Teoria y Politica Monetaria, Instructor: Marco Del Negro

Problem set 9, Solutions

1) Let us assume for the moment that real money balance do not affect the marginal rate of substitution between consumption and leisure u_c/u_l. Then under flexible prices the implementation of the Friedman's rule is bound to raise welfare: the real equilibrium is just the same, and real money balances are higher. With fixed prices on the other hand -assuming that the decline in inflation is not anticipated- there is a temporary cost in terms of output: this is the case studied in class 7 (see Gordon calculations). If real money balance affect the marginal rate of substitution between consumption and leisure u_c/u_l the issue is more complicated, because even under flexible prices the equilibrium changes.
2) This is exactly the ``currency crises'' case studied in class.