Ch. 4 - ECN101 Intermediate Macroeconomics Professor...

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ECN101 Intermediate Macroeconomics Winter 2009 Professor E.A.Frenkel Homework 4 - Solutions Now, turn to your Workbook, Chapter #4 Please do: (1) The fill-in questions and Multiple Choice questions # 1 through 21 (pages 59 ?64) This tests your understanding of the chapter you have carefully read. The problems that follow will test your understanding of expectations about the price level as well as how these expectations can impact the nominal interest rate, the demand for money and thus money income velocity of circulation. (2) Using the example from the lecture as a guide, try to trace through the impact on the price level from a central bank announcement that it is the intention of the central bank to lower the supply of money sometime in the future. This does not mean that the central bank will actually lower the money supply; it simply announces that it intends to do so in some future time. The correct answer will show how the actual price level might fall even if the stock of money in the economy does not change. That is, if the central bank wants to lower the price level our macro-theory says that it may accomplish this fact just by announcing an intended policy. Solution: When the central make that announcement about lower money supply, people’s expectation about future inflation decreases, that is, e π . According to the Fisher equation, nominal interest rate (i) also decreases. The lower nominal interest rate reduces the cost of holding money and therefore increases the demand for real money balances (M/P) D . The velocity of money decreases. Because money supply today is actually not changed. The increased demand for real money balances would then have to
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