Reference no: EM131022295

Week 2

Suppose the economy, in aggregate, has a money demand function given by

M^D = 18 + .85Y -.40i,

where Y = national income (GDP) and i = the domestic nominal interest rate. The Federal Reserve exogenously sets the money supply at

M^S = 15,

(all figures are in trillions of dollars).

a) Suppose GDP is initially at Y = 3 trillion. What amount of money will be held by the public? What is the equilibrium nominal interest rate? If the nominal interest rate is below this equilibrium rate (so that the money market is in disequilibrium) describe the forces that would move the money market into equilibrium.

b) Suppose the Fed conducts expansionary monetary policy, increasing the money supply to 20 (trillion dollars). What is the new equilibrium nominal interest rate and what are the new money balances held? Repeat this comparative statics exercise (starting from the initial equilibrium) for an increase in GDP from 3 trillion to 5 trillion dollars. Illustrate both changes graphically.

c) Suppose we do not know the M^S and M^D functions but we do know that the money market is in equilibrium. Let this equilibrium be disturbed by a simultaneous contraction in the money supply by the Fed and a contraction in money demand (due to, say, a financial innovation). After the money market settles at a new equilibrium can we say whether the new equilibrium nominal interest rate and money balances held are higher or lower than before? Why or why not?