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Suppose that the money demand function is (M/P)d = 5000 – 250r, where r is the real interest rate in percent
Suppose that the money demand function is (M/P)d = 5000 – 250r, where r is the real interest rate in percent. The money supply M is 2500 and the price level P is 1.
a.) Graph the supply and demand for real money balances.
b.) What is the equilibrium interest rate?
c.) Assume that the price level is fixed. What happens to the equilibrium interest rate if the supply of money is raised from 2500 to 4000?
d.) If the Fed wishes to raise the interest rate to 15 percent, what money supply should it set?
Expert Solution
b M/P = 5000 - 250r
2500/1 = 5000 -250 r
250r = 2500
r= 10 real interest rate = 10%
C. When supply of money is raised to 4000 the new supply of real balances = 4000/1 = 4000
Equilibrium interest rate =4%
4000= 5000-250r
250r = 1000
r= 1000/250 r =4%
D In equilibrium M/P = 5000 -250r, setting the price level =1 and substituting interests rate =15
M/1 = 5000 -250(15)
M= 5000- 3750
M = 1250
Thus fed should set the money supply at 1250
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