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Practice Exam 1- Spring 2012

# iii 14 pts consider a large open economy carefully

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Unformatted text preview: terest rate, and Y is income. In the money market, the nominal money supply is assumed to be exogenous and controlled by the Fed. Explain what will happen to the equilibrium price level in this market under the following cases. Make sure to label: i). the axes; ii). the curves; iii). the initial equilibrium values; iv). the direction curves shift; and v). the terminal equilibrium values. a. [5 pts] People in the economy revise their expected rate of inflation upward. r r1 M/P2 M/P1 A C B P↑ e π↑ e L(r + π 1, Y1) e L(r + π 2, Y1) M/P In order to understand the effect of the increased expected rate of inflation, we can rewrite the general money demand function by using the Fisher equation, so that (M/P)d = L(r+πe, Y), where r is the real interest rate and πe represents the expected rate of inflation. When people revise their expected inflation rate upward, the ex- ante nominal interest rate increases. Since the opportunity cost of holding money become more expansive, the demand for money decreases. Graphically, this is represented as a leftward shift in the money demand function since for every possible value of r, your money demand becomes lower. The market immediately moves to B after the shift in the money demand function. However, B cannot be the equilibrium in this market since the real interest rate that is exogenously determined outsid...
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