Question

2. The demand for money is: Mº = PYL (1), where P is the price level, Y is the real GDP and L () is an inverse function of the rate of interest (i.e. when i increases, L (1) decreases, and vice versa). Money supply is: M$ = mH, where H is the high-powered money issued by the central bank and m is the money multiplier. (a) Draw the money demand and supply curves on a graph with money demand and supply on x axis, and interest rate (i) on y axis. Clearly mark the equilibrium point and label the equilibrium interest rate as i. [3 points (b) Now suppose that the real GDP (Y) increases. How will this change affect the money demand and supply curves? Draw the new curves on the same graph that you have drawn for part (a). What happens to the equilibrium interest rate? Label the new equilibrium interest rate as iz in the graph. [2 points) (c) Draw money demand and supply curves on a new graph with money demand and supply on r axis, and the price level (P) on y axis. Clearly mark the equilibrium point and label the equilibrium price level as R. [3 points) (d) Now suppose that the real GDP (Y) increases. How will this change affect the money demand and supply curves? Draw the new curves on the same graph that you have drawn for part (c). What happens to the equilibrium price level? Label the new equilibrium price level as P, in the graph.

Answer 1

a).

Consider the given problem here the demand for money is, => Md = P*Y*L(i), where “L()” is negatively related to interest rate (i). So, the demand for money is also negatively related to interest rate. On the other hand the money supply is completely independent with interest rate, => it is vertical. Consider the following fig.

i Ms1 il Md1 → Md, Ms

Here “Md” is the demand for money and “Ms” is the supply of money, => the equilibrium is the intersection of Md and Ms. So, the equilibrium interest rate is “i1”.

b).

Now, let’s assume the GDP increases, => the demand for money also increases, => Md will shift to Md2, given the money supply. So, the new equilibrium is the intersection of Md2 and Ms.

i Ms1 i2 il Md2 Mdi Md, Ms

So, the equilibrium interest rate increases to i2.

c).

Now, the demand for money is positively related to the price (P), => if we measure “P” on the vertical axis, => the money demand schedule should be upward sloping. On the other hand the money supply is vertical.

P Ms1 Md1 P1 Md, Ms

So, the equilibrium is the intersection of Md1 and Ms, => the equilibrium price is P1

d).

Now, let’s assume the GDP increases, => the demand for money increases, => Md will shift to Md2 for each price level.

P Ms1 Md1 Md2 P1 E P2 Md, Ms

So, the new equilibrium is the intersection of Md2 and Ms, => the equilibrium decreases to P2.