Suppose the real money demand function is M^d/P = 2400 + 0.2Y - 10,000 (r + π^e) .
Assume M = 5000,P = 2.0,and π^e = .03.If Y were to increase from 4000 to 5000,then the real interest rate would increase by how many percentage points?

Question

Quizplus · Accepted Answer

Given the real money demand function and the provided values, we first calculate the change in real money demand due to the increase in Y (income) from 4000 to 5000. The coefficient of Y in the demand function is 0.2, so the increase in demand due to the increase in Y is 0.2 * (5000 - 4000) = 0.2 * 1000 = 200.Since the money supply (M) and price level (P) are constant, any change in real money demand must be offset by a change in the interest rate to keep the money market in equilibrium. The term for the interest rate in the demand function is -10,000(r + π^e), where π^e is the expected inflation rate, given as 0.03 or 3%.To find the change in the interest rate that offsets the increase in money demand, we set the increase in demand equal to the change in the term involving the interest rate, keeping in mind that the demand function is initially in equilibrium. Thus, 200 = 10,000 * Δr, where Δr is the change in the real interest rate. Solving for Δr gives Δr = 200 / 10,000 = 0.02 or 2 percentage points.

Suppose the Real Money Demand Function Is Md/P = 2400

Suppose the Real Money Demand Function Is M^d/P = 2400