Economics 311 Money and Income Second Exam-Spring 2002 Department of Economics College of Business and Economics California State University-Northridge Professor Kenneth Ng Friday, January 29, 2016

Question 1 Write down the formula for the total cost of holding cash balances.  Suppose expected inflation and real income increased simultaneously.  Algebraically show how this will effect the total cost of holding cash balances if a household doesn’t adjust its’ transaction interval.  Draw the interest foregone, transaction costs and total cost of holding money lines on the graph below. Label both axes. Graphically show how the will affect transaction costs, interest foregone, and the total cost of holding cash balances on the graph below.  Write down the formula for optimal real cash balances and velocity. How will the increase in expected inflation and real income affect these? Explain and show algebraically.

An increase in expected inflation reduces the transaction interval, reduces average cash balances, and increases velocity. An increase in real income (C), reduces the transaction interval, increases average cash balances, and increases velocity. The overall effect is to reduce the transaction interval and increases velocity. The effect on cash balances is uncertain because the effect of higher inflation and more real income work in opposition.

Effect of an increase in expected inflation and consumption $ Transaction Interval Fewer Trips  T*T* T*T*

Question 2 Last summer George Bush and the Republicans passed a tax cut bill that included a $300 per person lump sum reduction in taxes. When the tax cut bill was passed, the reduction in taxes was temporary. Use the graphs on the next page and fully analyze the effects on work effort, output, interest rates, bond prices, and the price level.  After the tax cut, terrorists attacked the World Trade Center. Did the terrorist attack cause a permanent or temporary change in the production function?  Would the effects of the terrorist attack reinforce or counter the effects of the Bush tax cut. Explain and depict on the second set of graphs.  Suppose this spring, George Bush and the Republicans pass a bill which makes the tax cut permanent. Will this cause the economy to contract or expand? Depict and fully analyze on the third set of graphs.

The lump sum increase in income causes a small parallel shift outward of the inter- temporal budget constraint. Households will spend part of the tax cut today and save part to be spent in the future. Effect of tax cut. Y1Y1 Y2Y2 C1C1 C2C2 The tax cut causes a parallel shift in the current production function. There will be a wealth effect but no substitution effect. Because the tax cut is temporary, there is no expected change in the future production function. If leisure is a normal good, work effort will decrease while income, including the tax cut, will increase.

The supply and demand for commodities shifts out, but the supply curve shifts out more than the demand curve. At the new equilibrium, the interest rate is lower and output is larger. This is consistent with the fact the households are saving part of the tax cut. The decrease in the interest rate will cause a rotation in the inter-temporal budget constraint. Effect of tax cut. Y1Y1 Y2Y2 C1C1 C2C2

The decrease in the interest rate will cause an rightward shift in the money demand curve. The increase in consumption will also cause a rightward shift in the money demand curve. Effect of tax cut. Y1Y1 Y2Y2 C1C1 C2C2

Effect of Terrorist Attack. Y1Y1 Y2Y2 C1C1 C2C2 The terrorist attack causes a temporary degradation in the production function. Because the degradation is temporary, there is a large effect on current work effort. Households will reduce current work effort and try to maintain current consumption, by borrowing money and planning to work more in the future when the production function returns to normal.

Effect of Terrorist Attack. Y1Y1 Y2Y2 C1C1 C2C2 The inter-temporal budget constraint will shift in slightly because of the temporary reduction income. Households will decrease current output while trying to maintain current consumption. This will cause an increase in current borrowing (A to B). B A

Effect of Terrorist Attack. Y1Y1 Y2Y2 C1C1 C2C2 The current supply and demand for commodities will decrease but the supply will decrease more than the demand because households are trying to maintain current consumption in the face of a temporary degradation of the production function. Interest rates will rise and output/consumption will fall. B A

Effect of Terrorist Attack. Y1Y1 Y2Y2 C1C1 C2C2 The increase in the interest rate and the drop in consumption/output will cause the demand for money to fall or shift to the left. B A

Effect of Making Tax Cut Permanent. C 2 =Y 2 C 1 =Y 1

Curve

Questions about exam? ONE WEEK MANDATORY COOLING OFF PERIOD. No questions answered about exam or homework until next Tuesday.