We discussed numerous times the importance of identifying shocks
to money demand. In particular, we argued that the policy
implications of shocks to money demand differ based on whether the
shock to money demand was real or portfolio.
a) (5 points) Let us consider a portfolio shock that increases
money demand, say due to non-monetary assets becoming riskier and
less liquid. Draw a real money demand and real money supply diagram
locating the initial equilibrium point as point A and then locate
the new equilibrium, assuming the Fed did nothing as point B.
Employing our general equilibrium framework, what would happen to
output in the short run and why? Be specific.
A correct and completely labeled diagram is worth 10 points
b) (5 points) Now comment on what would happen to the general price
level and why in the long run. Is this long run result desirable or
not? Please explain in detail (hint: its a central banking
nightmare!). Feel free to use the Fisher equation to support your
argument.
c) (5 points) Now connect this portfolio shock to the quantity
theory of money in percent change form. In particular, given the
increase in money demand due to the portfolio shock as outlined
above, what are the implications on the growth rate of the velocity
of money? Using the quantity theory of money in percent change
form, what is likely to happen if the Fed does nothing (i.e., does
not accommodate the shock to money demand). Assume we are in a
Classical world so that output growth is unaffected by the
portfolio shock. Is your answer similar or different than your
answer in part b?
d) (5 points) We now consider the appropriate response of the
Federal Reserve. Referring to the quantity theory of money in
percent change form, explain what the Fed should do and why. Locate
this as point C on your diagram.
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