BODM 7200 Self-Check Problems – Chapter 10 with Complete
Solutions
1. An economy begins in long-run equilibrium, and then a change in government regulations allows
banks to start paying interest on checking accounts. Recall that the money stock is the sum of
currency and demand deposits, including checking accounts, so this regulatory change makes holding
money more attractive.
a. How does this change affect the demand for money?
b. What happens to the velocity of money?
c. If the Fed keeps the money supply constant, what will happen to output and prices in the short
run and in the long run?
d. If the goal of the Fed is to stabilize the price level, should the Fed keep the money supply
constant in response to this regulatory change? If not, what should it do? Why?
e. If the goal of the Fed is to stabilize output, how would your answer to part (d) change?
1. a. Interest-bearing checking accounts make holding money as checkable deposits more attractive.
This increases the demand for money.
b. The increase in money demand is equivalent to a decrease in the velocity of money. Recall
the quantity equation
M/P = kY,
where k = 1/V. For this equation to hold, an increase in real money balances for a given amount of
output means that k must increase; that is, velocity falls. Because interest on checking accounts
encourages people to hold money, money circulates less frequently.
c. If the Fed keeps the money supply the same, the decrease in velocity shifts the aggregate
demand curve downward, as in Figure 10-6. In the short run, when prices are sticky, the
economy moves from the initial equilibrium, point A, to the short-run equilibrium, point B. The
drop in aggregate demand causes output to fall below its natural-rate level.
Chapter 10—Introduction to Economic Fluctuations 1
, Over time, the lower level of aggregate demand causes prices and wages to fall. As prices fall, output
gradually rises until it reaches the natural-rate level of output at point C.
d. The decrease in velocity causes the aggregate demand curve to shift downward, which in the
long run results in a lower price level. If the Fed’s goal is to stabilize the price level, then it
should increase the money supply to offset the shift in the demand curve and thereby return the
economy to its original equilibrium at point A, as in Figure 10-7.
Chapter 10—Introduction to Economic Fluctuations 2
Solutions
1. An economy begins in long-run equilibrium, and then a change in government regulations allows
banks to start paying interest on checking accounts. Recall that the money stock is the sum of
currency and demand deposits, including checking accounts, so this regulatory change makes holding
money more attractive.
a. How does this change affect the demand for money?
b. What happens to the velocity of money?
c. If the Fed keeps the money supply constant, what will happen to output and prices in the short
run and in the long run?
d. If the goal of the Fed is to stabilize the price level, should the Fed keep the money supply
constant in response to this regulatory change? If not, what should it do? Why?
e. If the goal of the Fed is to stabilize output, how would your answer to part (d) change?
1. a. Interest-bearing checking accounts make holding money as checkable deposits more attractive.
This increases the demand for money.
b. The increase in money demand is equivalent to a decrease in the velocity of money. Recall
the quantity equation
M/P = kY,
where k = 1/V. For this equation to hold, an increase in real money balances for a given amount of
output means that k must increase; that is, velocity falls. Because interest on checking accounts
encourages people to hold money, money circulates less frequently.
c. If the Fed keeps the money supply the same, the decrease in velocity shifts the aggregate
demand curve downward, as in Figure 10-6. In the short run, when prices are sticky, the
economy moves from the initial equilibrium, point A, to the short-run equilibrium, point B. The
drop in aggregate demand causes output to fall below its natural-rate level.
Chapter 10—Introduction to Economic Fluctuations 1
, Over time, the lower level of aggregate demand causes prices and wages to fall. As prices fall, output
gradually rises until it reaches the natural-rate level of output at point C.
d. The decrease in velocity causes the aggregate demand curve to shift downward, which in the
long run results in a lower price level. If the Fed’s goal is to stabilize the price level, then it
should increase the money supply to offset the shift in the demand curve and thereby return the
economy to its original equilibrium at point A, as in Figure 10-7.
Chapter 10—Introduction to Economic Fluctuations 2
