ECON 304 HW 8

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Economics

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Jan 9, 2024

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Name _______________________________________________ Date_________ last 4 PSU ID _______ Economics 304WD -- Homework - Lesson 8 – Demand for Money - 85 points total  You need to show your work, not just the final answer  Use the template to complete your work or points will be taken off.  Please put your name and PSU ID number at the top of the page  Save the file on your computer ( .PDF is the only format allowed ) and then upload it to the Canvas dropbox for this homework assignment.  Be sure your assignment is all on one file. Failure to submit a single file will result in points being deducted 1. (65 points total) Suppose the real money demand function is: Assume M = 4000, P = 2.0, π e = 0.01, and Y = 5000. Note: we are holding P and Y constant in this problem until we get to case #2 below. a) (5)What is the market clearing real interest rate? r = b) (10)Show your results on a real money supply, real money demand diagram and label this initial equilibrium point as point A. Be sure to label your graph completely! Correctly drawn and completely labeled diagram is worth 10 points total. Be sure to put relevant shift variables in parentheses next to the appropriate function. Case #1 7/8/2022 1,500 + .2 ( 5,000 ) − 10,000 ( r + 0.0 = 0.04 m/p R 0.045 0.04 2,000 1

c) (5 points) Suppose Janet Yellen and the Fed were successful in their campaign to decrease inflationary expectations to 0.5% (.005). Why would they want to do this? Use the Fisher equation to support your argument. d) (5 points) Solve for the real interest rate that clears the money market given the change in inflationary expectations. Please show work and Label this new point as point B on your diagram above. r = Fisher equation r = i − π π = inflation i = nominal interest rate r = realinterest rate Fed decline inflationary expectations then real rates will rise. ideal to do this to pull back on a growing economy. 1500 + 0.2 ( 5,000 ) − 10,000 ( r + .005 ) = 4000 2 − 10000 r + 2450 = 2000 r = − 450 − 10000 = 9 200 .045 2

e) (10 points) Explain how this strategy of decreasing inflationary expectations is supposed to pull back on the economy. Recall that output is equal to C + I + G! Be very specific. Hint: The price of current consumption in terms of future consumption and the user cost of capital most definitely need to be in your response. Case #2 f) (5 points) We now experience an economic slowdown so that Y = 4000. This is the only change. Resolve for the market clearing real rate of interest and label on your diagram as point B. Please show all work and label this as point B on the graph above. Correctly Higher real interest rate will pull back the economy over investment. When real interest rate inclines the user cost of capital increase. Firms must decrease the level of capital investment to maintain profit maximization circumstances. When the desired capital stock decreases, the investment decreases. I = K ¿ − Kf + dk . An incline in real rates will cause an incline in the price of current consumption. The greater r will draw back investment. Let us return to our original conditions. Please redraw the original graph locating point A (this is with  e = 0.01, we are holding expected inflation constant in case #2) r 0.04 0.03 0.02 2000 1800 3

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