Econ402_Solutions_Set5 - Economics 402 Winter 2009 Problem...

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Economics 402, Winter 2009 Problem Set 5 Suggested Solutions 1 Changes in the Commodity Market and their Implications for the Money Market (20 points) Use the intertemporal general equilibrium model with money to answer the following three questions: 1. Suppose there is a positive (exogenous) change in aggregate (output) demand for every real interest rate r , what will happen to the aggregate price level, P ? Can you answer this question unambiguously? (6) The exogenous change in aggregate demand means that in the goods market, the Y d curve shifts right as the first step: Thus, the quantity of real output, Y rises as well as the real interest rate r . The question asks about the aggregate price level, P . Therefore, we do not need to consider the labor market for this problem, since the amount of labor or the real wage has no effect on money demand (or supply). Money supply is fixed by the Fed (see part (3) below), so it does not shift. What about money demand? Y has gone up, causing money demand PL ( Y, r + i ) to rise for every given P . r has also risen, however, causing money demand to fall for every given P . The effect is ambiguous unless we make some assumption about the relative strength of the income effect ( Y ) versus the interest rate effect ( r ) on the money demand curve. 1
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Assuming that the income effect dominates the interest rate effect, we get that money demand increases (rotates right); in other words, for every given price level P , households demand more money, M . If this is the case, the price level will fall. If we do not make this assumption, then the answer is ambiguous. Consider the opposite case, in which the interest rate effect dominates the income effect. Then, money demand decreases (rotates left), and the price level rises. 2. Suppose there is a positive (exogenous) change in aggregate (output) supply for every real interest rate r , what will happen to the aggregate price level, P ? Can you answer this question unambiguously? (6)
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