1. (4.5 p.) Consider Baumol-Tobin model of money demand but now assume that real transaction costs per one withdrawal are not constant but are positively related to the amount of withdrawal so that: b = b+az , where Z is the amount of withdrawal b, 20, and a > 0 stays for the commission charged by the bank. (a) Setup the cost minimization problem and find the money demand. (b) Compare the demand found in (a) with the one derived at lecture and provide an intuitive explanation. (c) The government earns seigniorage revenue equal to the rate of inflation multiplied by the real money supply (this is a linear approximation for the actual seigniorage revenue). The welfare cost of inflation is calculated by subtracting seigniorage revenue from the sum of household transaction costs (except the commission which represents a transfer from households to the banks) and foregone interest. (i) Assuming the household makes the optimal number of withdrawals, find the welfare cost. (ii) Assume that real interest rate is 0. Which inflation rate gives the lowest welfare cost? Explain the economic intuition behind your answer. 1. (4.5 p.) Consider Baumol-Tobin model of money demand but now assume that real transaction costs per one withdrawal are not constant but are positively related to the amount of withdrawal so that: b = b+az , where Z is the amount of withdrawal b, 20, and a > 0 stays for the commission charged by the bank. (a) Setup the cost minimization problem and find the money demand. (b) Compare the demand found in (a) with the one derived at lecture and provide an intuitive explanation. (c) The government earns seigniorage revenue equal to the rate of inflation multiplied by the real money supply (this is a linear approximation for the actual seigniorage revenue). The welfare cost of inflation is calculated by subtracting seigniorage revenue from the sum of household transaction costs (except the commission which represents a transfer from households to the banks) and foregone interest. (i) Assuming the household makes the optimal number of withdrawals, find the welfare cost. (ii) Assume that real interest rate is 0. Which inflation rate gives the lowest welfare cost? Explain the economic intuition behind your