Week 3 Tutorial Questions (ECF5923)

Ch.7 – The Asset Market, Money and Prices (Asset market equilibrium)
- Numerical problem 4 (a and b only) (pg. 310)
- Numerical problem 𝜶 (not in textbook)
- Numerical problem 𝜷 (not in textbook)
- Working with macroeconomic data 𝜸 [Mandatory Question]
-

Note: due to time constraints, it may not be possible to do all questions during your tutorial class.
Nonetheless, its HIGHLY ADVISED that you do ALL tutorials questions in your own time. However, the
mandatory question must be answered.

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CH.7 – THE ASSET MARKET, MONEY AND PRICES (ASSET MARKET
EQUILIBRIUM)

Numerical problem 4 (a and b only) (pg. 310)

Suppose the money demand function is:

𝑀𝑑
= 1000 + 0.2𝑌 − 1000(𝑟 + 𝜋 𝑒 )
𝑃

a. Calculate velocity if Y = 2000, r = 0.06, and 𝜋 𝑒 = 0.04

We know that V = PY/M = Y/(M/P). But first we need to find what M/P is. Substituting in the
values in the money demand function we get:

𝑴𝒅
= 𝟏𝟎𝟎𝟎 + 𝟎. 𝟐(𝟐𝟎𝟎𝟎) − 𝟏𝟎𝟎𝟎(𝟎. 𝟎𝟔 + 𝟎. 𝟎𝟒) = 1300
𝑷

So, V = 2000/1300 = 1.54

b. If the money supply (Ms) is 2600, what is the price level?

𝑴𝑺
We know that P = 𝒅 = 2600/1300 = 2.
(𝑴 ⁄𝑷)

Numerical problem 𝜶 (not in textbook)

Consider an economy with a constant nominal money supply, a constant level of real output Y = 100,
and a constant real interest rate r = 0.10. Suppose that the income elasticity of money demand is 0.5
and the interest elasticity of money demand is -0.1.

a. By what percentage does the equilibrium price level differ from its initial value if output increases to
Y = 106 (and r remains at 0.10)? (Hint: Use Eq. 7.12.)

∆P/P = –𝜼𝒀 ∆Y/Y = –0.5%  6% = –3%. Thus, the price level will be 3% lower.

b. By what percentage does the equilibrium price level differ from its initial value if the real interest
increases to r = 0.11 (and Y remains at 100)?

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Numerical problem 𝜷 (not in textbook)

Suppose that the real money demand function is:

0.01𝑌
𝐿(𝑌, 𝑟 + 𝜋 𝑒 ) =
𝑟 + 𝜋𝑒
where Y is real output, r is the real interest rate, and 𝜋 𝑒 is the expected rate of inflation. Real output is
constant over time at Y = $150. The real interest rate is fixed in the goods market at r = 0.05 per year.

a. Suppose that the nominal money supply is growing at the rate of 10% per year and that this
growth rate is expected to persist forever. Currently, the nominal money supply is M = 300. What
are the values of the real money supply and the current price level? (Hint: What is the value of the
expected inflation rate that enters the money demand function?).
𝚫𝑴
𝝅𝒆 = 𝑴 = 10% (note that both real output and real interest rate are constant/fixed and the
money growth rate is expected to persist forever).

i = 𝒓 + 𝝅𝒆 = 15%

M/P = L = 0.01  150/0.15 = 10.

P = 300/10 = 30.

b. Suppose that the nominal money supply is M = 300. The central bank announces that from now on
the nominal money supply will grow at the rate of 5% per year. If everyone believes this
announcement, and if all markets are in equilibrium, what are the values of the real money supply
and the current price level? Explain the effects on the real money supply and the current price
level of a slowdown in the rate of money growth.
𝚫𝑴
𝝅𝒆 = = 5%
𝑴

i = 𝒓 + 𝝅𝒆 = 10%

M/P = L = 0.01  150/0.10 = 15.

P = 300/15 = 20.

The slowdown in money growth reduces expected inflation, increasing real money demand,
thus lowering the price level.

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Working with macroeconomic data 𝜸 [Mandatory Question]

a. The following Figure plots the Inflation rate (green solid line), the 3-month Treasury Bill interest rate
(blue solid line), and the 10-year government bond interest rate (red dotted line) for the United
Kingdom between 1960 to 2017.

i. In general, how are changes in interest rates related to changes in inflation? Why?

▻ In general, interest rates move in the same direction as inflation.

▻ That is not surprising because if real interest rates do not change too much, and because
the nominal interest rate equals the real interest rate plus the inflation rate (if actual and
expected inflation rates are similar), then nominal interest rates will move in the same
direction as inflation.

ii. Is the 3-month rate or the 10-year rate more sensitive to current changes in inflation? Explain in
economic terms.

▻ Because the inflation measure is a short-term one, 3-month T-Bill rates move more in
tandem with inflation than the 10-year T-bond.
▻ The ten-year rate would be sensitive to long-run changes in inflation, but many inflation
movements are short-lived.

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b. The following Figures plot the inflation rate (green solid line), M1 money growth (blue solid line), and
M2 money growth (red dotted line) for the United States between 1960 and 2016. Th first figure plots
these variables over the year. The second figure plots these variables over three-year averages (for
example, the three-year average of the year 2000 is 1998, 1999, and 2000).

Is the inflation rate more closely related to M1 growth of M2 growth? Is the relationship of inflation to
money growth stronger in the short-run (in annual data) or in the longer run (using three-year averages)?
What happened to the link between inflation and money growth since 1980?

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▻ In the 1960s and early 1970s, M1 growth was more closely related to inflation.
▻ In the 1980s, M2 growth was more closely related to inflation.
▻ The relationships are stronger in the long run than in the short run.
▻ The relationship between M2 growth and inflation weakened after 1990.

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