Question

Assume the real money demand function is

L(Y;i)=2000+0.3Y-5000i

where Y is real output, P is the price level, i is the nominal interest rate on non-monetary assets and monetary assets earn no interest.

a) Assuming that the asset market is in equilibrium at i=0.05. Find equilibrium levels of real money supply, nominal money supply, and the velocity of money if P=100, and

Y=2000.

b) Find the real income elasticity of money demand at the equilibrium level of money balances found in previous part.

c) The rate of inflation in this economy is defined as the growth rate of the nominal money supply minus an adjustment for the growth rate of real money demand arising

from growth in real output: π=∆M/M - ηy(∆Y/Y

Assuming that real income is expected to grow by 5% over the next year, and the interest rate remain constant. Find out by how much should the central bank increase the money supply if pursuing an ination targeting policy to maintain a zero ination rate for next year.

d) Does the quantity theory of money hold in this economy? state your reason by considering above part

Answer #1

a) Real Money Supply = M/P. Using i= 0.05 and Y= 2000.

M = 2000 + 0.3*2000 -5000*0.05

M = 2350

Real money supply must be 2350

Nominal money supply = 2350*100 = $235000.

Velocity = (P*Y)/M

Velocity = 85.10

b) Real income elasticity of money = dL/di * (i/L)

Elasticity = -5000* (0.05/2350)

Elasticity = -0.106

c) The central bank will increase the money supply by 0.05*235000 = 11750

* For solution to other parts please post as a new question . CAn solve only these many parts

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