Question

Consider an economy with the money demand function is (m/d)ᵈ = 1/2 × y/i Round answers to two places after the decimal when necessary. f. Assume in the aftermath of the announcement, both the economy's output and the current money supply aré unchanged. Calculate the new price level. Price le The decline in the nominal interest rate the opportunity cost of holding money, leading to in the demand for real money balances. Incorrect g. If the new central banker wants to keep the price level the same after the announcement, at what level should she set the money supply?

Answer 1

To maintain the price level after a decrease in the nominal interest rate, the central banker must adjust the money supply to counterbalance the increased demand for money due to the lower opportunity cost of holding it.

Step-by-step explanation:

The student's question relates to the effect of nominal interest rate changes on the price level and money supply in an economy when employing a money demand function (m/d)ᵇ = 1/2 × y/i. To find the new price level after the announcement of a lower nominal interest rate, we must realize that a decline in the interest rate decreases the opportunity cost of holding money, thereby increasing the demand for real money balances.

If the central banker desires to keep the price level constant despite the interest rate change, she needs to adjust the money supply accordingly. The adjustment can be done by setting the new money supply at a level that counteracts the effect of the interest rate change on the demand for money—thereby leaving the price level unchanged. The exact new level of the money supply can be calculated by equating the initial price level (before the interest rate change) with the output and the adjusted money supply after the change.