278
Chapter 7 The Asset Market, Money, and Prices
fiat is the relationshi p between the pnce level and
the nominal money supp ly? Wh at is the relati onship
between inflation and the grow th rate of the nominal
money sup p ly?
• List an d d iscuss the mac roecono .
affect the ag gregate demand for mone y.
8. Wh y is equilibrium in the asset mark et escn bed by the
f l equa l real money
ss u m ption is ne eded to
d em and? What aggr ega t'o
allow ignoring the mar ts for other asset s?
j
I
I
"
NUMERICAL PROBLEMS
ive an example of a factor th at would increase the
pu
' exp ected ra te of infla tio n. All el se being
ould this increas e in the exp ected infla­
equ al, ho
bon rate affect interest rat es?
c HA-,rel. -'1_ _
Qu esti ons marked with a bro wn circle are avail ab le in
MyEconLab at w ww.m yecon lab.com .
Su ppose the interest rate on a one-year bond toda y is
6% per ye ar, the in teres t rate on a on e-yea r bond one
year from no w is expected to be 4% p er yea r, and the
in teres t rate on a one-yea r bond two yea rs from now IS
exp ected to be 3% per year. The nsk pr emium on a
tw o-year bond is 0.5% per year an d th e n sk pr emium
on a thr ee-year bond is 1.0% per yea r. In equ ilib rium,
wh at is the in teres t rat e today on a tw o-year bond? On
a th ree- ye ar b ond ? What is th e sh a p e of th e y ield
curve ?
Money demand in an economy in which no int er est
paid on money is
IS
Md
- - ; 50Q+0 .2Y -1000i.
p
a. Sup pose that P = 100, Y =-1000, and i =0.10. Find real
m one y d emand , n ominal mone y demand , an d
velocity
b. The price level doubles from P z; 100'to P = 200. Find
real money d em and, norrunal mon ey demand, and
velocity.
c. Sta rting from the valu es of the va na bles given in
Part (a) and assum ing that the mone y d emand func­
tion as w rit te n holds, de termine h ow veloc ity IS
affected by an increa se in real rncome. by an increa se
in the nominal int erest rat e, an d by an increase In
the pnce level.
Mr. Mid as has w eal th o f $100,000 th at he in ves ts
en tire ly in money (a checking acco un t) and govern­
ment bonds . Mr. Mid as in stru cts his broker to in vest
$50,000 in bonds, plus $5000 more in bonds for ever y
p e rce n ta g e p oint that the interest rate on b ond s
exceed s the intere st rate on his ch eckin g account.
a. Write an algeb raic formula th at gI ve s Mr Midas's
demand for m one y as a fun ction of bond and check­
mg acco un t interest rate s.
b Write an algebraic formula that gIves Mr MIdas's
demand for bonds. What is the s um of hIS demand
for mone y and his demand for bonds?
c. Suppose that all holders of wea lth in the econo my
are Identical to Mr. Mid as , Fixed asset supplies p er
per son are $80,000 of bonds and $20,000 of checking
accounts. Chec kin g acco unts pa y no interest . Wha t ·
IS th e in terest ra te on bonds in asset m ar ket equihb­
rium?
, Ass u me that the quantit y th eory of money ho lds and
th al velocit y is con s tant at 5. Output is fixed a t Its
full-emplo yment va lue of 10,000, and the pnce level
is 2.
a Dete rmine the real demand for money and the nom­
inal demand for mo ney.
b. In this sam e econom y th e gov ern me n t fixes th e
norrunal money su pp ly at 5000. With ou tp u t fixed at
its full-employment level and w ith the assumption
that prices are flexibl e, what will be the new price
level? 'lA/hat happens to the price level if the nominal
mone y supply n ses to 6000?
Consider an economy with a constant nominal money
supply, a consta nt level of real ou tp u t Y = 100, and a
consta n t real in terest rate r := 0.10. Sup pose that the
inco me elas ticity of mone y demand is 0.5 and the inter­
es t elasticity of money demand is - 0.1
a. By w hat percentage doe s the equilibnum p nc e level
di ffer from its initial value if output increa ses to Y:=
106 (and r rema ins at 0.10)? tHint: Use Eq. 7.11.)
Chapter Summary
vel and
ionship
.ornina l
b. By wha t p erc entage do es the equilibr ium price level
differ from its init ial valu e if the real int ere s t in creas­
es to r =0.11 (and Y rema ins a t 100)?
c. Suppose th at the real interest ra te inc reases to r
0.11 Wh at w ould real o utput ha ve to be for the equi­
librium price leve l to remain at its ini tial va lu e?
=0
ase the
bein g
d infla ­
~
G Suppose th at th e real money de m and func tion is
o.oir
L(Y ,r +n e ) = - - ,
r+n e
w here Y is real o u tpu t, r is the real in terest ra te, an d rr'
is the expected ra te of in flation. Real o u tp u t is cons tan t
over time a t Y = 150. The rea l interest ra te is fixed in the
goods ma rk et at r = 0.05 per year.
a.
bo nds
-lnt.
-Iidas 's
check ­
Suppose that the nominal m oney supply is growing
at th e ra te of 10% per year an d th a t th is gro w th rate
is expec ted to pe rsist fore ver. Currently, the nomi­
nal m oney s u pp ly is M = lOa What a re th e va lues
of the re al money s upp ly and the cu r re n t price
lev el? (Hin t: W ha t is the va lue of th e expec ted in fla­
tion ra te th at enters the m on ey demand fu nc tion?)
279
b. Suppose tha t the nominal mo ney sup ply is M = 300
Th e centra l ba nk anno unces that from no w on the
nomi nal m oney supply w ill grow a t th e ra te of 5%
per yea r. If everyo ne be liev es thi s anno uncement,
an d if all mar ke ts are in eq uilibrium , what are th e
values of the real money s up p ly and the current
price lev el? Exp lain th e effects on the real m one y
supply an d the curren t price level of a slo w d ow n in
th e ra te of mon ey growth .
The income elas tici ty of mon ey d emand is 2/ 3 an d th e
in ter es t e las ti city of m oney d ema nd is - 0. 1. Re al
income is expected to grow by 4.5% over th e next yea r,
and the real interest rate is expe cted to remain constant
ove r th e nex t year. Th e rate of infla tion has been ze ro
for se ve ral years.
a. If the cen tral bank w ant s zero infla tion over th e ne xt
year, w ha t gro w th rat e o f th e nom inal mon e y
su pply should it ch oos e?
b. By ho w much w ill velo city change o ver the next
ye a r if the ce n tra l ba n k foll o w s th e p oli cy tha t
ach iev es zero in fla tion ?
-lid as's
ernand
)nomy
ies p er
ecking
. What
q ui lib ­
i s and
2
at its
lev el
~
n om-
es th e
.xed at
, p tion
, p rice
.minal
noney
and a
at the
int er­
; level
to Y=
)
A N A LY T I C A L PROBLEMS
Qu est ions m arked wi
MyEcon Lab a t -"w,-,w",--"w"." m~v"","~~~L!.!..l.".
AIl else being eq ual, how wo d each of th e follow ing
affect the demand for M1? The d and for M2? Explain.
a. The maximum number of checks
mon th that can
ds and money
be wr itten on mone y ma rket mutual
m arket deposi t accoun ts is raised from tlii' to thir ty.
b. H ome eq u ity lines of cre d it th at allow hom vners
to w rite checks against the val ue of their hom
in trod uced .
c. Th e stock market crash es, and further sharp dec !' e
in the marke t are widely feared.
d. Bank s in troduce overd raft prot ection, u n er wh ich
fu nd s are automatically transferred h om savings to
checking as n eeded to cover
C s.
e. A cra ckd ow n red uces th illega l drug trad e (w hich
is carried o ut la rgel~ In cu rrenc y) .
, Fig ure 7.1 show. Hiat, be fo re the 1980s, M1 velocity
generally r
o ver time . Suggest some explana tions
for this upward trend.
3. The pri soner-of-war camp d es cribed by Rad fo rd (Bo x
71) peri odica ll y rec ei v ed large sh ip m en ts of ciga ­
rett es from th e Red Cross or other so rce .
How d id ciga rette shipm~
ect the price lev el
(the prices of goods i terms of ciga rettes) in the
POW camp?
b. (More d im uH O n so me occasi on s the prisoners
knew i a vance when th e cigarette sh ipm en ts were
to arr ive. What happened to the d emand for ciga­
. e tte mone y and the p rice level in th e camp in the
da ys just befo re an anticipat ed shipm en t?
a.
Assume tha t prices and w ages adjust rapidl y so th at
t 1 markets for labor, good s, and asse ts are al wa ys in
equl rium . What are the effects of each of th e foll ow ­
ing on
tp ut, the real in terest rat e, an d th e cur rent
p rice le ve .
a. A ternporar j inc rease in go vernment purchases.
b. A redu ction in . ected inflation ,
c. A temp orary increase in lab or supply.
d, An increase in theinterest rate paid on money.
.. .
,'....
- . ~. ;,.
---
348
Chapt er 9 The IS-Lf\1/AD- AS Model
s. Define general
equil ibriu m and sh ow th e general equ i­
librium POin t in the I S-LM d iagram . If the econom y
isn ' t In gen eral equilibrium, wh at determine s ou U
and the rea l in teres t rate? Wha t economic for e
t to
bring the economy back to genera l eq uilib ~u m ?
• Define monetary neuirulitu. Show tha t ffer prices adjust
completely, m oney is neutral in th
- LM model. Wh at
are the classical and Keynesi n views about whether
mo n ey 15 neu tra l in the s
t ru n ) In the long run?
,,
A '
•
!I '
,:I :.
Wha t tw o va r ia b les are re lated b y th e agg rega te
de m an d (A D ) curve? Wh y does th e A D curve slo p.
mv ar d ? Give two examp les of changes in the eConhe n ght and
om y th at shif t the AD curve up and
explain why the shifts occur
8. Desc rib e the sh or t-run a gt:e ate sup ply (SRAS) Curve
and th e lon g-ru n ag ega te su p p ly (LRAS) cu rve.
Why is one of th se curves horizontal an d th e other
ve rtical?
9. Use th
- A S framework to ana lyze w h ether money
IS
tral in the sho rt ru n and whether It is neutral in
re lon g ru n .
•
I
NUMERICAL PROBL EMS
•
i
Ques tion s ma rked w ith a bro w n circle are a vailable in
My EconLab at w w w.myecon lab.com .
"
•
,
I
C HAfre~ .. 9­
Desi red con sumpt ion and in vest m ent are
c Use M =­ 6000 aga m and rep eat Pa rt (a) for n' =: 0.03.
Com pare th e LM curve in th is case wi th th e one in
Part (a) .
"
f» An ec on o my has full -emplo ym ent o ut put of 1000.
Cd -= 4000 - 40001' + 020 Y;
[a = 2400 - 40001'.
Desired consumption and desired investmen t are
Cd =: 200 + 0.8(Y ­
[d =: 200 - 500r.
As usual, Y IS output and r IS th e real interest ra te.
Go vernmen t p urc hases, G, ar e 2000.
a. Find an equa tion relating de sired n a tion al saving,
Sd, to ra nd Y
Md
P
T = 20 +0 .25Y
Money de m and is
Md
-
o
P
= 05 Y ­ 250(1' + n' ),
w h ere the expe cted ra te of in flat ion , n' , is 0.10. The
nominal su p p ly of money M =­ 9890.
a. Wh at are the general equi librium values of the real
interest rate, price level. cons ump tion. and investment?
b. Suppose that govern men t p urchas es are Increased
to G =: 216. What are the ne w genera l equ ilibn um
values of the rea l int erest rat e, the price lev el, con­
sump tion, an d investment?
The productio n func tion in an econ om y is
=­ 300 + OI Y -10,0001.
Assume tha t M = 6000, P = 2.0, and n' =: 0.02.
a. Wh at is the real In terest rate, r, th at clears the asset
m arket w hen Y =: 8000? When Y =: 9000? Graph the
LM cu rv e.
b. Rep ea t Part (a) for M = 6600. How does the LM curv e
in this case compare With the LM curve tn Part (n)?
n - 5001';
Go vernmen t purchases are 196, an d taxes ar e
b. What value of th e rea l int ere st rate clears the goods
m ar ket when Y =: 1O,000? Use b o th forms of th e
goo d s market equilibnum cond ition . What value of
the real in teres t rate clears the goods m ark et w hen Y
=: 1O,200? Gra p h th e I S cu rve.
c. Go vernmen t purchases rise to 2400. How does tlu s
increase ch an ge th e equa tion for nati on al saving In
Part (a)? What va lue of th e real int erest ra te clears
the goods market w hen Y =: 1O,000? Use both form s
of th e go od s market equilib rium con d ition . How IS
th e [5 curve affe cted by th e increa se in G7
In a p ar ticul ar econ om y th e real m oney de m and func­
tion is
-
Y =: A (5N ­ 0.0025N'-) ,
w he re A
IS
productivit y. With th is p ro d uction fun ction,
t h e ~ '~bo Y cU-tnG\hQ... .
kJl:
Mfl!;.j =
Sup p ose tha t A
=:
SA - 0.005ANS
2, The labo r supply cu rve is
NS = 55 + 10(1 - tlw,
Chapter Summary
'n­
ld
wh ere NS is the amoun t of labor sup p lied , tv is th e real
wa ge, an d t is the tax ra te on wage income, which is OS
Desired con su mp tion and in vestmen t are
ve
'e,
I d = 258.5 - 2501,
Taxes and gov ernm en t purcha ses ar e
T= 20 + O.5Y;
G = 50.
~y
in
Money d em and is
Md
-
3,
n
J,
e
i.l
?
:l
p
Real money de mand
L = O.5 Y - 200i.
Full-employment outp u t Y = 4600.
Exp ected inflation
ITe = O.
a. Su pp ose tha t T -= G = 450 an d that M = 9000. Find an
equat ion descri bing the IS curv e. (Hint : Set de sired
Cd = 300 + 0.8(Y - T ) - 200r;
er
34{§)
= 0.5Y - 250(r + n e),
Th e exp ected rat e of in flation, IT! , is 0.02, an d the nom­
in al money suppl y M is 9150.
a. Wh at are th e general equ ilibriu m leve ls of the real
wage, em ployme n t, and ou tpu t?
b. For any lev el of o u tp u t, Y, find an equatio n th at
give s ,the real interest rate, r, tha t clea rs the goods
m arket; this equation de scribe s th e IS cur ve. (Hint:
Wri te the goods mar ket eq uilib rium cond ition an d
solv e for r in ter ms of Y an d other variables.) Wh at
are the gene ral equilibriu m value s of the real interest
rate, cons um p tion, an d inves tmen t?
c. For an y level of ou tp u t, Y, find an equation that gives
the rea l int erest rate that clears th e asset marke t; this
equation d escribes the LM curve. [Hint: As in Part
(b), write the ap p ropriat e equilibrium condition an d
solve for r in terms of Yand other variables.] Wha t is
the general equilibrium value of the pr ice level?
d. Suppose th at govern me n t pu rch ases increase to G
= 72.5. Now what are th e gen eral equ ilib rium values
of the real wage, em p loyme n t, ou tp u t, the real inter­
es t rat e, con sumption , inves tm en t, an d pr ice level?
Con side r the follow in g economy:
Desired consu mption
Cd = 1275 + 0.5(Y - T) - 2001.
Id = 900 - 200r.
Desired inves tmen t
n ation al saving and d esired investment equal, an d
solve for the relatio nship be tween r an d Y) Find an
equ ati on d escribi ng th e LM curve. (Hint, Set real
money supp ly and real mone y de man d eq ual, and
again sol ve for th e relationshi p between r and Y,
given P ) Fina lly, fin d an equation for the aggregate
dem and cuzve. (Hint : Use the IS an d LM equation s
to find a relationsh ip bet ween Y and P) W ha t are
th e gen er al e qu ili br i um va lues of ou tp u t, con­
sump tio n, in vestment , th e real interest ra te, an d
pr ice level?
b. Suppose that T = G = 450 an d that M = 4500. Wh a t is
the equ ati on for the aggregate de m an d cu rve n ow?
Wh at are the ge nera l equi libriu m values of ou tp u t, '
cons u mp tion , investment , the real interes t rate, an d
p rice level? Assume that fu ll-employme n t outp u t Y
is fixed ,
c. Repea t Par t (b) for T = G = 330 and M = 9000.
• (Ap pend ix 9.B) This qu estion ask s you to use the for ­
mul as in Ap pend ix 9.B to fin d the gen era l equilib rium
va lues of v a ria b les fo r th e econom y desc r ibed in
Nu merical Problem 4. Assume that G = 50.
a. Use the d at a from N u me rical Probl em 4 , to fin d
the numerical values of the parame ter s A, 11,/2'
c.. to' i , iO' i; RO, t ; an d e, defi ned in
Append ix 9.B.
b Substitu te the va lue s of th ese behav iora l pa ram e­
ters int o the relevant equ ations in App endix 9.B to
com p u te the general equ ilibrium va lues of the real
w age, em ploym en t, output, th e real int erest rate,
an d the pri ce level.
c. Ass um e th at governm ent p urcha ses, G, in crea se to
72.5, an d rep ea t Part (b).
nO' n w ' CO' Cy,
n
NALY TiCAL PROB LEMS
Questions m ark ed wi th a brown circl e ar e ava il
MyEconLab a t w w w.myeconlab .com .
e in
Use the IS-L M model to deter mi
e effects of each of
th e following on th e general equilibr iu m values of the
real wage, employmen t utput, real int erest rat e, con ­
su mption , in vestme , an d pri ce level.
a.
A red u cti on ' th e eff ectiv e tax r a te on ca p ita l
increases d esi red investment
b. The expected rat e of inflatio n rises.
c. An infl ux of wor king-age immigrants in creases
labor sup p ly (ign
any other p ossible effects of
IOn) .
increased pop'
d. In crea sed
a g e of a u to ma tic telle r ma ch ines
red uces he de m and for money.
Use tli' IS- LM model to analyz e the general equilibrium
ects of a per man ent increase in the price of oil (a per ­
man ent adv ers e supply sh ock) on cu rre n t output,
- - -:.-..;.:-
.....