1 University of Maryland Department of Economics Economics 325 Spring 2017 PROBLEM SET 6 50 POINTS...

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1 University of Maryland Department of Economics Economics 325 Spring 2017 PROBLEM SET 6 50 POINTS Please be kind to your TAs: Type or otherwise neatly write your answers. Make LARGE diagrams and label everything clearly. Use colors if necessary. You can’t get points if the TAs can’t understand your answers. Due in class on Monday, May 8. No late submissions are accepted. Solutions will be posted on Elms after the due date. 1. [15 points] Consider a numerical problem in monetary model. Suppose we have an estimated money demand function ???? = ????(??, ??), with ??(??, ??) = ?? - 100??. The economy is in equilibrium at ?? = 10, ?? = 1 and ???? = 5. a. Use the definition of money market equilibrium to obtain the equilibrium real interest rate. Suppose that the central bank increases money supply to the new level ???????? ?? = 7.5. b. Consider the classical model with flexible prices. What is the new real interest rate and price level? Use the Fisher approximation to compute the new nominal interest rate. c. Consider the sticky price model in which the price level remains fixed. What are the new real and nominal interest rates? 2. [15 points] Determine how the following affect the slope of the output demand curve, and explain your results: a. The marginal propensity to consume decreases. b. The intertemporal substitution effect of the real interest rate on current consumption increases. c. The demand for investment goods becomes more responsive to the real interest rate. 3. [20 points] Consider the sticky price model. Suppose that we are in an equilibrium with price level P=1, zero inflation and that the central bank has set a level of money supply M* that is associated with a real interest rate r*. Equilibrium output is given by some 2 combination of private and government spending. Now suppose that government spending decreases such that there is a decline in aggregate demand. Answer the following questions with graphs and words. Consider only the short run dynamics, during which time prices remain fixed. a. What is the effect of the decline in government spending on the goods market, labor market and money market in the sticky price model? b. What, if anything, can the central bank do to stabilize the economy?

David · Accepted Answer

1. [15 points] Consider a numerical problem in monetary model. Suppose we have an estimated 
money demand function ??=(?,?), with ?(?,?)=?−100?. The economy is in equilibrium at ?=10, 
?=1 and ??=5.
a. Use the definition of money market equilibrium to obtain the equilibrium real interest rate.
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Suppose that the central bank increases money supply to the new level ?  ??=7.5.  
b. Consider the classical model with flexible prices. What is the new real interest rate and price 
level? Use the Fisher approximation to compute the new nominal interest rate.
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1 University of Maryland Department of Economics Economics 325 Spring 2017 PROBLEM SET 6 50 POINTS Please be kind to your TAs: Type or otherwise neatly write your answers. Make LARGE diagrams and...

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