October 25, 2021

1 The Solow Model [20 Points]

Consider a Solow economy which is identical to the one we studied in Lecture 2. The production function is
Cobb-Douglas, Y = A · K ↵ · N 1 ↵
. The saving rate is s, population growth rate n and depreciation rate d.

1. Derive the golden rule saving rate, sG , so that the maximum of steady-state consumption is achieved.
Solution: In a steady state
↵
s · A · (k ⇤ ) = (n + d) · k ⇤

Consumption at the steady state

↵
c⇤ = (1 s) · f (k ⇤ ) = f (k ⇤ ) s · f (k ⇤ ) = A · (k ⇤ ) (n + d) k ⇤

Golden Rule capital-labor ratio kG satisfies

f 0 (kG ) = A · ↵kG
↵ 1
=n+d

The Golden Rule saving rate

(n + d) kG n+d
sG = ↵ = ↵ 1 =↵
AkG AkG

2. Suppose the economy stays at its steady state. At Period T , a group of immigrants move to this
economy. Does it a↵ect the steady state? Please explain.
Solution: Due to immigration, L increases to L0 , but n does not change. The steady-state k ⇤⇤ and
y ⇤⇤ will not be a↵ected, but steady-state K ⇤⇤ and Y ⇤⇤ will be larger. As for transition dynamics,
following the increase in L to L0 , k drops to k 0 < k ⇤ . At k 0 , actual investment is greater than break
even investment, so k increases till k = k ⇤ .

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2 Natural Disaster in the General Equilibrium Model [30 Points]
Consider the standard equilibrium business-cycle model with labor, rental and asset markets. The economy
is populated by many identical households and a representative firm. Denote the real wage rate by w/P
and real rental price by R/P . The firm behaves competitively and produces with a standard Cobb-Douglas
function: Y = AK ↵ L1 ↵
, where A, K and L are productivity, capital and labor input, respectively, and
↵ > 0. The household’s period utility is u(c, l), where c and l are consumption and leisure time, respectively.
Households make decisions on consumption c, savings s and leisure time l each period. And they supply the
rest of their time to the labor market. Households own the capital stock and the capital utilization rate is
exogenous, i.e.,  = 1. Households live for many periods.
is a one-time decrease in the capital stock K, caused by a natural disaster. Before the shock, the economy
is in general equilibrium.

1. Analyze in a graph the e↵ect of the natural disaster in capital rental market. Explain carefully. [Hint:
You may want to discuss its e↵ects on supply/demand curves and equilibrium.]
Solution: The supply curve of capital servies is vertical as  = 1. As K is reduced, the supply curve
shifts to the left. The demand curve is unchanged as there is no change in A, ↵ or L. Therefore,
equilibrium K ⇤ decreases and real rental price increases.

2. How does the nominal rental price (R) react to this disaster?
Solution: As shown in Q4.1, real rental price increases. With a decrease in K, Y decreases. P is
counter-cyclical and therefore it increases. Therefore nominal rental price increases.

3. How does the price of government bond react to this disaster?

Solution: Rate of return on bonds r = R increases. So price of government bond decreases.

4. Analyze in a graph the e↵ect of the natural disaster in labor market. Explain carefully. [Hint: You
may want to discuss its e↵ects on supply/demand curves and equilibrium.]
Solution: M P L = (1 ↵)AK ↵ L ↵
. As K is reduced, the demand curve of labor shifts to the left. The
supply curve of labor also changes. Given the interest rate changes, there is inter-temporal substitution
e↵ects. Households think the present value of future wage is lower and they increase labor supply
for any current real wage rate. Therefore the labor supply curve shifts to the right. Therefore, both
equilibrium real wage and L⇤ decrease.

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3 Money Demand, Money Supply and Monetary Policy [40 Points]
1. Suppose the price level in the economy is P and the nominal money supply is M s . Real money demand
L(Y, i) is a function of real income Y and nominal interest rate i. And the nominal money demand is
as follows,
M d /P = L(Y, i) = Y ⌘y · i ⌘i

where 1 > ⌘y > 0 and ⌘i > 0. Suppose further that the growth rate of nominal money supply µ,
inflation rate ⇡, income growth rate g, and the real interest rate r, are all constant over time. Derive
the relation between ⇡, µ and g, when the asset market is in equilibrium.
Solution: Asset market equilibrium gives

Mts = Mtd

So
⌘y
Mts /Pt = Yt ·i ⌘i

Taking log of both sides gives

ln(Mts ) ln(Pt ) = ⌘y · ln(Yt ) ⌘i · ln(it )

and
s
ln(Mt+1 ) ln(Pt+1 ) = ⌘y · ln(Yt+1 ) ⌘i · ln(it+1 )

Since it = rt + ⇡t = r + ⇡ is constant, we have

s
[ln(Mt+1 ) ln(Mts )] [ln(Pt+1 ) ln(Pt )] = ⌘y · [ln(Yt+1 ) ln(Yt )]

By approximation,
Ms P Y
= ⌘y ·
Ms P Y
Therefore,
⇡=µ ⌘y · g

2. Considering the following statement. “Commercial banks attract deposits from households so that they
can lend deposits to firms. In other words, loans are created based on the quantity of deposits. ” Is it

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 true or false? Explain your answer carefully.
Solution: False. Deposits are created when loans are issued to households or enterprises.

3. Considering the following statement. “Federal funds rate is a market rate, and therefore it cannot be
a↵ected by the central bank. ” Is it true or false? Explain your answer carefully.
Solution: False. Federal funds rate can be influenced by the central bank through open market
operations to reach the federal funds rate target. The central bank can decrease liquidity by selling
government bonds, thereby raising the federal funds rate because banks have less liquidity to trade with
other banks. Similarly, the central bank can increase liquidity by buying government bonds.

4. Explain why the conventional monetary policies can not be e↵ective if the economy is stuck in a liquid
trap.
Solution: If the nominal interest rate is just about equal to zero, people consider money and non-
monetary assets to be perfect substitutes. If there is an increase in money supply, people are ready and
willing to just absorb the newly issued money in their portfolios.

5. Considering the following statement. “The purpose of QE is to spend a large amount of money on
goods and services produced in this economy to boost the aggregate demand e↵ectively.” Is it true or
false? Explain your answer carefully.
Solution: False. Through purchasing long-term bonds, QE directly repress long-term interest rates.
Moreover, the central bank can more credibly commit to keeping future short-term interest rates low
and alter expectations. These help stimulate lending and spur economic activities.

4 Price-Misperceptions Model[10 Points]

Consider the standard price-misperceptions model. Suppose the economy is in the long run equilibrium,
where P e = P = P ⇤ . P is the actual price level, and P e is household’s perceived price level. Moreover, given
the price level P , the equilibrium nominal wage rate is w, which clears the labor market. Suppose the money
supply increases by 10% in this economy and it is totally unperceived by households. Therefore, we suppose
that in the short run, P e = P ⇤ and P = 110% · P ⇤ .

1. What happens to the nominal wage rate, w, in the long run? Choose correct statement(s) from below
and justify carefully your choice.

A. The nominal wage rate w, increases by exactly 10%;

B. The nominal wage rate w, increases by less than 10%;
C. The nominal wage rate w, increases by more than 10%;
D. The nominal wage rate w, decreases by exactly 10%;
E. The nominal wage rate w, decreases by less than 10%;
F. The nominal wage rate w, decreases by more than 10%;
Solution: A. Money is neutral in the long run.

2. What happens to the nominal wage rate, w, in the short run? Choose correct statement(s) from below
and justify carefully your choice.

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A. The nominal wage rate w, increases by exactly 10%;
B. The nominal wage rate w, increases by less than 10%;
C. The nominal wage rate w, increases by more than 10%;
D. The nominal wage rate w, decreases by exactly 10%;
E. The nominal wage rate w, decreases by less than 10%;
F. The nominal wage rate w, decreases by more than 10%;
Solution: B. The nominal wage rises, but less than 10%, The real wage rate is lower. The nominal
wage has to be higher to induce more labor input, but the increase is smaller than 10%, given the
real wage rate in equilibrium is lower.

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