(15 points] Consider a numerical problem in monetary model. Suppose we have an e
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Question
(15 points] Consider a numerical problem in monetary model. Suppose we have an estimated money demand function Md-PL(Y,T), with L (Y, r) = Y-100r. The economy is in equilibrium at Y-10, P = 1 and MS-5. Use the definition of money market equilibrium to obtain the equilibrium real interest rate a. Suppose that the central bank increases money supply to the new level Mhew-7.5 Consider the classical model with flexible prices. What is the new real interest rate and price level? Use the Fisher approximation to compute the new nominal interest rate b. c. Consider the sticky price model in which the price level remains fixed. What are the new real and nominal interest rates?Explanation / Answer
A) MD=Money supply=5
5=10-100r
100r=5
Thus r=0.05 i.e. 5% interest rate
B) under classical economics or according to quantity theory of money, there is direct relation between price and money supply. Thus there will be 50% inlfation or new price will be 1.5
New nominal interest rate=5+50=55%
C) if prices are same then
7.5=10-100r
r=2.5/100=0.025
Since inflation=0. Real intetest rate=nominal intetrst rate=2.5%
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