Question

Consider an economy with the following money demand function, real aggregate income, nominal money supply, and price level:

Mᵈ=P∗(0.25Y−8,000i)
Y=4000
Mˢ = =2000
P=5
a. According to the Liquidity Preference Theory of interest rates, what is the equilibrium nominal interest rate?
b. Assuming that the price of goods (P) and real aggregate income (Y) remain fixed, what would the new equilibrium nominal interest rate be if the nominal money supply (M⁵ ) increased from 2000 to 3000 ?
c. According to classical macroeconomic theory, a change in the money supply will change the price of goods proportionately in the long run (i.e. - if M₂=zM₁
​
, then P₂ =zP₁
​
). If that theory is correct, what will the price of goods be in the long run, once the money supply is increased from 2000 to 3000 ? Assume that real aggregate income is unaffected
. d. What will the equilibrium nominal interest rate be in the long run?

Answer 1

An increase in the nominal money supply while holding the velocity of money and real GDP constant will lead to a proportional increase in the price level, causing inflation without affecting unemployment or real GDP. The nominal interest rate is also expected to rise in the long run as people demand compensation for the reduced purchasing power of money.

Step-by-step explanation:

When the nominal money supply increases from 2000 to 3000 in an economy, the long-run implication, according to the quantity theory of money, is an increase in the price level. Assuming the velocity of money is constant and that real GDP remains unchanged, the increase in money supply leads to proportional inflation. If initially, the price level was P1 and the money supply increase should cause a 10% rise, the new price level will be P2, which is 10% higher than P1.

Also, since the real aggregate income is unaffected, the increase in the money supply will not change real GDP or unemployment but will apply upward pressure on the price level, shifting the equilibrium from Eo to E1 to E2.

As for the equilibrium nominal interest rate, in the long run, it will adjust upward in response to the increased inflation expectations as people will demand higher interest rates to compensate for the decrease in their money's purchasing power.