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Assume that the quantity theory of money holds and that velocity is constant at 5. Output is fixed at its full-

employment value of 10,000, and the price level is 2.

a) Determine the real demand for money and the nominal demand for money.

b) In this same economy the government fixes the nominal money supply at 5000. With output fixed at its full-

employment level and with the assumption that prices are flexible, what will be the new price level? Whathappens to the price level if the nominal money supply rises to 6000?

The quantity theory of money states that (Prices x Output = Nominal money supply x Velocity). Velocity is ameasure of how hard money 'works' (the amount of purchases a single dollar facilitates).

a) PY=MV2*10,000=M*54,000 = M (the nominal money supply/demand)

Real demand for money is defined as (Nominal Demand/Price Level). M/P = 4,000/2 = 2,000

b) i) Y=10,000 (fixed output)M= 5,000 (fixed nominal money supply)

V=5 (constant)

P=MV/YP=5,000*5/10,000P=2.5 (The price level when nominal money supply is held constant at 5,000 is 2.5)

ii) M=6,000

P=6,000*5/1,000P=3 (When the nominal money supply rises to 6,000 the price level increases to 3,ceteris paribus).

Macroeconomics, Seventh Edition Andrew B. Abel, Ben S. Bernanke, Dean Croushore

Pg 272 Long run Economic Performance

4. Assume that prices and wages adjust rapidly so that the markets for labor, goods, and assets are

always in equilibrium. What are the effects of each of the following on output, the real interest rate, and

the current price level?

a. A temporary increase in government purchases :

A temporary increase in government purchases would decrease savings, which would lead to the

government implementing higher taxes in other to math prices and wages.

This would lead for output to stay the same, Real Interest to increase and current price level to increase

as well.

b. A reduction in expected inflation.

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A reduction in expected inflation would lead to an increase in real money demand because people do

not expect inflation to increase for a while. Therefore more demand creates a decrease in the price

level. Everything else stays the same. This would lead for output to stay the same, Real Interest to stay

the same and current price level to decrease.

A temporary increase in labor supply.

A temporary increase in labor supply would mean more people have jobs and therefore more people

can save. If more people save the interest rates are prone to decrease therefore money demand will

increase. . This would lead for output to increase, Real Interest to decline and current price level to

decrease.

An increase in the interest rate paid on money.: .

An increase in the interest rate paid on money will cause a higher demand of money. With the same

nominal money supply and a higher demand of money the price would decline but everything else stays

constant. This would lead for output stay the same, Real Interest to stay the same and current price

level to decrease.

Refer q14 dox

Solution: The meaning of the questions in prices and wages to adjust quickly hypothesis shows that this problem is

to construct the basic spirit of the classical school , the

To highlight the effect of intertemporal substitution of labor , so that a more complete coverage of the model , weuse the following school of thought into the RBC

Line analysis:

( 1 ) the effect of fiscal policy :

Government spending increased , causing real interest rates to rise, through the " labor market intertemporal

substitution effect " , the current increase in labor supply,

The next stage to reduce the supply of labor , thus increasing the total supply , AS curve to the right . Therefore, an

increase in government spending , resulting in increased output

Plus , real interest rates rise ; Regarding the impact on prices determined . Because of increased government

spending , total final demand of goods and services

Increase , however, through the " labor market intertemporal substitution effect " , AS also increased , the larger the

labor market if the intertemporal substitution effect ;

AS AD rate of increase is greater than the rate of increase will cause prices to fall; smaller if the labor market

intertemporal substitution effect ; AS

AD is less than the rate of increase of increase will cause inflation .

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( 2 ) has a neutral monetary policy : money supply , inflation would result in the same proportion , output and real

interest rates remain

Unchanged, there is no intertemporal substitution effect occurs , labor supply will no

(3) the expected inflation rate rose:

ps5_sol IMPORTANT question 8