Question

Use the classical model of a closed economy (chapter 3) and the quantity theory of money (chapter 5, section 1) to predict how each of the following shocks would affect real aggregate income (Y), the real interest rate (r), and the price of goods and services (P) in a closed economy in the long run, all else equal. For each shock, be sure to clearly state a prediction for all three variables (up, down, or no change) and illustrate your predictions with supply/demand diagrams for the goods market and the loanable funds market. a. A decrease in supply of capital (K$ down). b. An increase in the income velocity of money (V up). C. A decrease in the nominal money supply (M$ down).

Answer 1

"If the amount of money available to borrow (M$) goes down, the amount of things produced (Y) will go down, the cost of borrowing money (r) will go up, and the price of things (P) will go down."

Step-by-step explanation:

a. A decrease in the supply of capital (K$ down):

* Real aggregate income (Y): down

* Real interest rate (r): up

* Price of goods and services (P): no change

b. An increase in the income velocity of money (V up):

* Real aggregate income (Y): up

* Real interest rate (r): down

* Price of goods and services (P): up

c. A decrease in the nominal money supply (M$ down):

* Real aggregate income (Y): down

* Real interest rate (r): up

* Price of goods and services (P): down

Note: These predictions assume a closed economy, long-run analysis, and all else being equal. The diagrams would show shifts in the supply and demand curves for the goods market and loanable funds market, illustrating the effects on Y, r, and P.

original question:

What happens to :

number of things made (Y),

cost of borrowing money (r) &

price of things (P)

when

amount of money available to borrow (M$) goes down,

machines and tools used to make things (K$) get smaller, or

speed at which money is used to buy things (V$) gets faster?

formulas mentioned in the original question:

* Real aggregate income (Y): Y = C + I + G

* Real interest rate (r): r = r^d - π

* Price of goods and services (P): P = M/V

Where:

* C is consumption

* I is investment

* G is government spending

* r^d is the desired real interest rate

* π is inflation

* M is the money supply

* V is the velocity of money (income velocity of money)

metaAI

Answer 2

In a closed economy using the classical model and the quantity theory of money, a decrease in the supply of capital decreases output and raises prices and interest rates. An increase in the velocity of money raises the price level with no direct long-term effect on output or interest rates. A decrease in the nominal money supply lowers the price level without affecting output in the long run.

Step-by-step explanation:

When analyzing the effects of shocks in a closed economy using the classical model and the quantity theory of money, we consider how these changes affect real aggregate income (Y), the real interest rate (r), and the price of goods and services (P) in the long run.

1. A decrease in the supply of capital (K down) would likely lead to a decreased output (Y down) since capital is one of the inputs in the production function. The goods market equilibrium would show a shift to the left in the supply, increasing the equilibrium price level (P up). As for the loanable funds market, with less capital being supplied, the supply of loanable funds would decrease, shifting the supply curve to the left and increasing the real interest rate (r up).
2. An increase in the income velocity of money (V up) would imply that for each dollar of money supply, more transactions are taking place. Applying the quantity theory of money, if money supply (M) and real output (Y) are held constant, the increase in velocity would lead to an increase in price level (P up), as more transactions would bid up the prices of goods and services. There is no direct impact on real GDP or the real interest rate in this scenario in the long run, as output is determined by the supply-side factors in the classical model.
3. A decrease in the nominal money supply (M down) would, according to the quantity theory of money, result in a lower price level (P down) as there is less money chasing the same amount of goods and services. As money supply decreases, real balance effects may temporarily increase the real interest rate (r up), but this is not a long-term effect since in the classical model, the interest rate adjusts to equate savings and investment, independent of money supply changes. Real GDP (Y) remains unaffected in the long run since it is determined by the supply-side factors of labor, capital, and technology.

It is important to understand that these predictions hold in the long run, where prices and wages are flexible. The neoclassical model suggests that ultimately, the economy returns to its potential GDP, with adjustments in wages and prices determining the speed of the macroeconomic adjustment.