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Take-Home 1.

by Jorge Rojas

Problem.
Consider the following money demand function, where all variables are in natural loga-
rithms.

mt − pt = − (Etpt+1 − pt) ∀t = 0, 1, 2, 3, (1)

Etpt+1 = pt+1 (perfect foresight) (2)

where mt is the log of the money supply, pt is the log of the price level at t, and Etpt+1
the public’s expectation of pt+1 formed at time t.
(a)
Suppose that mt = 10 for t = 0, 1, 2, 3, . Using lag operators compute the equilibrium
value for pt for t = 0, 1, 2, 3, 4, 5.
We know that mt = 10 ∀t. From equations (1) and (2) we obtain as follows:

mt − pt = − (Etpt+1 − pt)
mt − pt = − (pt+1 − pt)
mt − pt = − pt+1 + pt
mt + pt+1 = 2 pt
1 1
⇒ pt = pt+1 + mt (3)
2 2

We can see from equation (3) that pt will converge smoothly to a certain value p∗
through time because the coefficients for pt+1 and mt of the difference equation are
smaller than 1 and greater than zero.
We can write equation (3) in its general form as:

pt = φ pt+1 + ρ mt (4)
1 1
where φ = 2 and ρ = 2 .

We can rearrange equation (4) as follows:

⇒ pt − φ pt+1 = ρ mt
pt − φ L −1 pt = ρ mt

1 − φ L−1 pt = ρ mt
ρ
⇒ pt = mt (5)
(1 − φ L−1)

1
We also know that:

X i 1
φ L−1 = ∀|φ| < 1 (6)
1 − φ L−1
i=0

Therefore, combining (5) and (6):


" ∞
#
X i
pt = ρ φ L−1 mt
i=0
X∞
= ρ mt φi L−i
i=0

X
= ρ φi L−i mt
i=0

X
φi L−i mt

= ρ
i=0

X
= ρ φi mt+i
i=0

Therefore, we obtain equation (7)



X
pt = ρ φi mt+i (7)
i=0

Now, we can use the fact that mt is constant and equal to ten for all periods of time.
Thus,

X
pt = ρ m̄t φi (8)
i=0

The sum in equation (8) is a geometric sum. In general, we know that:


n
X φk − φn+1
φi = (9)
1− φ
i=k

1
In our case we have that φ = 2 and n → ∞. Thus, equation (9) can be reduced to:


X φk
φi = ∀|φ| < 1 (10)
1− φ
i=k

Applying equation (10) into (8) we obtain equation (11):

1 1
(b)pt = × 10 × 1
= 10 ∀t = 0, 1, 2, 3, . (11)
2 1− 2

Therefore, the equilibrium value for pt is constant and equal to 10. Notice that mt is
also 10 for every period of time.

2
(b)

Suppose now that the path for mt is:

mt = 10 t = 0, 1, 2, 3
mt = 12 t = 4, 5, 6, 7

Compute the equilibrium values of pt for t = 0, 1, 2, 3, 4, 5, 6. How does this time path for
pt compare with that compute in part (a)? Plot the time paths.

The expression given in equation (7) in part (a) is a valid in general. In the new case,
we have that mt is constant and equal to 10 for t = 0, 1, 2, 3 and then increases to 12 per-
manently.

Let us calculate the value for p0. To do so we will use the identity given in equation (10)
1
and the values for ρ = 2 = φ.


X
p0 = ρ φi m0+i
i=0

X
= ρ φ mi
"i=0 ∞
#
X
= ρ m0 + φ m1 + φ2 m 2+ φ3 m3 + φi mi
" i=4 #

X
= ρ m0 + φ m1 + φ2 m2 + φ3 m3 + m̄4 φi ; m̄4: constant
i=4
φ4
 
= ρ m0 + φ m1 + 2+ φ2 m φ3 m3 + m̄4
1− φ
"  2  3 #
1 1 1 1 1/2)4
= × 10 + × 10 + × 10 + × 10 + 12 ×
2 2 2 2 1 − (1/2)
81
=
8
p0 = 10.125

We proceed in a similar way for p1, p2, p3, p4, p5 and p6.


X
⇒ p1 = ρ φi m1+i
"i=0 ∞
#
X
= ρ m1 + φ m2 + φ2 m3 + φi m1+i
" i=3 #

X
= ρ m1 + φ m2 + φ2 m3 + m̄4 φi ; m̄4 = 12
i=3
φ3
 
= ρ m1 + φ m2 + φ2 m3 + m̄4
1− φ

3
"  2 #
1 1 1 1/2)3 41
= × 10 + × 10 + × 10 + 12 × =
2 2 2 1 − (1/2) 4
p1 = 10.25


X
⇒ p2 = ρ φi m2+i
"i=0 ∞
#
X
= ρ m2 + φ m3 + φi m2+i
" i=2 #

X
= ρ m2 + φ m3 + m̄4 φi ; m̄4 = 12
i=2
φ2
 
= ρ m2 + φ m3 + m̄4
1− φ
" #
2
1 1 (1/2)
= × 10 + × 10 + 12 ×
2 2 1 − (1/2)
21
=
2
p2 = 10.5


X
⇒ p3 = ρ φi m3+i
"i=0 ∞
#
X
= ρ m3 + φi m3+i
" i=1 #

X
= ρ m3 + m̄4 φi ; m̄4 = 12
  i=1
φ
= ρ m3 + m̄4
1− φ
 
1 (1/2)
= × 10 + 12 ×
2 1 − (1/2)
p3 = 11


X
⇒ p4 = ρ φi m4+i
i=0

X
= ρ m̄4 φi ; m̄4 = 12
i=0
1
= ρ m̄4
1−φ
1 1
= × 12 ×
2 1 − (1/2)
p4 = 12

We can see that after t = 4 the value of mt is constant, and therefore, the problem is
reduced to the answer in part (a). In other words, the equilibrium pt will be constant
and equal to mt. Thus, we have that p5 = p6 =
= pn = 12 ∀n > 4.

4
Figure 1.

From figure 1, we can see that the increase in the money supply has a clear effect on the
price level, but this effect is smoothly done. In other words, the increase in money
supply in period four and afterwards has its complete effect after 4 periods. The loga-
ritm of the price level, pt increases slowly from 10 to the new steady state at 12. Unlike,
part (a) in which the money supply is constant, and hence pt is also constant.