TABLE OF CONTENTS

Question 1 of 3

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An economy has the following money demand function: (M/P)d = (1/3)Y/i.

Derive an expression for the velocity of money. What does velocity depend on? Explain why this dependency may occur.

Velocity = ×

Velocity depends on the nominal interest rate because when the nominal interest rate is higher, the opportunity cost of holding money is higher, so people hold less money and effectively use each dollar more often to carry out the same amount of transactions.

Calculate velocity if the nominal interest rate i is 6 percent.

Velocity =

Velocity depends on the nominal interest rate because when the nominal interest rate is higher, the opportunity cost of holding money is higher, so people hold less money and effectively use each dollar more often to carry out the same amount of transactions.

If output Y is 2,000 units and the money supply M is $500, what is the price level P?

Price Level =

Review text pages 106-110 and 118-120 for a discussion of quantity theory of money and the demand for money.
Review text pages 106-110 and 118-120 for a discussion of quantity theory of money and the demand for money.

An economy has the following money demand function: (M/P)d = (1/3)Y/i.

Suppose the announcement of a new head of the central bank, with a reputation as a tough inflation fighter, reduces expected inflation by 2 percentage points. According to the Fisher effect, what is the new nominal interest rate?

Nominal Interest Rate = %

Review text pages 106-110 and 118-120 for a discussion of the quantity theory of money, the Fisher effect, and the demand for money.

Calculate the new velocity of money.

Velocity =

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An economy has the following money demand function: (M/P)d = (1/3)Y/i.

If, in the aftermath of the announcement, both the economy’s output and the current money supply are unchanged, what happens to the price level?

Review text pages 102-106 for a discussion of quantity theory of money.

Explain why this occurs.
To understand why the price level falls, first note that the decline in expected inflation and, hence, the nominal interest rate reduces the opportunity cost of holding money, leading to an increase the demand for real money balances. Because the nominal money supply is unchanged, the price level must decline to increase the real money supply into line with the new higher demand for real money balances.

If the new central banker wants to keep the price level the same after the announcement, at what level should she set the money supply?

Money Supply = $

Review text pages 106-110 for a discussion of quantity theory of money.
Review text pages 106-110 for a discussion of quantity theory of money.