Question

Answer each of the questions in Section B. Answers should typically be no more than 2-3 sentences in length. 1. In the long-run model of chapter 4, what assumption about the demand for real money balances ensures that the velocity of money V is constant? Be sure to explain why this is the case. 2. When discussing the Quantity Theory of Money, we concluded that the nominal money supply M determined nominal GDP. Explain exactly what we meant by this. 3. In the simple formulation of the aggregate demand curve from chapter 9, what should the central bank do if it wants to exactly counteract a 10% rise in velocity? 4. In the Keynesian cross analysis, explain in your own words why the tax multiplier is smaller (in absolute value) than the government spending multiplier. 5. Explain why the IS curve is downward-sloping using the loanable funds market approach.

Answer 1

Part 1

Increase in inflation will result in the increase in the demand for real money balances. This happens because people demand money for transactional and speculative purposes. While the former refers to the day to day expenditure, the latter refers to demand for money for investment purposes. If inflation increases then for a given transactional demand for money the supply for real money balances will decline as the purchasing power of the money declines with inflation. So, people will demand more real money.

Part 2

Ex ante real interest rate is the anticipated real interest rate that is calculated as nominal interest rate minus the expected inflation rate.

Ex post interest rate is the actual real interest rate that is calculated as nominal interest rate minus the actual inflation rate.

Part 3

Nominal interest rate is the interest rate that does not take into account the level of inflation in the economy.

Real interest rate is the interest rate that takes into account the account the level of inflation in the economy.

For example, if the nominal interest rate in the economy is 6% and the inflation rate is 3%, then the real interest rate will be 3%.

Part 4

In the long-run the supply curve is vertical on the full employment level of output. So, in the long run, only changes in the supply will affect the output as changes in demand with respect to vertical supply curve will have no effect on the output.

On the other hand in the short-run, the output is demand determined. This happens because though in the short-run the supply curve is upward sloping, changes in supply can take place due to factors like change in technology, innovation, or introduction of new technologies. All these things take time to happen. On the other hand changes in demand can take place due to factors that are faster, for example, increase in money supply, or changes in government expenditure or tax rates.

Part 5

The investment-saving (IS) curve is downward sloping because increase in interest rate results in decline in output and vice-versa in the goods market.

For example, if there is an increase in the interest rate, then there will be a decline in the level of investment in the economy. This happens because for investors borrowing money for purchasing plants and machinery becomes expensive. As a result there will be a decline in the output in the economy. On the other hand a decline in the interest rate will increase investment spending as borrowing funds for investment will become cheaper. This will result in increase in the output.