Question

The (nominal) money demand function of individuals is given as Md = $Y L(i), where $Y is nominal income (that is nominal GDP) and L(i) is a function of the interest rate. Suppose that the function L(i) has two components (without actually specifying a particular function here): (1) a component that depends on the interest rate, just as we discussed in class and (2) a component that is independent of income and the interest rate. This second component says that individuals would like to hold a certain amount of money regardless of what the current interest rate is and what their current income is. Let’s call this component the ”autonomous money demand”.

Suppose that individuals decide to increase their autonomous money demand. Assume an upward sloping LM curve.

a. Use the 3-graph method which we discussed in class to analyze the short-run effects of this change in the behavior of individuals. Clearly label which graph represents the money market, the goods market and the IS-LM model. Also label each axis, all curves and equilibrium outcomes clearly!

b. For each of the shifts that you drew in your graph above, explain briefly in words what causes the shift. That is, explain the mechanism behind the changes.

Answer 1

A, B).

Consider the three fig shows the “money market”, “goods market” and “IS-LM”.

So, here “money demand” function depends on “Y” and “i”. Now, the initial money demand function was “Ld1” and the initial equilibrium is given by “1”, => “Y=Y1” and “r=r1”. Now, as the “Ld” decreases because of the autonomous component, => the “Ld1” shift right to “Ld2”, => the “r” increases to “r2” given the same level of “Y”, => LM will shift up to LM2. So, as “r” increases, => investment will falls, => AD will decreases to “AD2” from “AD1”, => the “Y” also decreases from “Y1” to “Y2”. So, the new equilibrium is given by “2” where “r2 > r1” and “Y2 < Y1”.