Question

Money demand in an economy in which no interest is paid on money is

M^d/P = 4000 + 0.3Y − 900i.

a. You know that P = 125, Y = 1000, and i = 0.10. Find real money demand, nominal money demand, and velocity.

b. The price level doubles from P = 125 to P = 250. Find real money demand, nominal money demand, and velocity.

c. Starting from the values of the variables given in part (a) and assuming that the money demand function as 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.

Answer 1

The money demand equation for an economy is given as,

Md/P=4000+0.3Y-900i

Here, P=125, Y=1,000, ‘i’ =0.10

1. The real demand for money is indicated as Md/P.

So, the real demand for money is 4,210.

The nominal demand for money is real demand times price.

So, the nominal demand for money is 526,250.

According to the quantity theory of money,

So, the velocity of money is 0.23.

b. The price is assumed to be doubled to 250.

The real demand for money will be,

So, the real demand for money is 4,210.

So, the nominal demand for money is 1,052,500.

According to the quantity theory of money,

So, the velocity of money remains the same at 0.23.

c. We see that an increase in the price level has no effect on the velocity of money.

Now, let us assume that the Y increased to 1,500 while other variables are at their initial values.

So, the real demand for money is 4,360.

So, the nominal demand for money is 545,500.

According to the quantity theory of money,

MV=PY

So, the velocity of money is 0.37.

We see that an increase in real income caused the velocity of money to increase as well.

Now, let's assume the nominal interest rate increased to 0.20 while other variables are at their initial values.

So, the real demand for money is 4,120.

So, the nominal demand for money is 515,000.

According to the quantity theory of money,

MV=PY

So, the velocity of money is 0.37.

We see that an increase in the nominal interest rate caused the velocity of money to increase as well.