Question

Consider two economies: Economy A and Economy B. Both economies have the same population, supply of fiat money, and endowments. In each country, the number of young people born each period is constant at N, and the supply of fiat money is constant at M. Young people are endowed with y units of the consumption good but receive nothing when old. The only difference between these two economies is that people in Economy A have preferences that lean toward first period consumption, i.e., they’re relatively impatient, while the people in Economy B have preferences that lean towards second-period consumption, i.e., they’re relatively patient.

(a) Draw two diagrams using indifference curves and budget constraints to illustrate Economy A and Economy B.

(b) Will there be a difference in the rates of return of fiat money in the two economies? If so, which economy will have a higher rate of return on fiat money?

(c) Will there be a difference in the value of money in the two economies? If so, which economy will have a higher value of money?

Answer 1

a) Budget constraint;

• r = rate of return, c1 & c2 are consumption levels, m1 & m2 are income in present and future respectively
• Now looking that budget constraint equation we can find out slope = ∆c2/∆c1 = -(1+r)
• Using these information, let's draw the graph for Economy A where c1 > c2

• For economy B

b) interest rate is determined by money market equillibrium

• Since consumption is more in economy A this means return on savings must be lower --> interest rates are lower
• In economy B, people are saving because interest rates as higher and savings will give more returns in future.
• Thus interest rates are lower in economy A as compared to economy B

C) value of money also depends on supply and demand for money

• In economy B, money supply in the economy will be lower in period 1 than economy A, since people are saving their money.
• Lower money supply --> low inflation --> higher value of money.
• So value of money will be higher in economy B as compared to economy A