# PS7 - Problem Set 7 Solutio ns Chapter 9#1 a...

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Problem Set # 7 Solutions Chapter 9 #1 a. Interest-bearing checking accounts make holding money more attractive. (Due to their ‘instant access’ nature, checking account balances are counted as ‘cash’ or ‘money’). This increases the demand for money b. The increase in money demand is equivalent to a decrease in the velocity of money. Recall the quantity equation M/P = kY where k = 1/V. For this equation to hold, an increase in real money balances for a given amount of output means that k must increase; that is, velocity falls. Because interest on checking accounts encourages people to hold money, dollars circulate less frequently. If the Fed keeps the money supply the same, the decrease in velocity shifts the aggregate demand curve downward, as in the figure below. In the short run when prices are sticky, the economy moves from the initial equilibrium, point α , to the short-run equilibrium, point B. The drop in aggregate demand reduces the output of the economy below the natural rate. Over time, the low level of aggregate demand causes prices and wages to fall. As prices

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PS7 - Problem Set 7 Solutio ns Chapter 9#1 a...

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