1. Suppose the real money demand function is:

Md/P = 1500 + 0.2 Y - 10,000 (r + pe).

Assume M = 4000, P = 2.0, pe = 0.01, and Y = 5000. Note: we are holding P and Y constant in this problem until we get to case #2, see below.

a) What is the market clearing real interest rate? Show your results on a real money supply, real money demand diagram and label this initial equilibrium point as point A. Be sure to label your graph completely!

Correctly drawn and completely labeled diagram is worth 10 points total. Be sure to put relevant shift variables in parentheses next to the appropriate function.

b) Suppose Bernanke and the Fed were successful in their campaign to raise inflationary expectations to 4% (.04). Why would they want to do this? Use the Fisher equation to support your argument.

c) Solve for the real interest rate that clears the money market given the change in inflationary expectations. Please show work and Label this new point as point B on your diagram.

d) Explain how this strategy of raising inflationary expectations is supposed to stimulate output. Recall that output is equal to C + I + G! Be very specific as this question is worth 10 points. Hint: The price of current consumption in terms of future consumption and the user cost of capital most definitely needs to be in your response.

e) Let us return to our original conditions. Please redraw the original graph locating point A (this is with pe = 0.01, we are holding expected inflation constant in case #2). We now experience some economic growth so that Y = 6000. This is the only change. Resolve for the market clearing real rate of interest and label on your diagram as point B. Please show all work.

Correctly drawn and completely labeled diagram is worth 10 points total. Be sure to put relevant shift variables in parentheses next to the appropriate function.

f) Now explain exactly why the real rate of interest had to change the way it did to clear the money market. Please be clear with the intuition being sure to refer to the bond market in your answer. You should begin your response with "At the same real rate of interest, the money market is no longer clearing. In particular money demand ....." you can finish the rest.

g) Suppose the Fed wanted to keep real interest rates constant at their original level. Suppose also that the money multiplier is 0.8, which is consistent with reality since the Fed began paying interest on reserves beginning in October 2008. What exactly would the Fed have to do to keep real interest rates constant at their original level? Be specific with regard to the type and quantity of open market operations the Fed would need to conduct to be successful in keeping real interest rates constant at their original level.

h) Finally, explain the movement to the new equilibrium in the money market given the Fed expansion and show on your diagram as point C. Be sure to refer to the bond market as you did in part f). In fact, you should start your response the same way.

2. During the video lectures in this lesson, I tried my best to emphasize the importance of being able to identify shocks to money demand. During the Great Recession there was very much turmoil in financial markets and as a result, money became more attractive relative to many non-monetary assets. The graphic below is from a WSJ article from the fall of 2011. The left hand panel shows that the bid/ask spread for stocks was increasing which suggests that stocks, the non-monetary asset we are focusing on in this question, are becoming less liquid The graphic on the right can be thought of as a measure of risk and the implication in viewing the graphic is that stocks are becoming riskier

a) In the space below, draw a money market diagram labeling the initial equilibrium as point A. Note that this is a 'generic' graph meaning that there are no numbers. Now lets pretend that we have two portfolio shocks to money demand, much like above so that 1) non-monetary assets become less liquid (left hand panel) and 2) non-monetary assets become more risky (right hand panel). Show exactly how your diagram is effected and explain exactly why real interest rates changed the way they did. Label this new equilibrium as point B.

Correctly drawn and completely labeled diagram is worth 10 points total. Be sure to put relevant shift variables in parentheses next to the appropriate function.

b) Given that the economy is weak and the unemployment rate is much higher than that associated with NAIRU, the Fed wants real rates to fall, not rise. Explain exactly what the Fed would need to do. This is referred to as accommodating the shock to money demand. Label this as point C on your diagram.

c) Now explain how your answer would change if instead the shock to money demand was real. That is, the same movement in the money demand curve from above was not caused by portfolio shocks but was caused by a change in real output. Are the policy implications the same or are they different? Explain. (hint: the term 'potential growth rate of the economy' should be in your answer).