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Money Demand in the Republic of Wakanda is given by: MD = PY (0.25 – i)...

Money Demand in the Republic of Wakanda is given by:

MD = PY (0.25 – i)

a) Suppose initial equilibrium interest rate is 5%. The Wakanda FED is concerned about the economy over-heating and inflation rising. How much must they reduce the money supply by to raise interest rates by 5% to 10%? Show graphically and explain.

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Answer #1

Money Demand function is MD = PY (0.25 – i)

a) Suppose initial equilibrium interest rate is 5%.At this rate, money demand is PY(0.25 - 0.05) = 0.20PY.

Money demand should be equal to money supply whe money market is in equilibrium. Hence money supply is currently 0.20PY. When the interest rate is 10%, money demand becomes

PY (0.25 – 0.10) = 0.15PY.

This should be the new money supply because money demand will experience an upward movement along the curve while money supply will shift leftwards.

Reduction in money supply = (0.20PY - 0.15PY)*100/0.20PY = 25%.

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