Question

6) Suppose an economy is in its long-run equilibrium and the real money demand function for the economy is (M/P) d =0.2Y. Now suppose suddenly money demand becomes (M/P) d =0.4Y.

a) Draw a graph and show the initial long-run equilibrium and then show the short-run equilibrium that would results from this change in money demand [Hint: You are drawing the graph from Chapter 10 but think about how this money demand change affects velocity from Chapter 5.]

b) Assuming policymakers take no action, how would the economy transition back to the long-run equilibrium? Show this on your graph from part a).

c) Briefly explain, could monetary policy change the money supply to offset this change in money demand? If so, how would they do that?

Answer 1

Solution: 6) Given (m/pds 0.2 y (initially) CMID) d = 0.4 y llater) short wn @ G Daph of initial long sun equilibrium and equilibrium : - In the following graph, the long dun equilibrium is at point A where Apo Caggregate demand, LRALO Clongwin aggregate supply) and Sraso (shortan aggregate Supply) comes intersect, with long son equilibrium price level Po and real Gpp = (potential GPP) yo. when demand for money increases, money supply remaining unchanged, intereft rate increases, which decreases the investment demand, there by reducing aggregate demand. This shifts ad come left ward to API intersecting SRASO at point B with lower price level p, and the

lowey seal Gop Yu, causing a recesſionary gapin short run. LRASO Graph: SRASO ADO Yo Yo makers take no action then: b) If policy In the absence of policy interventional, lower price level reduces cost of inputs in long run, do firms increase output. Aggregate supply rises, shifting SRaso rightward to SRAS , intersecting Ap, at point c with forthes lower price level pa and Restoring real app to the potential Gop of Yo .

c) could monetary policy change the money supply to offect this change in money demand; >> If condal bank decreated money supply using Contractionary monetary policy, interest rate will inceasef which will eventually decrease the demand for money and restore money demand at original level. • central bank decreases money supply by open market Sale of government securities and / or by increating discount rate and / or by in creating required reserve ratio