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ECON 2000 Lecture 49: ECON 2000 Lecture 49

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School
York University
Department
Economics
Course
ECON 2000
Professor
Irene Henriques

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ECON 2000
Lecture 49
A Quantity-Equation Interpretation of the LM Curve
When first discussed AD and short-run determination of income, we
derived AD curve from quantity theory of money – we describe money
market with quantity equation:
o MV = PY
We assumed V as constant, which means that for given price level P,
the supply of money M by itself determines the level of income Y
LM curve usually vertical as income doesn’t depend on interest rate, but
we can derive more realistic LM curve from quantity equation by relaxing
assumption that velocity is constant
Assumption of constant velocity based on assumption that demand for
real money balances depends only on level of income
Yet, we have just noted in liquidity-preference model that it depends on
interest rate as well
o Higher interest rate raises cost of holding money and reduces
money demand
When people respond to higher interest rate by holding less money,
each dollar they hold must be used more often to support given volume
of transactions – that is, V must increase
o MV(r) = PY → V(r) indicates that velocity is positively related to
interest rate
This form of quantity equation yields LM curve that slopes upward
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Document Summary

When first discussed ad and short-run determination of income, we derived ad curve from quantity theory of money we describe money market with quantity equation: mv = py. We assumed v as constant, which means that for given price level p, the supply of money m by itself determines the level of income y. Lm curve usually vertical as income doesn"t depend on interest rate, but we can derive more realistic lm curve from quantity equation by relaxing assumption that velocity is constant. Assumption of constant velocity based on assumption that demand for real money balances depends only on level of income. Yet, we have just noted in liquidity-preference model that it depends on interest rate as well: higher interest rate raises cost of holding money and reduces money demand. This form of quantity equation yields lm curve that slopes upward.

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Related Questions

The demand for money
A) d and e are correct
B) all of the following are correct
C) decreases as the average selling price of a unit of outputincreases
D) increases as GDP increases
E) is increased by credit card usage
2. The higher the interest rate, the more of their wealth peoplewill hold as money.
A) True
B) False
3. The money demand curve slopes
A) downward because the cost of holding money decreases as theinterest rate decreases
B) downward because the cost of holding money increases as theinterest rate decreases
C) upward because people demand more money as GDP increases
D) upward because people demand more money as GDP decreases
E) downward because people demand more money as the price levelincreases
4. Which of the following, other things constant, will shift themoney demand curve to the left?
A) an increase in the interest rate
B) a decrease in the interest rate
C) a decrease in real GDP
D) an increase in real GDP
E) an increase in the price level
5. An increase in the money supply will
A) increase the demand for money at each interest rate
B) decrease the demand for money at each interest rate
C) lead people to try to exchange money for interest-bearingassets
D) lead people to try to exchange interest-bearing assets formoney
E) increase the interest rate
6. When an increase in the money supply reduces the interest rate,investment and nominal GDP increase.
A) True
B) False
7. In the short run, a decrease in the money supply will cause adecrease in Gross Domestic Product and a decrease in the pricelevel.
A) True
B) False
8. The demand curve for investment is graphed with __________ onthe vertical axis and __________ on the horizontal axis.
A) the interest rate; investment
B) investment; the interest rate
C) the price level; investment
D) investment; the price level
E) real GDP; investment
9. As the interest rate increases,
A) the demand for investment curve shifts to the right
B) the demand for investment curve shifts to the left
C) there is a movement downward along the demand for investmentcurve
D) there is a movement upward along the demand for investmentcurve
E) GDP increases
10. If the economy experiences a contractionary gap and the Fedstimulates the economy, then:
A) The money supply is increasing because the Fed prints moremoney
B) The money supply is decreasing because the Fed hoardsmoney
C) The money supply is increasing because the Fed makes open-marketpurchases
D) The money supply is decreasing because the Fed makes open-marketsales
E) There is no change in the money supply because the Fed cannotinfluence the money supply
11. If the Fed decreases the money supply, GDP
A) increases because the resulting increase in the interest rateleads to a decrease in investment
B) increases because the resulting decrease in the interest rateleads to an increase in investment
C) decreases because the resulting increase in the interest rateleads to a decrease in investment
D) decreases because the resulting increase in the interest rateleads to an increase in investment
E) decreases because the resulting decrease in the interest rateleads to an increase in investment
12. An increase in the money supply can increase the price level,real GDP, or both, but it is impossible to tell exactly what willhappen without knowing the slope of the aggregate supplycurve.
A) True
B) False
13. If the economy experiences an expansionary gap and the Fedsells US government securities in the open-market, then:
A) Money supply increases, investment increases, aggregate demandincreases
B) Money supply increases, the interest rate increases, and theaggregate demand increases
C) Money supply decreases, the interest rate decreases, and theaggregate demand falls
D) Money supply decreases, the investment decreases, and theaggregate demand decreases
E) Interest rate falls, investment falls, aggregate demandincreases
14. If the money supply equals $1,000 and nominal GDP equals$3,000, then V
A) equals 1/3
B) equals 3
C) equals 3 million
D) cannot be determined since we do not know anything aboutprices
E) cannot be determined since we do not know anything about realGDP
15. If the money supply is increasing at a constant 8 percent,velocity is constant, real GDP is increasing at 5 percent, and theinflation rate is 3 percent, which of the following is true?
A) The growth rate of GDP is too low to be maintained.
B) The inflation rate is too low to be maintained.
C) Velocity is too low to be maintained.
D) The money supply growth rate is too low to be maintained.
E) This situation can continue indefinitely.
16. If real output and velocity are stable and predictable, thenthe equation of exchange can be used to derive a simplerelationship between
A) the money supply and the price level
B) the money supply and the interest rate
C) the money supply and the foreign exchange rate
D) velocity and real GDP
E) velocity and nominal GDP
17. For the quantity theory of money to yield usefulpredictions,
A) fiscal policy must be ineffective in altering aggregatedemand
B) fiscal policy must be effective in altering aggregatedemand
C) the economy must be operating at the potential level of realGross Domestic Product
D) velocity must be stable or predictable
E) velocity must be unstable
18. A rising rate of inflation
A) makes people more willing to hold money as an asset
B) reduces the usefulness of money as a store of value and thusincreases the velocity of money
C) increases the usefulness of money as a medium of exchange andthus reduces the velocity of money
D) is usually preceded by a reduction in the money supply
E) does not, apparently, have any effect on the velocity ofmoney
19. There is considerable disagreement about whether the Fedshould
A) engage in open market operations
B) have the power to set reserve requirements
C) reduce the money supply when the economy is growing
D) allow banks to invest in the stock market
E) attempt to control interest rates or should instead attempt tocontrol the money supply
20. For interest rates to remain stable during economic expansions,the growth rate of the money supply should
A) exceed the growth in the demand for money
B) just match the growth in the demand for money
C) be less than the growth in the demand for money
D) be zero
E) just match the growth in nominal GDP


2. Assume that households’ consumption function is given by C(Y − T) = 50 + 0.75(Y − T), that firms’ investment function is I(r) = 150 − 10r, government spending is G = 150, and the tax bill T = 200.

(a) What is the Marginal Propensity to Consume (“MPC”)?

(b) What is the equilibrium level of real GDP, in the goods market, if the real interest rate is 5%? (Plug in r = 5 for 5%, rather than 0.05 This is an assumption about the way we scale the coefficients in the investment function.)

(c) Solve for the equation of the IS Curve (“Investment-Savings”). How will this equation change if government spending increases to 200? The money supply is MS = 3000 and the price level is P = 4. Money/liquidity demand is given by Md/P = L(r, Y ) = Y − 50r.

(d) Solve for the equation of the LM Curve (“Liquidity-Money”).

(e) Based on your answers to the previous two questions, what are the equilibrium levels of the real interest rate and real GDP? (G is back to 150.)

(f) Assume now that P is unknown. Solve for the equation of the Aggregate Demand curve (“AD”)

Part 1

Evaluate whether each of the following statements is true or false. Explain your answer and provide a supporting rationale.

a.The short-run aggregate supply (SAS) curve slopes upward because households spend more as their incomes increase.

b.The long-run aggregate supply curve can never shift.

c.Either a decrease in the nominal money supply by the Federal Reserve, all else held constant or an increase in the price level, all else held constant, will shift the aggregate demand (AD) curve to the left.

d.The Keynesian portion of the short-run aggregate supply (SAS) curve would be relevant during a recessionary situation.

e.Stagflation occurs when the aggregate demand (AD) curve shifts out on the upward sloping portion of the short-run aggregate supply (SAS) curve.

Part 2

Evaluate whether each of the following statements is true or false. Explain your answer and provide a supporting rationale, using graphs to support your answer. You can create graphs by hand and take pictures and upload them with your answers, or you may use Word or Excel, and upload the file created by these software packages.

a.If the real money demand is greater than the real money supply, interest rates must rise to reach equilibrium in the money market as institutions sell bonds to obtain more money.

b.The federal government's control of the money supply, which influences interest rates, is the primary tool that policymakers use to impact the macroeconomy.

c.A decrease in the reserve requirement decreases the money supply because banks have fewer reserves.

d.The real money demand curve shows how households and businesses change their spending in response to changes in the interest rate.

e.Both an increase in the nominal money supply by the Federal Reserve and an increase in the price level will cause the real money supply curve to shift to the right.