1- an economy begins in long-run equilibrium, and then a change in goverment reg
ID: 1187175 • Letter: 1
Question
1- an economy begins in long-run equilibrium, and then a change in goverment regulations allows banjs to start paying interest on checking accounts. recall that the money stock is the sum of currency and demand deposits, including checking accounts, so this regulatory change makes holding money more attractive.
a-How does this change affect the demand for money?
b-What happens to the velocity of money?
c-If the Fed keeps the money supply constant, what will happend to the output and prices in the short run and in the long run?
d-If the goal of the Fed is to stabilize the price level, should the Fed keep the money supply constant in response to this regulatory change?if not, what should it do? Why?
e-If the goal of the Fed is to stabilize output, how would your answer to part(d) change?
Explanation / Answer
a)Interest bearing checking deposits makes holding money more attractive, which increase the demand for money
b)Due to increased demand for money, interest rate increases decreasing the availibility of money thus decreasing the velocity of money.
MV = PQ
Where M is quantity of money,V is the velocity of money, P is price level and Q is the output.
This shows that the demand for money is inversely proportional to velocity. As demand increases velocity decreases.
c)Due to decrease in velocity, there is a reduction in aggregate spending this resluts in a shift in the aggregate demand curve towards its left, this reduces the output in the short run, but the prices remain same due to the sticky ness of the prices in short run.
In long run: low level of aggregate demand reduces the wages and prices, this makes the output to rise slowly reaching potential output. Here the price level will also decrease.
d)To stabilize prices fed should maintain a constant money supply, as it reduces the price level in the long run.
e)With constant money supply, there will be a decrease in aggregate spending shifting the AD curve toards its left reducing output and emplyment. To stabilize Fed should intervine by increasing the money supply which casuses a shift in AD towards its right restoring the long run equilibrium.
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