Economics 304 Homework - Lesson 8 - Money Market Equilibrium Correct Answers - Solved Assignments | Economics

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1Economics 304 Homework-Lesson 8-Money Market EquilibriumCorrect Answers100 points total:Instructions:Please show all work or points will be taken off. Good luck!1.(65pointstotal)Suppose the real money demand function is:Md/P=1500+0.2Y–10,000 (r+e).AssumeM=4000,P=2.0,e=0.01, andY=5000.Note: we are holding P and Y constant in thisproblem until we get to case #2, see below.a)(5points)What is the market clearing real interest rate?Show your results on a real money supply, real money demand diagram and label this initial equilibriumpoint as point A.Be sure to label your graph completely!Correctly drawn and completely labeled diagram is worth 10 points total.Be sure to putrelevantshift variables in parentheses next to the appropriate function.Case #1b)(5points)Suppose Bernanke and the Fed were successful in their campaign to raise inflationaryexpectations to 4% (.04).Why would they want to do this? Use the Fisher equation to support yourargument.c)(5points)Solve for the real interest rate that clears the money market given the change in inflationaryexpectations. Please show work and Label this new point as point B on yourdiagram.d)(10 points)Explain how this strategy of raising inflationary expectations is supposed to stimulateoutput.Recall that output is equal to C + I + G! Be very specific as this question is worth 10 points.Hint:The price of current consumption in terms of future consumptionandthe user cost of capitalmostdefinitely needs to be in your response.Case #2e)(5 points)Let us return to our original conditions.Pleaseredraw the original graphlocating pointA (this is withe=0.01, we are holding expected inflation constant in case #2). We now experience someeconomic growth so that Y = 6000. This is the only change. Resolve for the market clearing real rate ofinterest and label on your diagram as point B. Please show all work.Correctly drawn and completely labeled diagram is worth 10 points total. Be sure to putrelevantshift variables in parentheses next to the appropriate function.f)(5 points)Now explain exactly why the real rate of interest had to change the way it did to clear themoney market.Please be clear with the intuition being sure to refer to the bond market in youranswer.You should begin your response with"At the same real rate of interest, the money market is no longerclearing. In particular money demand ....."you can finish the rest.g)(5 points)Suppose the Fed wanted to keep real interest rates constant at their original level.Supposealso that the money multiplier is 0.8, which is consistent with reality since the Fed began paying interest onreserves beginning in October 2008.What exactly would the Fed have to do to keep real interest ratesconstant at their original level? Be specific with regard to thetypeandquantityof open market operationsthe Fed would need to conduct to be successful in keeping real interest rates constant at their original level.

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2h)(5 points)Finally, explain the movement to the new equilibrium in the money market given the Fedexpansion 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.2.(35 pointstotal)During the video lectures in this lesson, I tried my best to emphasize the importanceof being able to identify shocks to money demand. During the Great Recession there was very muchturmoil in financial markets and as a result, money became more attractive relative to many non-monetaryassets. The graphic below is from a WSJ article from the fall of 2011.The left hand panel shows that thebid/ask spread for stocks was increasing which suggests that stocks, the non-monetary asset wearefocusing on in this question, are becoming less liquid.1The graphic on the right can be thought of as ameasure of risk and the implication in viewing the graphic is that stocks are becoming riskier.2a)(10points)In the space below, draw a money market diagram labeling the initial equilibrium as pointA.Note that this is a 'generic' graph meaning that there are no numbers. Now lets pretend that we havetwo portfolio shocks to money demand, much like above so that1) non-monetary assets become less liquid(left hand panel) and 2) non-monetary assets become more risky (right hand panel).Show exactly howyour diagram is effected and explain exactly why real interest rates changed the way they did.Label thisnew equilibrium as point B.Correctly drawn and completely labeled diagram is worth 10 points total.Be sure to putrelevantshift variables in parentheses next to the appropriate function.b)(5 points)Given that the economy is weak and the unemployment rate is much higher than thatassociated with NAIRU, the Fed wants real rates to fall, not rise.Explain exactly what the Fed wouldneed to do.This is referred to as accommodating the shock to money demand.Label this as point C onyour diagram.c)(10points)Now explain how your answer would change if instead the shock to money demand was real.That is, the same movement in the money demand curve from above was not caused by portfolio shocksbut was caused by a change in real output.Are the policy implications the same or are they different?Explain. (hint: the term 'potential growth rate of the economy' should be in your answer).1The bid/ask spread is more of a money and banking/finance term and if you have never heard of it before,no worries.If you want to learn more, clickHere.2The VIX has received a great deal of attention throughout the Great Recession and the aftermath.Tolearn more about the VIX, clickHere.

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