Question

Suppose that the money demand function is (M/P)d=1000-200r where r is the interest rate in percent. The money supply M is 1200 and the price level P is 2.
a. Graph the supply and demand for real money balances.
b.What is the equilibrium interest rate?
c. Assume the price level is fixe
d. What happens to the equilibrium interest rate if the supply of money is raised from 1200 to 1600?
d. If the Fed wishes to raise the interest rate to 5 percent, what money supply should it set?

Answer 1

Answe and Explanation:

b) To find out the equilibrium interest we will equate the money demand function with the money supply:

1000 - 200(r) = 1200/2

r = 2%

c) If the price is fixed and if the supply of money of is increased from 1200 to 1400 then the supply of real balances will be 1400/2 = 700

The equilibrium interest would be:

1000 - 200(r) = 700

r = 1.5%

Thus, it shows that when the supply of money is increased and the price is fixed then the interest rate would fall from 2% to 1.5%

d) The supply of real balances would be 1600/2 = 800

Hence, the interest rate will be:

1000-200(r) = 800

r = 1%

As proved above, an increase in the money supply would decrease the interest rate keeping the price fixed.

e) If the Fed keeps the interest rate at 5% then,

1000 - 200(5) = Money supply/2

Money supply = 0

Reduce the money supply if the interest is increase from 2% to 5%

a) Picture is attached.