Suppose the money demand function is
MD = P× [(0.25 ×Y) ? (100 ×i)],where Y is expressed in billions of dollars and i is expressed in percentage points.
a.Suppose that initially P = 2, Y = 5,000, and i = 5. If income rises to 6,000, what is the new equilibrium nominal interest rate? b.Suppose that initially P = 3, Y = 4,000, and i = 7. If the price level falls to 2, what is the new equilibrium nominal interest rate?
What will be an ideal response?
a.First, use the initial values to determine nominal money demand, which determines nominal money supply. Initially, MD = P× [(0.25 ×Y) ? (100 ×i)] = 2 × [(0.25 × 5,000) ? (100 × 5)] = 1,500. Since MS = MD = P× [(0.25 ×Y) ? (100 ×i)], then i = [(0.25 ×Y) ? (MS / P)]/100 = [(0.25 × 6,000) ? (1,500 / 2)]/100 = 7.5%. b.First, use the initial values to determine nominal money demand, which determines nominal money supply. Initially, MD = P× [(0.25 ×Y) ? (100 ×i)] = 3 × [(0.25 × 4,000) ? (100 × 7)] = 900. Because MS = MD = P× [(0.25 ×Y) ? (100 ×i)], then i = [(0.25 ×Y) ? (MS / P)]/100 = [(0.25 × 4,000) ? (900 / 2)]/100 = 5.5%.
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