Soluions o End-of-Chapr Problms for Chaprs 26 & 27 in Txbook Chapr 26. Answrs o hs Tru/Fals/Uncrain can b found in h wrin x of Chapr 26. I is lf o h sudn o drmin h soluions. 2. For his qusion kp in mind ha M2 = M + all chquabl noic dposis + prsonal rm dposis. A chquabl noic dposi is a dposi ha pays inrs o h holdr bu rquirs h holdr o mainain a minimum balanc and giv prior noic (usually 30 days) bfor h accoun is closd. A prsonal rm dposi is an inrsarning dposi ha has a spcifid mauriy da. Th dposior arns h full inrs ra only if h/sh dos no mak a wihdrawal prior o mauriy. Early wihdrawal is subjc o a pnaly in h form of rducd inrs paymn. (a) A rducion in arly wihdrawal pnalis would ncourag prsons o shif funds from ohr asss ino prsonal noic dposis. Th dmand for M2 would incras. u bcaus lowr wihdrawal pnalis would ncourag som individuals o swich from chquing accouns o prsonal noic accouns, h dmand for M would dclin. (b) If I can' us my mony mark funds o wri chqus, I will hav o mov som asss ou of hos funds and ino chquabl dposis a my bank. oh M and M2 will incras by qual amouns. (c) ATM ransacions ar usd o ihr mak cash wihdrawals or o pay bills by ransfrs from chquabl accouns. Wih a ax on ATM ransacions, I will hav o mak my cash wihdrawals by visiing my bank. This is lss convnin han an ATM, and so I will likly mak largr and lss frqun cash wihdrawals. I will also hav o pay my bills by wriing mor chqus. u nihr of hs rsponss will alr ihr my avrag cash holding nor my avrag chquing accoun balanc. Thrfor, hr is no ffc on ihr M or M2. (d) This ax will ffcivly lowr h ra of rurn on govrnmn scuriis making boh mony holdings and prsonal noic dposis mor araciv. oh M and M2 will incras wih M2 having h largr incras. 3. (a) Wih π = 0 and i = 4%, h ral ra of inrs is r = 4%. Wih π = 0% and i = 4%, h ral ra of inrs is sill r = 4%. (b) I will b assumd for Par (b) ha you do no sll your hous, so hr is no capial gain o b considrd.
Th afr ax nominal ra of inrs is i(-τ). Hr h ax ra is τ = 0.25. Wih π = 0 and i = 4%, h ffciv ral inrs ra afr ax is r = 0.75(4%) 0 = 3%. Wih π = 0% and i = 4%, h ffciv ral inrs ra afr ax is r = 0.75(4%) 0% = 0.5%. (c) To fully answr his qusion on mus know how homownrs ar axd in Canada. Thr is no morgag inrs dducibiliy as in Par (b). In addiion, a axpayr is no subjc o capial gains axs on his/hr "principal rsidnc". Th lar mans ha an individual who owns only on hous will no pay axs on any capial gains whn ha hous is sold. If an individual owns 2 houss, h/sh mus dsignad which hous is h "principal rsidnc". If h ohr hous is sold, h individual mus pay incom ax on ½ of any capial gain ha is ralizd. Wih ha informaion, w can answr Par (c). W would xpc ha h pric of a hous would chang ovr im a h ra of ovrall pric inflaion. Inflaion would, hrfor, hav no ffc on h ral valu of a "principal rsidnc"; consqunly inflaion would b nural (nihr good nor bad) for ownrs of principal rsidncs. Howvr, ownrs of scond houss would b wors off wih high inflaion bcaus hy would b accruing nominal capial gains ha will b subjc o axs a h im h scond hous is sold. 4. Hisorically, h rlaionship bwn inflaion and M2 growh has bn lss rraic han h rlaionship bwn inflaion and M growh. (S Figurs 26- and 26-2). This mans ha M2 has bn h br prdicor of pric inflaion. Givn h siuaion ha M2 growh = 0, hr is no much rason o b concrnd ha inflaion will b high. 5. I am no qui crain wha h auhors of our xbook hav in mind for h soluion o his qusion, bu hr is my soluion. Th monary auhoriis can lowr h mark ra of inrs by incrasing h mony supply (which will shif h LM Schdul downward o h righ c.). Looking a Equaion 26., on way o do his would b for h monary auhoriis o incras h monary bas H. Thr ar 2 ways hy could do his. On way is for hm o buy govrnmn scuriis (bonds) in h opn mark. Th sllrs of hs bonds would rciv chqus drawn on h cnral bank. Ths chqus would g dposid in charrd banks which would hn giv hos banks highr slmn balancs, i.. highr H. A scond way o incras H would b for h cnral bank o shif som of is govrnmn dposis o chard banks wih h ffc of dircly incrasing slmn balancs. Looking a Equaion 26., i appars ha hr ar 2 mor ways o incras M by rducing h valus of ihr of h raios c or θ ha ar par of h "mony muliplir". Howvr, h monary auhoriis canno affc h valu of h currncy-o-dposi raio c; his is nirly drmind by h gnral public. Similarly, h monary auhoriis hav no dirc conrol of h slmn balancs-o-dposi raio θ, which is drmind by dcisions of charrd banks. Howvr, h monary auhoriis migh nic charrd banks o lowr θ by lowring h ank Ra (which will simulanously lowr 2
h arg ovrnigh loan ra by 0.25%). Wih a lowr ank Ra, charrd banks will find ha i will cos lss o borrow if hy run shor of slmn balancs. This should induc h banks o rduc hir holdings of slmn balancs somwha lading o a fall in θ and a ris in M. 6. Th samn is ru. In fac, our govrnmn currn offrs a rang of subsidis o ncourag crain aciviis, such as highr xpors. Whil hy ar no currnly in plac, h govrnmn has in h pas providd subsidis o ncourag conomy-wid invsmn spnding (and borrowing) hrough somhing calld an "invsmn ax crdi". I is oo far afild o go ino his in dail, bu an "invsmn ax crdi" rducs a businss's ax liabiliis by X dollars for vry $ of nw invsmn spnding undrakn by h businss. Th highr h valu h govrnmn ss for X, h grar h incniv o undrak nw invsmn. Chapr 27. Answrs o hs Tru/Fals/Uncrain can ihr b found dircly in h wrin x of Chapr 27 or radily dducd from ha x. I is lf o h sudn o drmin h soluions. 2. This qusion is poorly posd. In ordr o answr i I will assum ha h db-o- GDP raio givn as 00% applis o is i (.0) + = 0. 04.. Thn h "official" govrnmn budg dfici (a) Th primary dfici/surplus is = 0. 06. [This is a budg surplus of 6% of GDP]. (b) Th inflaion-adjusd dfici surplus is ( i π )(.0) + = 0. 03. [A surplus of 3%]. (c) Assum ha if h unmploymn ra wr o fall by 2% o h naural ra, ral GDP would incras by 2%, which would caus fall by %. (S p. 534 for an xplanaion). Thn h cyclically-adjusd, inflaion-adjusd dfici/surplus would qual -0.04. [A surplus of 4%]. 3
(d) = ( r g) + = -0.05. [Th db/gdp raio will dclin by 5%]. G T () Now his is ough. Givn ha h primary dfici surplus is xpcd o b -6% during ach of h nx 0 yars, on can dduc from h quaion ha appars in Par (d) ha h db/gdp raio 0 yars from now will saisfy h following + 0 + 0 = ( + r g) 0.06[ + ( + r g) + ( + r g) 2 + ( + r g) 3 +... + ( r g) 0 ]. ( + r g) =.0, so (.0) =.57 and h sum in squar bracks quals 0.4622. [S p. 35 in Ch. 8 for a formula for finding h sum of a gomric sris]. Thn + 0 + 0 = 0.4880. 3. * E+ E (a) Rcall ha uncovrd inrs ra pariy implis i = i + ( ). E W will assum ha invsors assign a probabiliy of 0.5 o h possibiliy ha E+ E ihr qual E or.2e. Thn ( ) = 0.0, and i = 0.2 (or 20%). E E + will (b) Wih π = 0, r = i = +0.0 (or + 0%). This incras in h ral ra of inrs will caus domsic invsmn o dclin and lowr h ra of growh in ral oupu. (c) Th official budg dfici will ris by i -. Th inflaion-adjusd dfici will also ris by his amoun bcaus r = i = +0.0. (d) Th chang in h db raio (s quaion in Q3. Par (d)) will incras by h amoun ( r g) = (0.4). [No: In Pars (c) and (d) I hav ignord any ffcs ha lowr growh migh hav on ax collcions and, hnc, on h primary dfici.] () Invsors wr righ o worry and hir concrns hav bcom slf-fullfilling. 4
4. I can only find 3 rrors in rasoning in h samn. (i) Th mporary dficis will caus h govrnmn's db o incras. Th govrnmn will hav o rais axs or lowr spnding afr h war o prvn h db from acclraing ou of conrol. (ii) If Ricardian Equivalnc holds, consumrs will fors fuur ax incrass and will rduc consumpion and incras saving now (during h war). Thir acions will prvn hr from bing a simulus o h conomy during h war. (iii) Availabl vidnc dos no fully suppor h Ricardian Equivalnc proposiion ihr bcaus consumrs do no look ino h disan fuur or bcaus hr ar liquidiy consraind housholds. 5