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. M/P = L(r+Eπ,Y). 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.

a. 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.

b. 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

SOLUTION:-

a. The real money demand is negatively related to rate of interest because as rate of interest increases, keeping money in cash increases the opportunity cost of holding money and this increase in opportunity cost will reduce the demand for money . On the other hand, as rate of interest in the economy decreases, the opportunity cost of holding money also decreases and thus demand for money increases. Thus, both are negatively related.

As national income increases, real demand for money increases and as national income decreases, the demand for money decreases, Thus both are positively related.

b. If people expect that prices will increase in future, this will reduce the real purchasing power of money decreases, the demand for money will increase in the present. This increase in the demand for money will increase nominal interest rate in the money market and also increase inflation rate.

THANK YOU

If any quearies please leave your valuable comment on comment box..........