7QQMM205

1. Question 1 (SHORT QUESTION)

In the context of the overlapping generations model, explain why if we allowed

individuals to trade bilaterally (without money) there would be no trade? What is
the friction that the introduction of money overcomes in the overlapping generations
model?

Answer to Question 1
The problem for every young member of future generations is to find a way to
acquire consumption goods in the second period of life. In a decentralised environ-
ment, such acquisitions can occur only through mutually beneficial bilateral trades.
A currently young member of future generations can potentially trade with individu-
als alive in the current period, that is, other young individuals or the old individuals.
No mutually beneficial trade can take place between young individuals of the same
cohort because they are all alike and they are all trying to do the same thing, namely
acquire goods in the future. Further, no mutually beneficial trade can take place
between a young and a currently old individual because the young has what the
old wants but the old does not have what the young wants. A currently young
individual would want to trade with a young individual of the next period because
that individual will have the goods the currently young wants. The problem, how-
ever, is that the young individual of the next cohort has no interest in trading with
the current young because he is not around today. This lack of double coincidence
of wants in cross-generational trades is what prevents trades and allows money to
arise naturally as a medium of exchange. Thus, market incompleteness is the main
friction in the overlapping generations model: markets between currently alive and
future generations do not exist.

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2. Question 2 (SHORT QUESTION)

Suppose you are using a VAR model to study the response of the economy to
a monetary policy shock. Suppose the variables of the model are z t and it (in any
order), with z t a potentially large vector of m variables and it the interest rate
controlled by the central bank. Suppose that the equation of the structural VAR
model for the interest rate is written as
p h i
X
it = α01 z t + β 0l z t−l + γl it−l + δit (1)
l=1

it ∼ N (0, 1) (2)

Explain which of the following options is correct and motivate your answer:

(a) We can conclude that the recursive identification strategy is certainly being
used to identify the monetary policy shock.

(b) We can conclude that the recursive identification strategy is certainly not
being used to identify the monetary policy shock because this identification
is inconsistent with the equation provided.

(c) We cannot conclude whether the identification strategy for the monetary pol-
icy shock is the recursive one or not because not enough information is pro-
vided. The equation is consistent with the recursive identification, under
certain assumptions (explain which ones, in case).

Answer to Question 2
Option c is correct: it could still be the recursive, as long as it is ordered last.

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3. Question 3 (LONG QUESTION)

In this exercise we consider a simple overlapping generation model where the

young are endowed with y units of the consumption good, while the old get nothing.
The fiat money stock is constant. The population grows at rate n. In each period,
the government takes away θ units of consumption good from each young person
(we can think about it as tax). The total proceeds of the tax are then distributed
equally among the old who are alive in that period.

(a) Write down the first- and second-period budget constraints facing a typical
individual at time t. Combine the constraints into a lifetime budget constraint.

(b) Find the rate of return on fiat money in a stationary monetary equilibrium.

(c) Does the monetary equilibrium maximise the utility of future generations?

(d) Does this government policy have any effect on an individual’s welfare?

(e) Consider now a modification to our original model assumptions and suppose
that for every unit of collected tax from the young, the government can only
distribute half unit to the old. The other half is lost due to the cost of
redistribution. Does the government policy have any effect on an individual’s
welfare now?

Answer to Question 3

(a) The young are taxed θ goods, and old is given all the proceeds. Since the
population is growing at rate n, each old gets nθ units of goods. Hence the
period budget constraint is

c1t + vt mt + θ ≤ y (3)
c2t+1 ≤ vt+1 mt + nθ. (4)

Substituting out mt from the two constraints, we get the life-time budget
constraint
 
vt vt
c1t + c2t+1 ≤ y + nθ − θ (5)
vt+1 vt+1

item[(b)] The money market clearing condition is

vt M = Nt (y − c1t − θ)

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implying
Nt (y − c1t − θ)
vt = .
M
This implies the rate of return on money in the stationary allocation, c1t = c1
is
Nt+1 (y − c1 − θ)
vt+1 M Nt+1
= = =n
vt Nt (y − c1 − θ) Nt
M
(c) The feasible set is characterised by

Nt c1 + Nt−1 c2 ≤ Nt y

implying
1
c1 + c2 ≤ y
n
If we compare this constraints with the life-time budget constraint taking into
account the rate of return on money, we obtain
 
vt 1 vt
c1 + c2 = c1 + c2 ≤ y + nθ − θ = y.
vt+1 n vt+1

Thus, the two constraints are the same. Since the utility functions are the
same, the Golden Rule allocation and the monetary equilibrium is identical,
hence the monetary equilibrium maximises the utility of future generations.

(d) The government policy has no effect on welfare because the only term in the
households’ budget constraint which is effected by tax
 
vt
n−1 =0
vt+1

is zero in the stationary equilibrium where the rate of return on money n.

(e) The life-time budget constraint in this case would be:

 
vt vt nθ
c1t + c2t+1 ≤ y + −θ (6)
vt+1 vt+1 2

or in a stationary monetary equilibrium,

 
1 1 nθ θ
c1 + c2 ≤ y + −θ =y− (7)
n n 2 2

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In this case, the budget set would lie within the feasible set. The monetary
equilibrium could not achieve the golden rule allocation. In this case, the
tax/transfer system (due to its inefficiency) would have a negative impact on
welfare. It would be better to eliminate the tax/transfer system. Individu-
als can provide for their own second-period consumption through fiat money
holdings.

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4. Question 4 (LONG QUESTION)

Suppose you are addressing the following research question: when real wages
increase, will employment increase or decrease? On the one hand, an increase in
the real wage increases the return from working, which increases the incentive to
work. On the other hand, an increase in the real wage increases income on every
hour worked, hence one could actually work less and earn the same income. Which
of these forces prevails is not clear.
Suppose you are willing to address this research question using a Vector Au-
toregressive (VAR) model that includes four variables: real wage, the number of
people employed, the aggregate level of consumption, and the value of real GDP.
The variables enter the model in the following order:
   
wt Real waget
 n   Employmentt 
   
yt =  t  =  .
 ct  Consumptiont 
yt GDPt

The structural model used by the researcher is

Ay t = Ãy t−1 + st , (8)

with st normally distributed uncorrelated shocks. The aim of the researcher is to

identify the structural shocks
 real wage 
st
 emp 
 s
st =  t c  , (9)

 st 
sgdp
t

and to generate the impulse response to shock sreal

t
wage
. The reduced form repre-
sentation of the model is given by

y t = Πy t−1 + rt , (10)

with r t normally distributed with covariance matrix Σ, given Σ = A−1 A0−1 . Define
B = A−1 .

(a) Explain briefly the difference between the reduced form VAR (10) and the
structural VAR (8). What feature are they meant to capture in the data?

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(b) Suppose you identify the shock of interest using the recursive identification
approach, hence introducing the restrictions
 
a11 0 0 0
a21 a22 0 0
 
A= . (11)
a31 a32 a33 0 
a41 a42 a43 a44

What is the economic intuition behind the zero restrictions introduced by

the first researcher to identify sreal
t
wage
? Is this compatible with the idea
that wages respond slowly in the economy, contrary, for instance, to financial
variables, which usually respond quickly? Explain which variable(s) is (are)
allowed to respond to the shock both on impact and at future horizons, and
how this compares to other shocks.

(c) As an alternative identification approach, suppose you are considering identify-

ing the shock of interest using an external instrument. Explain what properties
the instrument should satisfy. What is the main advantage, i your view, in
identifying the model using an external instrument rather than the recursive
approach?

Answer to Question 4

(a) The reduced form model captures the correlations in the data and can be
used, at best, to forecast. The structural model captures the causal structure
driving the data, and can be used for impulse responses. It can address cause-
effect questions

(b) This recursive ordering implies that only the shock of interest can affect all
variables contemporaneously. All other shocks take at least one period to af-
fect wages, a restriction which is consistent with the theory of slowly adjusting
wages. All variables potentially respond to all shocks after one lag.

(c) An instrument must be correlated with the shocks of interest and uncorrelated
with any other shock. IF you have one, you can test zero restrictions, and
remove the assumption that only one shock can affect wages on impact.

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