return. The population of a generation grows by 10% each period. In the initial pe
1, 000, 000. Because of a political impasse, government expenditures exceed (non-seigniorage) tax revenues by 40 goods per young person in every period. Each young person wishes
to hold real money balances worth 200 goods regardless of the rate of inflation. Assume
that there is no debt coming into the first period (bo = 0).
(a) Use the government budget constraint to find the rate of fiat money creation that is
required to finance the excess of government expenditures over taxes. (20%)
(b) Find the fiat money stock and the price level in periods 1 and 2. Use these results to
verify that the gross rate of inflation is indeed equal to z/n, where z is the growth rate of money and n the growth rate of population. (30%)
(c) Suppose instead now that in the initial period (period 1), the monetary authority hesitates to print new money, forcing the government to issue debt at the market rate of interest. In the second period, the monetary authority relents, printing enough
government expenditures over taxes. Find the fiat money stock in period 2 and compare it with your answers in part a. Explain the difference. (35%)
(d) Using results from point c., find the price level in period 2 and the rate of inflation
between period 1 and period 2. (15%)
