Question

Suppose that money supply and money demand determine the price level (P) in an economy. As shown in the equation below, in equilibrium, money demand equals to money supply.

where M is the quantity of money, P is the price level, r is the real interest rate, Eπ is the expected inflation, and Y is the national income.

1. Does the real money demand positively or negatively depend on nominal interest rate, i = r + Eπ? Does the real money demand positively or negatively depend on national income, Y? Why? Briefly explain your answer.

2. For given values of r, Y and M, explain how nominal interest rate (i), real money demand, and price level (P) respond to an increase in Eπ. Briefly explain your answer.

Answer 1

Answer 1:

a. The real money demand depends negatively on the rate of interest in the money market. As rate of interest in the money market increases, the opportunity cost of holding money will increase and this will reduce demand for money in the money market. On the other hand, as rate of interest decreases, the opportunity cost of holding money will decrease and thus demand for money will increase.Thus, real money demand depends negatively on the rate of interest.

The real money demand in the economy depends positively on the level of national income in the economy. As national income in the economy increases, the production will increase and aggregate demand increases which means economy is booming and this will increase demand for money in the money market. On the other hand, a decrease in national income will reduce the demand for money.

b. An increase in expcted rate of inflation will make people believe that real value of money will decrease in future. Given this expectation, the people will be holding less of the money in anticipation that real value of money will fall in future. Thus, demand for money curve will shift leftwards and this reduces nominal interest rate in the money market and real money demand also decreases.