Money demand in an economy in which no interest is paid on money is Md/p = 5000

Question

Money demand in an economy in which no interest is paid on money is Md/p = 5000 + 0.2 Y + 1000i

a) Given P= 100, Y= 1000, i = 0.1 find real money demand, nominal money demand, and velocity. if the price level doubles from p 100 to p 200. find real money demand, nominal money demand, and velocity

(b)Assuming that the money demand function has written holds, determine how velocity is affected by an increase in real income, by an increase in the nominal interest rate, and by an increase in the price level

Explanation / Answer

a) Given these values, we have Md/100 = 5000 +0.2*(1000) +1000*(0.1), Md/100=5000+200+100. Thus we have Md=530000. This is the nominal money demand. The real money demand is given by 5300. The velocity is given by 5300*V=100000,V= 18.9. This is the velocity of money.

Now if P=200, we have real money demand as Md/200 = 50000 + 0.2*(1000) +1000*(0.1) = 5300. The nominal money demand is given by 200*5300 = 1060000. Thus velocity now is given by 5300*V=200*1000, V= 38.

b) As the real income level increases then this will mean that people have more to spend, as per the quantity theory of money, as real income rises the velocity will increase.As nominal interest rates increases, then people find it more expensive to borrow. This will mean less money will circulate across the economy and so velocity will fall.As the price level rises people have to spend more to get the same goods they want more and so the velocity will increase.

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