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    EC2102 Topic 6 - Solution Sketch

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    The document provides a solution sketch for an economics problem. It includes: 1) Calculating equilibrium output and interest rate using goods and loanable funds market conditions. The equilibrium interest rate is found to be 0.10. 2) Defining parameters in a money demand function and calculating income and interest elasticities using given values. 3) Showing that for the money supply to increase nominal money growth by 8% to achieve asset market equilibrium given expected inflation of 10%.

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    EC2102 Topic 6 - Solution Sketch

    Uploaded by

    sqhaa
    193 views3 pages
    The document provides a solution sketch for an economics problem. It includes: 1) Calculating equilibrium output and interest rate using goods and loanable funds market conditions. The equilibrium interest rate is found to be 0.10. 2) Defining parameters in a money demand function and calculating income and interest elasticities using given values. 3) Showing that for the money supply to increase nominal money growth by 8% to achieve asset market equilibrium given expected inflation of 10%.

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    EC2102 Topic 6 – Solution Sketch

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    The document provides a solution sketch for an economics problem. It includes: 1) Calculating equilibrium output and interest rate using goods and loanable funds market conditions. The equilibrium interest rate is found to be 0.10. 2) Defining parameters in a money demand function and calculating income and interest elasticities using given values. 3) Showing that for the money supply to increase nominal money growth by 8% to achieve asset market equilibrium given expected inflation of 10%.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    193 views3 pages

    EC2102 Topic 6 - Solution Sketch

    Uploaded by

    sqhaa
    The document provides a solution sketch for an economics problem. It includes: 1) Calculating equilibrium output and interest rate using goods and loanable funds market conditions. The equilibrium interest rate is found to be 0.10. 2) Defining parameters in a money demand function and calculating income and interest elasticities using given values. 3) Showing that for the money supply to increase nominal money growth by 8% to achieve asset market equilibrium given expected inflation of 10%.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 3

    Topic 6 – Solution Sketch

    Wong Wei Kang

    1.
    (i) Sd = Y - Cd - G
    = Y - (3600 - 2000r + 0.1Y ) - 1200
    = -4800 + 2000r + 0.9Y

    (ii) Using goods market equilibrium condition:


    Y = C d + Id + G
    Y = (3600 - 2000r + 0.1Y ) + (1200 - 4000r) + 1200
    = 6000 - 6000r + 0.1Y
    So 0.9Y = 6000 - 6000r
    At full employment, Y = 6000. Solving 0.9 × 6000 = 6000 - 6000r, we get r = 0.10.

    Alternatively, use the equilibrium condition in the loanable funds market:


    S d = Id
    -4800 + 2000r + 0.9Y = 1200 - 4000r
    0.9Y = 6000 - 6000r
    When Y = 6000, r = 0.10.

    2.
    !
    We are told that = 𝑎 + 𝑏𝑌 + 𝑐(𝑟 + 𝜋 ! )
    !
    LHS = Real Money Supply = Nominal Money Supply (M) / General Price Level (P)
    RHS = Real Money Demand = L(Y, i),
    Y is real output/income
    r = real interest rate
    πe = expected inflation rate
    Nominal interest rate i = r + πe

    (i)
    b = the sensitivity of real money demand to real income.
    b > 0 implies that a higher real output leads to more transactions, hence real money demand
    increases.
    c = the sensitivity of real money demand to the nominal interest rate
    c < 0 because a higher nominal interest rate implies a higher opportunity cost of holding
    money. Consequently, real money demand falls.

    Note that b and c are NOT elasticity. This is because


    Δ𝑦 𝑦 % Δ 𝑖𝑛 𝑦
    𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑦 𝑤𝑖𝑡ℎ 𝑟𝑒𝑠𝑝𝑒𝑐𝑡 𝑡𝑜 𝑥 = =
    Δ𝑥 𝑥 % Δ 𝑖𝑛 𝑥
    where Δ denotes change (in this case absolute change)
    Δ𝐿 % Δ 𝑖𝑛 𝐿
    𝑏= ≠
    Δ𝑌 % Δ 𝑖𝑛 𝑌
    Δ𝐿 % Δ 𝑖𝑛 𝐿
    𝑐= ≠
    Δ𝑖 % Δ 𝑖𝑛 𝑖

    1
    (ii)
    In 2001: M = 1,000; P = 1; I = 10% = 0.1; Y = 400; b = 2; c = -2,000

    Δ𝐿 𝐿 Δ𝐿 𝑌 𝑌 400
    𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑀𝑜𝑛𝑒𝑦 𝐷𝑒𝑚𝑎𝑛𝑑 = = =𝑏 =2 = 0.8
    Δ𝑌 𝑌 Δ𝑌 𝐿 𝐿 1000 1
    Δ𝐿 𝐿 Δ𝐿 𝑖 𝑖 0.1
    𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑀𝑜𝑛𝑒𝑦 𝐷𝑒𝑚𝑎𝑛𝑑 = = =𝑐 = −2000
    Δ𝑖 𝑖 Δ𝑖 𝐿 𝐿 1000 1
    = −0.2

    (iii)
    !!
    In 2002, expect = 10% = 0.1
    !
    !!
    Want =0
    !
    !!
    Want =0
    !

    Given asset market equilibrium condition,

    𝑀
    = 𝐿 𝑌, 𝑖 , 𝑤ℎ𝑒𝑟𝑒 𝑖 = 𝑟 + 𝜋 !
    𝑃

    Taking natural log on both sides and taking total derivatives,


    𝑑𝑀 𝑑𝑃 1 𝜕𝐿 𝜕𝐿
    − = 𝑑𝑌 + 𝑑𝑖
    𝑀 𝑃 𝐿 𝜕𝑌 𝜕𝑖

    LHS = Growth rate of nominal money supply (gM) – inflation rate (π)

    𝜕𝐿 𝑌 𝑑𝑌 𝜕𝐿 𝑖 𝑑𝑖
    𝑔! − 𝜋 = +
    𝜕𝑌 𝐿 𝑌 𝜕𝑖 𝐿 𝑖

    Using the information given,


    𝑔! − 0 = 0.8 10% + −0.2 0
    𝑔! = 8%

    Thus the central bank should increase nominal money supply by 8%.

    3.

    (i) Cigarettes = nominal money supply


    New cigarettes mean an increase in the money supply. Looking at the asset market
    equilibrium condition: Ms/P = L(Y, i)

    With higher nominal money supply and no change in real money demand, the
    equilibrium price level must rise.

    (ii) If people anticipate prices rising when the new cigarettes arrive, they will hold less
    money so that they will not lose purchasing power when prices go up. But if their
    real money demand is reduced, with the same nominal money supply the
    equilibrium price level must rise. This is again looking at the asset market
    equilibrium condition: Ms/P = L(Y, i), noting that the increase in money supply has
    not yet happened, i = r + πe and πe has increased.

    2
    The result is that when prices are anticipated to rise in the future, people may take
    actions that cause prices to rise immediately.

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