Answer to Question #193852 in Macroeconomics for esther

Question

QUESTION 2

2.1 Money demand in an economy in which no interest is paid on money is Md/P =1000 + 0.4Y- 100i

(a) Given that P = 100, Y = 1000, and i = 0.10. Find real money demand, nominal money demand, and velocity.(6)(b)The price level doubles from P =100 to P = 200. Find real money demand, nominal money demand, and velocity.( c) Starting from the variables given in part (a) and assuming that the money demand function as written holds, determine how velocity is affected by an increase in real income, (ii) an increase in the nominal interest rate, (iii) an increase in the price level.

2.2(a)How Permanent income hypothesis and life cycle hypothesis explain the differences between the long-run APC and the short-run APC?(b)Use an appropriate diagram based explain why the MEC-curve might overstate the additional investment that could be generated in an economy with a one-percent reduction in the rate of interest.

Answer 1

2.1

(a) The demand for money is given as $\frac{Md}{P} =1000 + 0.4Y- 100i.$

Substitute the values that are available, 

$\frac{Md}{P} =1000 + 0.4(1000)- 100(0.10)$

$\frac{Md}{P} =1000+400-10=1390$

Thus, the real demand for money is$1,390.$

$\frac{Md}{P}=1390$

$\frac{Md}{100}=1390$

$Md=139000$

Thus, the nominal demand for money is $1,39,000.$

Velocity$=\frac{PY}{M}$

Velocity$=\frac{100(1000)}{139000}$

Velocity$=0.719$

Thus, the velocity is $0.719$ .

(b)

Substitute the values that are available, 

$\frac{Md}{P}=1390$

$\frac{Md}{200}=1390$

$Md=278000$

Thus, the nominal demand for money is $2,78,000.$

Velocity$=\frac{PY}{M}$

Velocity$=\frac{200(1000)}{278000}$

Velocity$=0.719$

Thus, the only change seen will be in the nominal demand, after a price change.

(c)

(i)If there is a rise in Y to 2000, then the velocity of money will also rise. 

$\frac{Md}{P}=1000+0.4(2000)-100(0.10)=1790$

$Md=179,000$

Velocity$=\frac{100(2000)}{179000}=1.117$

(ii)If there is a rise in i to 0.20, then the velocity of money will also rise. 

$\frac{Md}{P}=1000+0.4(1000)-100(0.20)=1380$

$Md=138,000$

Velocity=$\frac{100(1000)}{138000}=0.724$

(iii)In the case of the price, computed in (b), that there will be no change in velocity. 

 

2.2

(a)(a) The average propensity to consume (APC) is a measure of the fraction of total income (Y) that is used for consumption (C). It is calculated by dividing C by Y. The Life-Cycle Hypothesis describes the spending and saving behavior of people over their lifetime. It argues that consumers aim at consumption smoothing and they do so by borrowing when their Y is low and saving when it is relatively high. The Permanent Income hypothesis says that an individual's current C is dependent not on the current Y but on the future Y expectations. Their current C is determined by the permanent income which is the expected long-term average Y or the permanent Y. The hypotheses explain the difference between long-run APC and short run APC as follows:

In the long run, APC remains fairly stable and does not change with the change in Y. This is because, in the long run, a rise in current Y implies a rise in permanent Y which raises current C. Thus, the ratio C/Y remains constant. The long-run consumption function has a constant APC.

In the short run, APC declines with a rise in Y. In the short run, changes in current Y are attributable to changes in the transitory Y. Rise in transitory Y does not cause any significant rise in C. Therefore, the ratio C/Y, that is the APC, declines in the short run. The short-run C function has a falling APC.

(b)This is because the business confidence is low in a liquidity trap and despite the low interest rates firms will tend not to invest because they have low expectations in future.