Chapter 1. Chapter 5 – Problem 3

Step 1

Work It Out
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You must read each slide, and complete any questions on the slide, in sequence.

Question

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?

Velocity = 607M7xmPORU= × TWZC+E3q0MB9vnrLGCAk7ovDG95Lbjyn074v5A==

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.

Question

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

Velocity = XfbQwBcbq1Q=

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.

Question

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

Price Level = a6I+FUZtzkQXEPsi88WHdSn1W40Fbavn

Review text pages 106-110 and 118-120 for a discussion of quantity theory of money and the demand for money.
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Step 2

Question

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 = h4XZagboIgc=%

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.

Question

Calculate the new velocity of money.

Velocity = DDH6Tw1RFEk=

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Step 3

Question

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

J1Jcdt9sKgF9q6CQ5DeAt/gfR5jLDvuxY55eCJze5TM6gJs38CWKkYcKxRvWUxIMcj8+SgMSo4xxk3Lo3Hvatf1XSxEFO10Z4psN+eLU4Jwc/oUaBbPOmEelyd7flnJMp5BH61F48TDVBJ89LUD2a3usKRrmORMvf411lk5EPMcDVWkJdxX+r5zFGt5TtH9ha7PMo6QS2xJETXQp3YGTliMkQEU+G2TvtwURCTRSsTw3+XSThVG5D9o87vWfdFjhRg0qjPzOdAAzaTYo9tcoPUOXxxB0agrH58QiTb11SIMmzFnCurUIN7kWREH/dYDqybYkaDU/v4ipmsKT81Z9jaFV3LQe2YlvZ8WSruhkctvvmcCfVUHloKEcxeg7i5Log8fe5A==
Review text pages 102-106 for a discussion of quantity theory of money.

Question

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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.

Question

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 = $Cna/muxNCTk=

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