Question-   If real money demand increases 5% and real money supply increases 10%, by about how much does the price level change?

Solution-

Question 1 (/2 points) –

If real money demand increases 5% and real money supply increases 10%, by about how much does the price level change?

 

Answer.

Money is said to have either a nominal value or a real value in the terms of its utility. In this regard, the nominal value of the money is said to be defined or measured in terms of the monetary value while the value of the real money is defined in terms of the good and services that are related to it. Thus in the macroeconomics sense, a real money is defined as nothing but an asset that has a store of value. It is the purchasing power that the money is said to have to buy goods and services. While the nominal money is not adjusted of inflation, the real money is adjusted of the sane and thus has fluctuations.

The real money is inversely proportional to the level of price. Price is the worth that has to be paid in order to obtain a product. Thus if the price of a particular goods or services increases the real money required to buy a commodity increases and so does its demand. Subsequently, when the price decreases the real money demand decreases.

Thus if the real money demand increases by 5% and the supply for the real money subsequently increases by 10%, the price level changes by 5%. This can be demonstrated using the Aggregate demand and the aggregate supply model in accordance to price. An increase in the demand percentage shifts the demand curve to the right. While an increase in the supply also shifts the supply curve to the right. Thus the price level increases by 5%. This is because price increases with increase in money supply. This is because people will have more money in their hands and thus have more purchasing power. As a result of this they will be demanding goods and services more thus increasing their price. Since the money demand is also increasing along with the money supply increase the effect of the price increase is by 5% rather than by 10%. And since here the money supply increase is more than that of the increase in money demand, the price level rises by 5%.

 

 

 
 

 

Question 2 (/ 4 points) –

What happens to real money demand (rises, falls, and no change) due to a change in each of the following factors?

a. The threat of a recession increases the riskiness of stocks and bonds.

b. The interest rate paid on chequing account balances declines.

 

Answer.

a) Rises; Recession refers to a substantial decline or fall in the economy of either the world or a particular country because of various factors. These factors may include reduction in trade and other industry related activities etc. A recession is generally identified by a fall in a nation GDP or Gross Domestic Product over two successive quarters. A threat of recession has various impacts on a countries economy. This includes the rise in the riskiness of stocks and bonds. If a country is expected to enter a recession it may be said that the money flow may decrease in the economy. As a result of this the real money demand increases substantially. And to recover the increase in demand for the real money, individuals or institutions may liquidify their investments in stocks and bonds. Thus, this increases the riskiness of these securities. This is because now people are more reluctant to sell them and get the money with them rather than stay invested. This increases the fluctuations in the stocks and bonds. And since the public demand is more on the real money than on the illiquid investments (such as stocks and bonds), they may tend to sell it. This increases their riskiness in the market. This is mainly caused by the increase in demand for the real money triggered by the threat of an upcoming recession. When a nation is at a threat of recession, people think that they may face shortages of real money with them. This leads them to encash money from wherever possible and looks towards various investments in stocks and bonds. Thus, the threat of a recession increases the riskiness of stocks and bonds makes the demand for real money rise.

b) Falls; an interest rate may be defined as number in percentage of the principal amount that is charged by a lender to the borrower of money. Interest Rates are used in various areas and also in banks. Banks give interest rates to the customers for depositing money to the bank. Furthermore, a bank also may charge interest rates from the customers for withdrawing in excess amount the money below the minimum exceeding balance. When an interest rate is paid on chequing such account balance declines it can be said that the inflation rate is falling in comparison to the interest rate and the demand for real money is also falling. People are more interested in keeping their money with the bank rather than withdrawing it. Thus the demand for money is higher than the interest rate charged by the back. When a country or economy is facing a deflation, the price of goods and services throughout the economy, decreases. There may be a lack of demand in the public that may lead to such outcome. Thus to uplift the economy, the central banks of those countries may sometimes increase the interest rates that the banks provide on deposits. Subsequently, the interest charged on withdrawing money below the minimum withdraw limit may also increase. Thus more and more people will keep their money in the banks with the hopes to get good interest and there will be fewer instances to paying interest rates on chequing account balance declines. Therefore, if the interest rate paid on chequing account balances declines, the real money demand falls.

 

 
 

 

 

Question 3 (/ 2 points) –

In analyzing the asset market, we relied on aggregate assumption that supposes there are only two forms in which to hold wealth: money and nonmonetary assets. The demand for money depends positively on the level of real income. How is the demand for nonmonetary assets affected by the level of income? Explain.

 

Answer.

There are two forms to hold ones wealth in. This includes monetary as well as non-monetary assets. Monetary Assets are those kinds of assets that include the cash and cash equivalents, like cash in hand, cash at bank, accounts receivables, liquid investments and also notes to accounts. The demand for money depends directly and positively on the level of real income. Similarly, non-monetary assets are those assets whose values are subject to change over time with respect to and in response of various economic conditions. Non-monetary assets include buildings, machineries, equipments, furniture’s, inventories, patents etc.

The level of income affects the demand for non-monetary assets. There is a positive relation between the demand for non-monetary assets and the level of income of an individual. That means that if the income of the individual increases, their demand of the non-monetary asset will also increase. However the positive relation is not proportionate. That means that if the level of income increases to a certain extent, the demand for the non-monetary asset will increase to a lessor extent when compared to the increase in income. This is because a portion of the income increase will be contributed towards monetary assets. Thus the demand for non-monetary asset is positively affected to the increase in income but not to the same proportion.

 

 
 

 

 

Question 4 (/2 points) –

What determines the position of the FE line? Give an example of changes in the economy that would shift the FE line to the right.

 

Answer.

The FE line also known as the Full-employment line is the line that is responsible for showing the employment level of an economy and also the production. The position of the FE line is determined by the labor market and also by the production function. The labor supply and the demand thereof determine the equilibrium. The employment of the employment level of output can be determined through the equilibrium employment in that of the production function. In the point of equilibrium, thus the FE line is vertical. Furthermore, the FE line shifts to the right if the supply of labor increases and also when there is an increase in capital stock. It also shifts to the right, if there is a beneficial supply shock in the economy.

One of the examples of shift of the FE or the Full-employment line to the right is the increase in the labor supply. When the number of labor population in an economy increases subsequently, the labor supply in that economy thereof also increases. This is turn leads to the increase in the equilibrium employment. As a result of this the full employment output increases and there is a rightward shift in the FE line. This is the case of populated countries of the world like India and China, where the labor population is very high.

 

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