Assume that the quantity theory of money holds and that velocity is constant at 5.

Output is fixed at its fullemployment value of 10,000, and the price level is 2. a) Determine the real demand for money and the nominal demand for money. b) In this same economy the government fixes the nominal money supply at 5000. With output fixed at its fullemployment level and with the assumption that prices are flexible, what will be the new price level? What happens to the price level if the nominal money supply rises to 6000? The quantity theory of money states that (Prices x Output = Nominal money supply x Velocity). Velocity is a measure of how hard money 'works' (the amount of purchases a single dollar facilitates). a) PY=MV 2*10,000=M*5 4,000 = M (the nominal money supply/demand) Real demand for money is defined as (Nominal Demand/Price Level). M/P = 4,000/2 = 2,000 b) i) Y=10,000 (fixed output) M= 5,000 (fixed nominal money supply) V=5 (constant) P=MV/Y P=5,000*5/10,000 P=2.5 (The price level when nominal money supply is held constant at 5,000 is 2.5) ii) M=6,000 P=6,000*5/1,000 P=3 (When the nominal money supply rises to 6,000 the price level increases to 3,ceteris paribus).

Macroeconomics, Seventh Edition Andrew B. Abel, Ben S. Bernanke, Dean Croushore

Pg 272 Long run Economic Performance

4. Assume that prices and wages adjust rapidly so that the markets for labor, goods, and assets are always in equilibrium. What are the effects of each of the following on output, the real interest rate, and the current price level? a. A temporary increase in government purchases : A temporary increase in government purchases would decrease savings, which would lead to the government implementing higher taxes in other to math prices and wages. This would lead for output to stay the same, Real Interest to increase and current price level to increase as well. b. A reduction in expected inflation.

A reduction in expected inflation would lead to an increase in real money demand because people do not expect inflation to increase for a while. Therefore more demand creates a decrease in the price level. Everything else stays the same. This would lead for output to stay the same, Real Interest to stay the same and current price level to decrease. A temporary increase in labor supply. A temporary increase in labor supply would mean more people have jobs and therefore more people can save. If more people save the interest rates are prone to decrease therefore money demand will increase. . This would lead for output to increase, Real Interest to decline and current price level to decrease.

An increase in the interest rate paid on money.: . An increase in the interest rate paid on money will cause a higher demand of money. With the same nominal money supply and a higher demand of money the price would decline but everything else stays constant. This would lead for output stay the same, Real Interest to stay the same and current price level to decrease. Refer q14 dox

Solution: The meaning of the questions in prices and wages to adjust quickly hypothesis shows that this problem is to construct the basic spirit of the classical school , the To highlight the effect of intertemporal substitution of labor , so that a more complete coverage of the model , we use the following school of thought into the RBC Line analysis: ( 1 ) the effect of fiscal policy : Government spending increased , causing real interest rates to rise, through the " labor market intertemporal substitution effect " , the current increase in labor supply, The next stage to reduce the supply of labor , thus increasing the total supply , AS curve to the right . Therefore, an increase in government spending , resulting in increased output Plus , real interest rates rise ; Regarding the impact on prices determined . Because of increased government spending , total final demand of goods and services Increase , however, through the " labor market intertemporal substitution effect " , AS also increased , the larger the labor market if the intertemporal substitution effect ; AS AD rate of increase is greater than the rate of increase will cause prices to fall; smaller if the labor market intertemporal substitution effect ; AS AD is less than the rate of increase of increase will cause inflation .

( 2 ) has a neutral monetary policy : money supply , inflation would result in the same proportion , output and real interest rates remain Unchanged, there is no intertemporal substitution effect occurs , labor supply will no (3) the expected inflation rate rose:

ps5_sol IMPORTANT question 8