Chpt 7: N: 2, 6
Chpt 7: A: 4      
Chpt 8: A: 5      
Chpt 9: R: 1,2,3

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.

6. (a) e M/M 10%. i r e 15%. M/P L 0.01 ´ 150/0.15 10. P 300/10 30.

(b) e /M 5%. i r e 10%. M/P L 0.01 ´ 150/0.10 15. P 300/15 20. The slowdown in money growth reduces expected inflation, increasing real money demand, thus lowering the price level.

 

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 quantity of 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 quantity of 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.

5. Growth that is "too rapid" most likely refers to a situation in which the aggregate demand curve has shifted to the right and, in the short run, intersects the SRAS curve at a level of output that’s greater than the full-employment level of output . This situation is associated with inflation because, in the long run, prices will rise, shifting the SRAS curve up to intersect with the LRAS and AD curves. The shock that is implicitly assumed to be hitting the economy is an aggregate demand shock, since that’s the only shock that increases output in the short run and inflation in the long run.

1. The position of the FE line is determined by the labor market and the production function. Labor supply and demand determine equilibrium employment. Using equilibrium employment in the production function gives the full-employment level of output. The FE line is vertical at that point. The FE line shifts to the right if there is an increase in labor supply or the capital stock or if there is a beneficial supply shock.

2. The IS curve shows combinations of the real interest rate (r) and output (Y) that leave the goods market in equilibrium. Equilibrium in the goods market occurs when the aggregate supply of goods (Y) equals the aggregate demand for goods (Cd Id G). Since desired national saving (Sd) is Y – Cd – G, an equivalent condition is Sd Id. Equilibrium is achieved by the adjustment of the real interest rate to make the desired level of saving equal to the desired level of investment. For different levels of output, there are different desired saving curves, with different equilibrium interest rates. When plotted on a figure showing output and the real interest rate, this forms the IS curve, as shown below. The curve slopes downward because as output rises, the saving curve shifts along the investment curve and the real interest rate declines.

The IS curve could shift down and to the left if: (1) expected future output falls, because this increases desired saving; (2) government purchases fall, because this increases desired saving; (3) the expected future marginal product of capital falls, because this decreases desired investment; or (4) corporate taxes increase, because this decreases desired investment.

3. The LM curve shows the combinations of output and the real interest rate that maintain equilibrium in the asset market. Equilibrium in the asset market occurs when real money demand equals the real money supply.

The figure below shows the derivation of the LM curve and why it slopes upward. An increase in output from Y1 to Y2 raises money demand, shifting the money demand curve from MD(Y1) to MD(Y2). With money supply fixed at MS, there must be a higher real interest rate to get equilibrium in the asset market. This gives two points of the LM curve, plotted on the right half of the figure. The result is that higher output increases the real interest rate along the LM curve, so the LM curve slopes upward.

Figure 9.16

The LM curve would shift down and to the right if the nominal money supply or expected inflation increased or if the price level or nominal interest rate on money decreased. In addition, the curve would shift down and to the right if there were a decrease in wealth, a decrease in the risk of alternative assets relative to the risk of holding money, an increase in the liquidity of alternative assets, or an increase in the efficiency of payment technologies.