31410fps3solutions

# 31410fps3solutions - Economics 314-1 Problem Set 3...

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Economics 314-1 Fall 2010 Problem Set 3 Suggested Solutions Question 1: a. Interest-bearing checking accounts make holding money more attractive. This change 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. c. If the Fed keeps the money supply the same, the decrease in velocity shifts the aggregate demand curve downward, as in the diagram below. In the short run when prices are sticky, the economy moves from the initial equilibrium, point A, to the short-run equilibrium, point B. The drop in aggregate demand reduces the output of the economy below the natural rate. Price level LRAS P P 1 SRAS B A P 2 C AD 1 AD 2 Y bar Y Income

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Over time, the low level of aggregate demand causes prices and wages to fall. As prices fall, output gradually rises until it reaches the natural-rate level of output at point C. d. The decrease in velocity causes the aggregate demand curve to shift downward. The Fed could increase the money supply to offset this decrease and thereby return the economy to its original equilibrium at point A, as in the diagram below. P LRAS A SRAS AD 1 AD 2 Y bar Y
To the extent that the Fed can accurately measure changes in velocity, it has the ability to reduce or even eliminate the impact of such a demand shock on output. In particular, when a regulatory change causes money demand to change in a predictable way, the Fed should make the money supply respond to that change in order to prevent it from disrupting the economy. e. The decrease in velocity shifts the aggregate demand curve down and to the left. In the short run, the price level remains the same and the level of output falls below the natural rate. If the Fed wants to stabilize output and return it to the natural rate, they should increase the money supply. Note that increasing the money supply in this case will stabilize both output and the price level so that the answer here is the same as in part d. Question 2: a. Total planned expenditure is PE = C(Y – T) + I + G. Plugging in the consumption function and the values for investment I, government purchases G, and taxes T given in the question, total planned expenditure PE is PE = 200 + 0.75(Y – 200) + 100 +200 = 0.75Y + 350.

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