EC111Class14Answers

EC111Class14Answers - EC111 MACROECONOMICS Spring Term 2012...

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EC111 MACROECONOMICS Spring Term 2012 EC111 Class 14 Solution Question 1 a. The quantity theory of money is a theory where the demand for money depends only on transactions demand: MV = PY, where M is the money supply, which is equal to money demand, V is the velocity of circulation, P is the price level and Y is real national income. The most important prediction from this simple theory is that an increase in the money supply leads to an equal proportional increase in the price level. The key assumptions are that: (i) velocity is stable (assumed constant); (ii) the price level is perfectly flexible, and (as a result of (ii)) real national income is always adjusted to the full employment level. Since Y and V are fixed, P is proportionate to M. b. In our simple economy we have two assets, money and bonds. The rate of interest on bonds represents the opportunity cost of holding money. According to liquidity preference people will hold less money the higher is the opportunity cost—the demand for money is downward sloping in the interest rate. The interest rate on bonds is the fixed coupon rate c divided by the price of bonds, Pb, so r = c/Pb. At a given interest rate (and income level) an increase in the money supply
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EC111Class14Answers - EC111 MACROECONOMICS Spring Term 2012...

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