Assignment 3 Answers

The real demand for money is defined as the nominal amount of money demanded divided by the price level. For a given money supply the locus of income-interest rate pairs at which money demand equals money supply is known as the LM curve. The magnitude of the volatility of money demand has crucial implications for the optimal way in which a. DEMAND EXTERNALITIES AND REAL EFFECTS OF NOMINAL MONEY Olivier 3. Blanchard Nobuhiro Kiyotaki Working Paper No. 1770 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 December 1985 We thank Andy Abel, Rudi Dornbusch, Bob Hall, Jeff Sachs, Larry Summers and Marty Weitzman for useful discussions. Real money demand is a function of real GDP and the nominal interest rate. Money demand The demand for money is used to meet the demand for precautionary, speculative and transaction purposes.

Instructions:

Money Demand Function I Making use of market-clearing and combining the FOC yields: ym t1 t = 1 Y t i 1 +i t I Re-arranging: m t = yY t 1 +i t i t I Demand for real balances: (i) increasing in Y t, (ii) decreasing in i t I Zero lower bound: must have i t 0 to get non-negative real balances. At i t!0, demand for real balances goes to in nity 24/37.
Econ 1) Money demand is a) Suppose that P = 100, Y = 1000, and i = 0.10. Find real money demand, nominal money demand, and the velocity of money. B) Suppose the price level doubles to 200. Find real money demand, nominal money demand, and the velocity of money.

Do NOT type this assignment. Graphsshould be drawn clearly and be properly labelled. Show ALL stepsand state ALL How to calculate real money demand

of your assumptions. Total points available: 100

1. This question examines the effect of a reduction in the effectivetax rate on capital. Assume that prices adjust slowly. [Note: This questionshould be answered in considerable detail.]

Real Money Demand And Nominal Money Demand Worksheet

a. Using a diagram with MPK^fand the tax-adjusted user costof capital, illustrate how a reduction in the effective tax rate on capitalchanges the level of desired capital stock. [5 points]
b. Explain how changes in the level of desired capital stock impactdesired investment. (Hint: use relationship on p. 129) [5 points]
c. Using the investment and savings diagram, illustrate the changesin the goods market equilibrium. [3 points] Derive the new IS curve.[3 points]
d. If prices adjust slowly, illustrate the short-run equilibrium in theIS-LM-FE framework. [5 points]
e. Why is the equilibrium in (d) not sustainable in the long run?[5 points]
f. In the long run, prices will change. Demonstrate how prices changeby drawing the asset market. [3 points] Derive the new LM curve.[3 points]
g. Examine the final IS-LM-FE equilibrium. How did the general equilibriumvalues of the real wage, employment, output, the real interest rate,consumption,investment, and the price level change? [7 points]

2. Define monetary neutrality. Show that, after prices adjust completely,money is neutral in the IS-LM model. What are the classical and Keynesianviews about whether money is neutral in the short run? In the long run?(A complete answer should include detailed diagrams showing boththe asset market equilibrium and the general equilibrium conditions.) [20points]

3. Money demand in an economy in which no interest is paid on moneyis

{M^d / P} = 750+ 0.4Y - 800i

a. You know that P = 80, Y = 900, and i = 0.08. Find real money demand,nominal money demand, and velocity. [3 points]
b. The price level doubles from P = 80 to P = 160. Find real moneydemand, nominal money demand, and velocity. [3 points]
c. Starting from the values of the variables given in part (a) andassuming that the money demand function as written holds, determine howvelocity is affected by an increase in real income. [3 points] Byan increase in the nominal interest rate. [3 points] By an increasein the price level. [3 points]

4. Consider a closed economy described by the following equations:
C^d = 400 + 0.8(Y-T) - 100r
I^d = 200 - 300r
G = T = 400
Y^f = 3500 (full-employment level of output)
Expected Inflation = 0.05
L = 0.5Y - 200i (money demand function)
M = 1730 (nominal money supply)

a. Derive the IS curve and the LM curve. Graph both of these curves.[6 points]
b. Find the equilibrium values of the real interest rate, the nominalinte rest rate, and the price level. What is the level of savings in thiseconomy? [5 points]
c. Suppose that the government doubles expenditures and doubles taxes(G=T =800). Find the new equilibrium values of the real interest rate,the nominal interest rate, and the price level. Will this economy be savingmore or less than it was? [5 points]

5. The nominal exchange rate is 15 crowns per florin, the domestic pricelevel is 6 florins/bottle, and the foreign price level is 2 crowns/bushel.

Real Money Demand And Nominal Money Demand Examples

a. What is the real exchange rate? [3 points]
b. What is the real exchange rate in the foreign country? [3 points]
c. If the domestic price level rises to 8 florins/bottle, what mustthe nominal exchange rate become if the real exchange rate remains unchanged?[4 points]

Assignment 3 Answers

Economics 222

Q1, Q2. The answers to these questions are largely graphical, butfollow closely the discussion in the text. See Chapter 10 in general, andFigures 10.2 and 10.3 in particular, for the discussion of how IS shifts due tochanges in the goods market. For a discussion of monetary neutrality, consult pp. 341-42 and theexplanation presented in Fig. 10.9.

Q3. For the given equation, M^d / P = 750 + 0.4Y - 800i,

a) Real money demand = 1046 ; Nominal money demand = 80* 1046 = 83680 ;Velocity = PY / M^d = 0.86

b) If price doubles to 160, real money demand (M / P) is unchanged. Nominalmoney demand is now 160*1046 = 167360. Since neither real income nor realmoney demand have changed, velocity is constant.

c) If real income rises, so does velocity (try Y=1000 in the aboveequation). If the nominal interest rate rises, so does velocity (try i = 0.1above). If the price level changes (as in part b), there is no effect onvelocity.

Q4.

a) First, find IS, where Y = C^d + I^d + G = 400 + 0.8(Y - 400) - 100r + 200 - 300r + 400. Solving for Y (but solving for r wouldwork as well), we get

Y = 3400 - 2000r

To find LS, use (M/P) = 0.5Y - 200i = 0.5Y -200(r + exp. Infl.) = 0.5Y - 200(r + 0.05). Solving again for Y, we get

What Is Real Money Demand

Y = 3460/P +400r + 20, with P unknown.

b) In a general equilibrium, it must be that Y =Y^fe . Thus, inIS, set Y = 3500 and solve for r = -0.05, the real interest rate. The nominalinterest rate is (r + exp. Infl.) = 0 . The price level is then P = M /0.5*Y^fe= 0.989.

c) When the government increases taxes and spending proportionately, the IScurve shifts outwards. By substituting the new T and G into the IS derivation,IS becomes:

Y = 3800 - 2000r

LM doesn't change, since the asset market is not directly affected. Again,set Y=Y^fe for an equilibrium, and use the IS to find the realinterest rate, r = 0.15. The nominal rate is 0.15 +0.05 =0.2. Then in LM (withY=Y^fe), P = M /(0.5*Y^fe - 200*(0.15+0.05)) = 1.012 is the new price level.

Recall National Savings (S) in a closed economy are S = Y - C - G. With T =G = 400, S = 3500 - 2880 - 400 = 220. Now S = 3500 - 2560 - 800 = 140. Sosavings have gone down.

Q5. For all questions use e = e_nom*(P/P_for)

a) e = [15 crowns / 1 florin ]*[6 florins / 1 bottle]*[1 bushel / 2 crowns]= 45 bushels / 1 bottle

b) Now home becomes foreign, and vice versa. Then for the other country, e =1 bottle / 45 bushels.

c) 45 bushels / 1 bottle = e_nom * [8 florins / 1 bottle] * [1bushel / 2 crowns]

e_nom = 11.25 crowns / 1 florin

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