14.

02 Feyrer
HW #3
Due 10/01

1. Suppose Congress passed a law requiring the Federal Reserve to eliminate inflation and
keep prices stable going forward.
a. Assuming the long-run growth rate of output is 3 percent per year, what would be
the long-run growth rate of the money supply under this policy scheme? Show
your work.
b. If the Fed brought down the growth of the money stock to this long-run level
immediately, what would the immediate effects be on:
i. inflation?
ii. the nominal interest rate?
iii. real money demand?
iv. the price level?

2. In 2002 the euro was introduced, replacing the national currencies of many European
nations. During the beginning of the year 2002, holders of German marks, French franks,
Italian lira, etc exchanged their national paper currencies for euro notes. This conversion
presented special problems for organized crime, whose operations rely heavily on cash.
Showing up at the bank with millions of German marks for conversion to euros would
have resulted in arrests and confiscation of ill gotten gains. In anticipation of the change
to the euro, European organized crime slowly converted their cash holdings into dollars
(mostly $100 bills as they are easiest to transport and store). It is estimated that over 50%
of US currency is held abroad, and that a significant portion of these dollars are in the
hands of organized crime.

Assume that organized crime exchanged $100B worth of European currencies for US
dollars in 2000. Suppose that the dollars held by organized crime are generally unused
for transactions. These dollars sit in mattresses as a store of value for those who cannot
use banks. Note that the Fed measures the money supply as the quantity of dollars that
are in circulation, including dollars in mobster mattresses.

a. Assume that the Federal Reserve held the currency supply constant. What
does this exchange of currency do to prices?
b. If you were the Federal Reserve chairman and wished to keep prices
constant, what would you do in response to the situation?
c. Assume that your actions in part (b) are successful. Are there any
negative or positive side effects to the dollarization of European organized
crime? (This answer should be short!)
3. In an economy that grows at a constant rate, the level of income in any given year
can be expressed by an exponential function, yt = y0*egt, where yt is the level of
income per capita in year t, y0 is the initial level of income per capita, g is the
growth rate of income, and t is the number of years which have passed since the
initial time.

The current level of US income per capita is about $40,000 per year. The current
level of income per capita in India is about $2,500 per year.
a. Assuming that income per capita in India grows at a rate g=0.02
(Historically, US per capita income has grown at about 2% per year) how
long would it take India to reach the current level of US per-capita
income?
b. What growth rate would allow India to reach the current level of US
income in 30 years?
c. (Optional -- Harder) If US per capita income grows at g=.02 and Indian per
capita income grows at g=.08 starting today, in what year will the US and India
have equal levels of per capita income?

Hint: All three parts require you to plug what you are given into the equation and
take the log of both sides. You could also set up a spreadsheet and search for the
correct value.