Name Date last 4 PSU ID Economics 304WD Homework Lesson 8 Demand for Money 85 points total Instructions Please show all work and use this template while completing this homework 1 65 points total Suppose the real money demand function is Assume M 4000 P 2 0 e 0 01 and Y 5000 Note we are holding P and Y constant in this problem until we get to case 2 below a 5 What is the market clearing real interest rate r b 10 Show your results on a real money supply real money demand diagram and label this initial equilibrium point as point A Be sure to label your graph completely Correctly drawn and completely labeled diagram is worth 10 points total Be sure to put relevant shift variables in parentheses next to the appropriate function 1 Case 1 c 5 points Suppose Janet Yellen and the Fed were successful in their campaign to decrease inflationary expectations to 0 05 005 Why would they want to do this Use the Fisher equation to support your argument d 5 points Solve for the real interest rate that clears the money market given the change in inflationary expectations Please show work and Label this new point as point B on your diagram above r 2 e 10 points Explain how this strategy of decreasing inflationary expectations is supposed to pull back on the economy Recall that output is equal to C I G Be very specific Hint The price of current consumption in terms of future consumption and the user cost of capital most definitely need to be in your response Case 2 Let us return to our original conditions Please redraw the original graph locating point A this is with e 0 01 we are holding expected inflation constant in case 2 3 f 5 points We now experience an economic slowdown so that Y 4000 This is the only change Resolve for the market clearing real rate of interest and label on your diagram as point B Please show all work and label this as point B on the graph above Correctly drawn and completely labeled diagram is worth 10 points total Be sure to put relevant shift variables in parentheses next to the appropriate function r g 5 points Now explain exactly why the real rate of interest had to change the way it did to clear the money market Please be clear with the intuition being sure to refer to the bond market in your answer You should begin your response with At the same real rate of interest the money market is no longer clearing In particular money demand you can finish the rest 4 h 5 points Suppose the Fed wanted to keep real interest rates constant at their original level Suppose also that the money multiplier is 0 8 which is consistent with reality since the Fed began paying interest on reserves beginning in October 2008 What exactly would the Fed have to do to keep real interest rates constant at their original level Be specific with regard to the type and quantity of open market operations the Fed would need to conduct to be successful in keeping real interest rates constant at their original level i 5 points Finally explain the movement to the new equilibrium in the money market given the Fed expansion and show on your diagram as point C Be sure to refer to the bond market as you did in part f In fact you should start your response the same way 5 2 10 Using the percent change of the equation of exchange explain what assumptions need to be made to make the argument that the Fed should allow for the nominal money supply to grow at 5 3 This question will dig deeper into the velocity of money a 5 Define the velocity of money b 5 What does it mean if the percent change in velocity is negative c 5 Give a real life example of how this could be possible d 5 What central banking nightmare can occur if we see the percent change in velocity of money turn negative and the Fed does not react 6