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ECON 102 Tutorial: Week 19 Ayesha Ali www.lancaster.ac.uk/postgrad/alia10/econ102.html a.ali11@lancaster.ac.uk office hours: 8:00AM – 8:50AM tuesdays LUMS C85

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Today’s Outline Week 19 worksheet – Money Markets: In class we’ll look at Q2, Q3, Q4, Q6 and Q7. Please make sure you review all of problems on your own and ask if you have any questions. If you’re unsure of any solutions here, please see Chapter 23 in your textbook – it provides detailed explanations and examples. If you didn’t receive your 2 nd exam, please collect it at the end of class. Exam 3 will be available some time after Easter holidays.

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Question 1 Suppose a household spends €1,680 evenly over the week. What is the household’s demand for money as measured by its average money holding per day? The average daily demand for money is €1,680 / 7 days, so €240 per day. For a more complex example of the average daily demand, see Example 23.2 in your book.

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Question 2 Draw a diagram to illustrate what might happen to the demand for money curve if the economy experiences a decline in real GDP. Here is our diagram for the Money Demand Curve (See Fig. 23.1 and 23.2 in your book): The money demand curve shows the relationship between the aggregate quantity of money demanded (M) and the nominal interest rate (i) The money demand curve is downward sloping because an increase in the nominal interest rate increases the opportunity cost of holding money, which reduces the quantity of money demanded.

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Question 2 Draw a diagram to illustrate what might happen to the demand for money curve if the economy experiences a decline in real GDP. A fall in real income reduces the demand for money at any interest rate as people need less money to buy goods and services. So the money demand curve (MD) shifts to the left. In Summary, things that might cause the money demand curve to shift are: Changes in Real Income (Real GDP) Changes in the Price level Changes to the cost or benefit of holding money. Examples of these would be technological and financial advances. Note: Please see your book for a more complete summary.

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Money Supply Notation

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Question 3

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Question 4(a) Because CUR = cr*D and RES = rr*D, we can re-write this as:

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Question 4(b)

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Question 5

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Question 6(a) Suppose the equation of the demand for money curve is MD = 20,000 8,000i. Find the equilibrium rate of interest if the central bank sets the money supply at 19,600. In equilibrium MS = MD 19,600 = 20,000 – 8,000i i = (20,000 – 19,600)/8,000 i = 0.05 So the equilibrium interest rate is 5%.

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Question 6(b) Suppose the equation of the demand for money curve is MD = 20,000 8,000i. In part (a) we found the equilibrium rate of interest is 5% if money supply is 19,600. By how much would the central bank have to change the money supply if it wished to increased the equilibrium rate of interest by 1 per cent, or 0.01? There are two methods we could use to solve this problem. Here’s one way: If Δi = 0.01, then i = 0.06. We can plug this in for i into the money demand equation and calculate the new equilibrium money supply, as we did in part(a): MS = MD MS = 20,000 – 8,000i MS = 20,000 – 8,000(0.06) MS = 19,520 So, ΔM = 19,600 – 19,520 = -80. Money Supply has decreased by 80.

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Question 6(b) alternative method Suppose the equation of the demand for money curve is MD = 20,000 8,000i. In part (a) we found the equilibrium rate of interest is 5% if money supply is 19,600. By how much would the central bank have to change the money supply if it wished to increased the equilibrium rate of interest by 1 per cent, or 0.01? Another way we can solve this problem is: The change in the money supply ΔM is: ΔM = -8,000 Δi ΔM = -8,000 * 0.01 ΔM = -80 So the central bank would have to reduce the money supply by 80.

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Question 7 Use the money market diagram (graph 1), to show how the central bank could prevent an increase in the equilibrium rate of interest following a rise in the price level. (graph 2) The rise in the price level increases money demand at any given interest rate, so the money demand curve shifts to the right. If the money supply stays unchanged, then the new equilibrium is at a higher nominal interest rate (economy moves from point E1 to A), i.e. only a higher interest rate will reduce money demand again so that it equals the unchanged money supply. Note: this is similar to Figure 23.4 in your book. (graph 3) But if the central bank raises the money supply, shifting the money supply curve also to the right, then the rise in the nominal interest rate can be prevented (economy moves from point E1 to E2 instead of to A).

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Next Class Week 20 Worksheet - IS-LM Model Chapter 24 in the Textbook Last tutorial session before Easter break!

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