Question

Suppose that changes in bank regulations expand the availability of credit cards, so people need to hold less cash.

a. How does this event affect the demand for money? (3%)

b. How does this event affect the money velocity? (3%)

c. If the Fed does not respond to this event, what will happen to the price level? (3%)

d. If the Fed wants to keep the price level stable, what should it do? (3%)

Answer 1

Equilibrium price level and quanitity of money is determined by the intersection of Money supply (which is controlled by the Feds) and money demand. Figure 1 shows the equilibrium

Figure 1

1) Now, as the number of credit cards increase, the money demanded by the people would fall. This is represented in figure 2. The money demand falls from D1 to D2. As a result, the new equilibrium is at point e2 where the price level rises (earlier it was corresponding to e1 point)

Figure 2

2) According to quantity equation,

M × V = P × Y

where M = quantity of money

V = velocity of money

P = price

Y = output

quantity equation can be re-written as:

V = (P × Y) / M

Now, as the price level increases (as argued earlier), the velocity of money would increase keeping everything else unchanged.

Hence, this event would lead to a rise in the velocity of money.

3) If the Fed does not respond to this event, the money demand falls from D1 to D2. And money supply does not change (since Fed do nothing). As as result, the value of money falls and therefore, the price level increase. The new equilibrium is at point e2 where the price level rises (earlier it was corresponding to e1 point). This is shown in figure 2.

Therefore, if Fed does not respond, price level would increase.

4) If the Fed wants to keep the price level stable, then it should reduce the money supply from S1 to S2 in figure 3. This would lead to shift in money supply to left which keeps the value of money same (as was at e1 point). Hence, price level become same as before.

Figure 3