(Money Demand) Suppose that you never carry cash. Your paycheck of $1,000 per month is deposited directly into your checking account, and you spend your money at a constant rate so that at the end of each month your checking account balance is zero.
- What is your average money balance during the pay period?
- How would each of the following changes affect your average monthly balance?
- You are paid $500 twice monthly rather than $1,000 each month.
- You are uncertain about your total spending each month.
- You spend a lot in the beginning of the month (e.g., for rent) and little at the end of the month.
- Your monthly income increases.
a. Your average balance is $500.
- Your money demand would fall because your average balance would decrease to $250.
- Your money demand would increase because you would be less likely to let your balance fall to zero.
- Your money demand would decrease because your average balance would decrease.
- Your money demand would increase.
2. (Market Interest Rate) With a diagram, show how the supply of money and the demand for money determine the rate of interest? Explain the shapes of the supply curve and the demand curve.
The money demand curve, Dm , slopes downward. As the interest rate falls, other things constant, so does the opportunity cost of holding money; the quantity of money demanded increases. Because the supply of money is determined by the Federal Reserve, it can be represented by a vertical line. At point a, the intersection of supply of money, Sm , and the demand for money, Dm , determines the market interest rate, i. Following an increase in the money supply to S′m, the quantity of money supplied exceeds the quantity demanded at the original interest rate, i.
People attempt to exchange money for bonds or other financial assets. In doing so, they push down the interest rate to i′, where quantity demanded equals the new quantity supplied. This new equilibrium occurs at point b.
9. (Money Supply Versus Interest Rate Targets) Assume that the economy’s real GDP is growing.
a. What will happen to money demand over time?
b. If the Fed leaves the money supply unchanged, what will happen to the interest rate over time? c. If the Fed changes the money supply to match the change in money demand, what will happen to the interest rate over time?
d. What would be the effect of the policy described in part (c) on the economy’s stability over the business cycle?
a. Money demand will increase.
b. If the money supply remains unchanged, the interest rate will also increase.
c. If the Fed increases the money supply at the same rate as money demand is rising, the interest rate will not change.
d. Following the policy described in part (c) requires the Fed to increase the money supply during expansions and decrease it during contractions. Thus, during expansions, the Fed is reinforcing the increasing aggregate demand; during contractions it is reinforcing the decreasing aggregate demand. Both expansions and contractions would tend to be stronger, thus adding more instability to the economy