product rπ
is even closer to zero.

1 + i = (1 + r) (1 + π)
= 1 + r + π + rπ
∼
=1+r+π (∵ rπ ∼
= 0)

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 Therefore,

i∼
=r+π or r∼
=i−π

(d) If i = 0.05 and π = 0.05, the approximate value of r is

r = 0.05 − 0.05 = 0

This is the same value we obtained in part (b). Intuitively, the nominal returns on deposits is completely
oset by ination. Hence, the real return on deposits is zero, no matter which formula we use.

(e) The exact value of r is r = 1.05/1.02 − 1 = 0.02941, and the approximate value is r = 0.05 − 0.02 = 0.03.
The exact value is very close to 0.03, and the mistake is only about 0.00059. Since both r and π are small, the
mistake does not matter, so we can conrm the validity of the approximate Fisher equation.

(f) The exact value of r is r = 2.1/2 − 1 = 0.05, and the approximate value is r = 1.1 − 1 = 0.1. The mistake is
big now (the dierence is 0.05). If we use 10% real interest rate instead of 5% (this is exact value of real interest
rate), it will lead to wrong decision! Thus, the approximate formula should not be used for high ination
countries. In fact, if π is not close to zero, the product rπ will not be close to zero; this means that i = r + π
is no more the approximate relationship of the exact relationship!

2 Introduction of ATM
(a) The costs of transacting between money and nancial assets are any direct and indirect costs that consumers
face when transferring their interest-bearing nancial assets (such as deposits or bonds) into money. Direct cost
includes bank fees, broker fees, transportation cost to the bank, etc. Indirect costs include the hours spent to
go to the bank and the minutes waiting in the bank (which represent opportunity costs of the time). Note that
these costs represent the real transaction cost ψ of going to the bank! These costs have nothing to do with the
opportunity cost of holding money.

(b) The introduction of ATM makes it easier to convert deposits into money. Therefore, transaction cost ψ is
reduced. As a result, consumers can aord to make more frequent transactions and keep less money in their
pockets. Thus, the real money demand (M d /P ) falls.

(c) The amount of money is unchanged because M is constant. Since the money demand decreases due to the
introduction of ATM (as we saw in part (b)), the price level increases from P ∗ to P ∗∗ .

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(d) In order to keep the price level P ∗ , the money supply should decrease to match a decreased money demand.
Therefore, in order to achieve the goal of no ination, the BOK should decrease the money supply from M to
M 0 . Then, the price level of the economy will remain at P ∗ .

3 Oil Shock: 1973 Oil Crisis and 1979 Oil Crisis

(a) A temporary adverse productivity shock is just the opposite of a temporary positive productivity shock we
have seen in class.
1. Direct eect: Y s ↓ (real market), no eect on money market

2. Indirect eect: Y d ↓ (less than Y s , i.e. 4C < 4Y s )

3. Real market: Y = C ↓, r ↑

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 4. Money market: higher r (so higher i) and lower Y → M d ↓ → P ↑

Overall, a temporary adverse productivity shock causes stagation in the classical model: output and con-
sumption go down (stagnation) while price goes up (ination).

(b) If the FRB wants to prevent prices from rising, it needs to decrease the money supply enough so that the
equilibrium between the reduced money demand and the money supply occur at the old price level P ∗ . Nothing
else changes in the analysis (when comparing with the results in (a)) because money is neutral in the classical
model. As a result, there is a recession (Y and C fall) without ination (P is unchanged) when the central bank
reduces the money supply responding to the adverse productivity shock.

(c) When one observes that money and output move simultaneously in the same direction, it is easily for her to
think that the decrease in money supply CAUSES output to decrease (that is, money is not neutral). However,
we should be careful about this hasty conclusion! The FRB knew about the decrease in output and deliberately
acted to decrease the money supply (as we saw in (b)). The change in money supply did not cause the change in
output; it changed just the price level. The fall in output was originated from the negative productivity shock.
Therefore, money is still neutral.
* Note: Comovement of money and output means that money and output are correlated. However, this
does not imply the change in money supply causes the changes in output. In other words, correlation and
causality are NOT the same!