ECON BADM 7200 Module 4 Self Check
Problems with Accurate Solutions
Chapter 11 Self-Check #1
Problem: 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.
1. How does this change affect the demand for money?
2. What happens to the velocity of money?
3. If the Fed keeps the money supply constant, what will happen to output and
prices in the short run and in the long run?
4. 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?
5. If the goal of the Fed is to stabilize output, how would your answer to part 4
change?
Solution:
1. Interest-bearing checking accounts make holding money as checkable
deposits more attractive. This increases the demand for money.
2. 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.
3. If the Fed keeps the money supply the same, the decrease in velocity shifts
the aggregate demand curve downward, as in Figure 10-6 below. 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.
,
, 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.
4. 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.
5. The decrease in velocity shifts the aggregate demand curve downward. In
the short run, the price level remains the same, and output falls below its
natural-rate level. If the Fed’s goal is to stabilize output, it should increase
the money supply. Increasing the money supply in this case stabilizes both
output and the price level, so the answer here is the same as in part 4.
Chapter 11 Self-Check #2 Solution
Problem: Suppose the Fed reduces the money supply by 5 percent. Assume the
velocity of money is constant.
1. What happens to the aggregate demand curve?
2. What happens to output and the price level in the short run and in the long
run? Give a precise numerical answer.
3. In light of your answer to part 2, what happens to unemployment in the
short run and in the long run according to Okun’s law? Again, give a precise
numerical answer.
4. In what direction does the real interest rate move in the short run and in the
long run? (Hint: Use the model of the real interest rate in Chapter 3 to see
what happens when output changes.)
Solution:
1. If the Fed reduces the money supply, then the aggregate demand curve
Problems with Accurate Solutions
Chapter 11 Self-Check #1
Problem: 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.
1. How does this change affect the demand for money?
2. What happens to the velocity of money?
3. If the Fed keeps the money supply constant, what will happen to output and
prices in the short run and in the long run?
4. 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?
5. If the goal of the Fed is to stabilize output, how would your answer to part 4
change?
Solution:
1. Interest-bearing checking accounts make holding money as checkable
deposits more attractive. This increases the demand for money.
2. 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.
3. If the Fed keeps the money supply the same, the decrease in velocity shifts
the aggregate demand curve downward, as in Figure 10-6 below. 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.
,
, 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.
4. 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.
5. The decrease in velocity shifts the aggregate demand curve downward. In
the short run, the price level remains the same, and output falls below its
natural-rate level. If the Fed’s goal is to stabilize output, it should increase
the money supply. Increasing the money supply in this case stabilizes both
output and the price level, so the answer here is the same as in part 4.
Chapter 11 Self-Check #2 Solution
Problem: Suppose the Fed reduces the money supply by 5 percent. Assume the
velocity of money is constant.
1. What happens to the aggregate demand curve?
2. What happens to output and the price level in the short run and in the long
run? Give a precise numerical answer.
3. In light of your answer to part 2, what happens to unemployment in the
short run and in the long run according to Okun’s law? Again, give a precise
numerical answer.
4. In what direction does the real interest rate move in the short run and in the
long run? (Hint: Use the model of the real interest rate in Chapter 3 to see
what happens when output changes.)
Solution:
1. If the Fed reduces the money supply, then the aggregate demand curve
