Question

Aggregate Demand I - Work It Out: Question 2 Suppose that the money demand function is + = 600 – 757 where r is the interest rate in percent. The money supply M is $1500, and the price level P is fixed at 5. Round answers to one place after the decimal when necessary. c. What happens to the equilibrium interest rate, r, if the supply of money is raised from $1500 to $1350? % d. If the central bank wants the interest rate to be 5.5 percent, what money supply should it set? Money supply = $

Answer 1

2. a. real Money supply = M/P = $1500/5 =$300.

Intercepts of money demand - when r=0, money demand is 600; when money demand is zero, 75r=600 - r=8.

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b. Equilibrium interest rate is

300 = 600-75r

or, -300 = -75r

or, r=4%

c. When M=1350 (money supply decreases), real money balance - M/P = 1350/5 = 270.

at equilibrium, 270 = 600-75r

or, r = 330/75

or, r = 4.4%

d. So lets set r=5.5 and calculate equilibrium real money balance.

M/P = 600-75*5.5

= 187.5

Given P=5, M = 187.5*5 = $937.5