1. Money is the economist’s term for assets that can be used in making
payments, such as cash and checking accounts. In everyday speech, people often
use the term "money" to refer to their income or wealth, but in
economics money means only those assets that are widely used and accepted as
payment.
2. The three functions of money are (1) the medium of exchange function,
which contributes to a better-functioning economy by allowing people to make
trades at a lower cost in time and effort than in a barter economy; (2) the
unit of account function, which provides a single, uniform measure of value;
and (3) the store of value function, by which money is a way of holding wealth
that has high liquidity and little risk.
My web page states that the next problem is numerical 1. It should
have been numerical 2 and I think I assigned it correctly in class. You
may want to look at 2.
1. For a two-year bond, according to the expectations theory, the interest
rate would be the average of the two one-year bonds, which is (6% + 4%)/2 =
5%. Adding the risk premium of 0.5% gives an interest rate on the two-year
bond of 5.5%.
For the three-year bond, according to the expectations theory, the interest
rate would be the average of the three one-year bonds, which is (6% + 4% +
3%)/3 = 4.33%. Adding the risk premium of 1.0% gives an interest rate on the
three-year bond of 5.33%.
The yield curve would show the interest rate on a one-year bond of 6%, the
interest rate on a two-year bond of 5.55%, and the interest rate on a
three-year bond of 5.33%, so it would be downward sloping, which is called
"inverted" in the market.
2. (a) Real money demand is
Md/P
=
500 +
0.2Y – 1000i
=
500 +
(0.2 ´ 1000) – (1000 ´
0.10)
=
600.
Nominal money demand is
Md
=
(Md/P) ´ P =
600 ´ 100 =
60,000.
Velocity is
V
=
PY/Md =
100 ´ 1000/60,000 =
1 2/3.
(b) Real money demand is unchanged, because neither Y nor i
has changed.
Nominal money demand is
Md
=
(Md/P) ´ P =
600 ´ 200 =
120,000.
Velocity is unchanged, because neither Y nor Md/P
has changed, and we can write the equation for velocity as
V
=
PY/Md =
Y/(Md/P).
(c) It is useful to use the last expression for velocity,
V
=
Y/(Md/P) =
Y/(500 +
0.2Y – 1000i).
(1) Effect of increase in real income:
When i
=
0.10,
V
=
Y/[500 +
0.2Y – (1000 ´ 0.10)]
=
Y/(400 +
0.2Y)
=
1/[(400/Y) +
0.2].
When Y increases, 400/Y decreases, so V increases.
For example, if Y =
2000, then V =
2.5, which is an increase over V =
1 2/3 that we got when Y =
1000.
(2) Effect of increase in the nominal interest rate:
When Y =
1000, V =
1000/[500 +
(0.2 ´ 1000) – 1000i]
=
1000/(700 – 1000i)
=
1/(0.7 – i).
When i increases, 0.7 – i decreases, so V
increases. For example, if i =
0.20, then V =
2, which is an increase over V =
1 2/3 that we got when i =
0.10.
(3) Effect of increase in the price level:
There is no effect on velocity, since we can write velocity as a function
just of Y and i. Nominal money demand changes proportionally
with the price level, so that real money demand, and hence velocity, is
unchanged.
4. (a) A temporary increase in government purchases reduces national
saving, causing the real interest rate to rise for a fixed level of income.
If the real interest rate is higher, then real money demand will be lower.
So prices must rise to make money supply equal money demand. The result is
that output is unchanged, the real interest rate increases, and the price
level increases.
(b) When expected inflation falls, real money demand increases. With no
effect on employment or saving and investment, output and the real interest
rate remain unchanged. With higher real money demand and an unchanged
nominal money supply, the equilibrium price level must decline. So output
and the real interest rate are unchanged and prices decline.
(c) When labor supply rises, full-employment output increases. Also, with
higher output, saving will increase, so the real interest rate will decline.
Both higher output and a lower real interest rate increase real money
demand. The price level must decline to equate money supply with money
demand. The result is an increase in output and a decrease in both the real
interest rate and the price level.
(d) When the interest rate paid on money increases, real money demand
rises. With no effect on employment or saving and investment, output and the
real interest rate remain unchanged. With higher real money demand and an
unchanged nominal money supply, the equilibrium price level must decline. So
output and the real interest rate are unchanged and prices decline.
6. The fact that some economic variables are known to lead the business
cycle is used to develop an index of leading economic indicators. The index
is used to forecast economic turning points.
7. The two components of a theory of business cycles are: (1) A
description of the types of factors (called "shocks") that have
major impacts on the economy, such as wars, new inventions, harvest
failures, and changes in government policy; and (2) a model of how the
economy responds to the various shocks.
8. Keynesians and classicals differ sharply in their beliefs about how
long it takes the economy to reach a long-run equilibrium. Classical
economists believe that prices adjust rapidly (within a few months) to
restore equilibrium in the face of a shock, while Keynesians believe that
prices adjust slowly, taking perhaps several years.
Because of the time it takes for the economy’s equilibrium to be
restored, Keynesians see an important role for the government in fighting
recessions. But because classicals believe that equilibrium is restored
quickly, there’s no need for government policy to fight recessions.
Since classicals think equilibrium is restored quickly in the face of
shocks, aggregate demand shocks can’t cause recessions, since they can’t
affect output for very long. So classical economists think recessions are
caused by aggregate supply shocks. Keynesians, however, think that both
aggregate demand and aggregate supply shocks are capable of causing
recessions.
7. The aggregate demand curve relates the price level to the aggregate
demand for goods and services. It is downward sloping, because with a fixed
nominal money supply, an increase in the price level shifts the LM
curve up, so the level of output at the IS-LM intersection is lower.
Factors that shift the aggregate demand curve up and to the right include
(1) an increase in expected future output, which reduces desired saving,
raises desired consumption, and shifts the IS curve up and to the
right; (2) an increase in government purchases, which reduces desired saving
and shifts the IS curve up and to the right; (3) an increase in
expected future MPK, which increases desired investment and shifts
the IS curve up and to the right; (4) a decrease in corporate taxes,
which increases desired investment and shifts the IS curve up and to
the right; (5) an increase in the nominal money supply, which raises the
real money supply and shifts the LM curve down and to the right;
(6) a decrease in the interest rate on money, which decreases the demand for
money and shifts the
LM curve down and to the right; and (7) an increase in the expected
inflation rate, which reduces the demand for money and shifts the LM
curve down and to the right.
8. The short-run aggregate supply curve is horizontal and the long-run
aggregate supply curve is vertical. The short-run aggregate supply curve is
horizontal because prices remain fixed in the short run. The long-run
aggregate supply curve is vertical because the aggregate amount of output
supplied is the full-employment level, regardless of the price level.
9. In the short run, money is not neutral, but in the long run it is
neutral. Suppose the economy is initially in general equilibrium, as shown
in Figure 9.18, where LRAS, SRAS1, and AD1
intersect.
Now suppose the money supply declines by 10%, so the aggregate demand curve
shifts down and to the left to AD2. In the short run, the
equilibrium occurs at the intersection of AD2 and SRAS1,
so output declines and the price level is unchanged. Since output declines,
money is not neutral. In the long run, however, the price level will decline
so the short-run aggregate supply curve shifts down to SRAS2.
The long-run equilibrium occurs at the intersection of AD2,
SRAS2, and LRAS, at which output has been restored
to its original level and the price level is lower. Since output is back at
its original level in the long run, money is neutral in the long run.
