NAME:____________________________
Spring 2016
Chapter 21 Quiz
1. Explain why the money demand curve is a decreasing function of the real interest rate. (25 pts)
Money demand refers to the amount of dollars an individual wants to hold either in their pocket
or in a non-interest bearing checking account. The liquidity of money explains why people choose
to hold it instead of other assets that could earn them a higher return, i.e. they need to have
money at their disposal to buys goods and services. However, the return on other assets (the
interest rate) is the opportunity cost of holding money. All else being equal, as the interest rate
rises, the quantity of money demanded will fall. Therefore, the demand for money will be
downward sloping.
2. The interest rate effect is one of the main justifications for the negative slope of the Aggregate
Demand Curve. Using the money market/Theory of Liquidity preference model, show how to
derive the Aggregate Demand curve. (25 pts)
According to the theory, the aggregate-demand curve slopes downward because: (1) a higher
price level raises money demand; (2) higher money demand leads to a higher interest rate; and
(3) a higher interest rate reduces the quantity of goods and services demanded. Thus, the price
level has a negative relationship with the quantity of goods and services demanded.
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3. Suppose Consumption is given by the following function: C= 500+.70(Y-Tx). Determine the
multiplier associated with a $1 increase in government expenditures and a $1 decrease in taxes.
(15 pts)
Government multiplier =1/(1-MPC) since MPC =.70, G-Mult=1/.3=3 and 1/3
Tax multiplier =MPC/(1-MPC)=.70/(1-.7)=2 and 1/3
4. Give the intuition for why for the multiplier effect. Explain why this intuition is almost certainly
wrong (i.e. the crowding out effect). (15 pts)
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Suppose that the government buys a product from a company. The immediate impact of the
purchase is to raise profits and employment at that firm. As a result, owners and workers at this
firm will see an increase in income, and will therefore likely increase their own consumption.
Thus, total spending rises by more than the increase in government purchases. This process will
continue as the workers and owners of firm 1 create income for the workers and owners of firm
2, who will then increase their consumption expenditures.
The crowding out effect argues that for every sequence of income, expenditures and output
created by the government increase in spending, there is an equal sequence that is destroyed.
Specifically, by spending $100 more the government will need to borrow $100 more. Before this
$100 was borrowed by someone else who used it to buy some good. Now that this good is no
longer bought, there is $100 less of income spent, and less of this income spent.
5. Use the Money Market diagram together with the AS/AD diagram to show the effect of each
change on the equilibrium price level, output and real interest rate. Start by showing the
economy at an initial equilibrium.
a. The Fed’s bond traders buy bonds in open market operations. (10 pts)
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The increase in the money supply will cause the AD curve to shift out resulting in the ShortRun equilibrium indicated by point B. The price level will increase as will real output. Note
that with the higher price level, the final MD curve (not shown above) will lie above the
original one above. The increase is not so large, however, relative to the supply increase as
the equilibrium interest rate must be lower.
b. An increase in credit card availability. (10 pts)
An increase in credit card availability will reduce the demand for money. This will in turn
increase AD.
With a reduction in money demand, the AD increases. The short-run equilibrium is given by point B.
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Notice that since Y and P increase in the Short-run, the short run position of the MD curve will not be
MD2 but rather somewhere between MD1 and MD2. The short-run real interest rate will be lower. (but
between r1 and r2).
c. A wave of optimism boosts investment. (10 pts)
This directly increases AD and the price level. This is just shown above.
Although there is no shift in the money market initially with this increase in AD, there is an
ex-post adjustment. Namely, with a higher price level, the MD must lie to the right of the
original MD curve. The short-run equilibrium interest rate will be higher.
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EXTRA CREDIT: 10 pts each
6. The Federal Reserve targets the federal funds rate in order to achieve its goal of full
employment and price stability. Use the money market and AS/AD diagram to answer whether
this policy will achieve these goals.
a. There is an increase in export demand (demand shock)
This is a direct increase in AD.
Absent any action by the Federal Reserve, this would cause Y and P to rise. The increase in P will cause
MD to increase and hence cause r to increase.
With an interest rate target, this will cause the Fed to increase the Money supply (see next figure),
which leads to a second shift in the AD3 curve. This is indicated by point C in the below diagram.
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b. There is an increase in technology (supply shock)
The first thing that happens is that the LRAS and SRAS increase.
If the Central bank does not do anything, then the new equilibrium would be at P2 and Y2.
With the lower price level, the money demand curve would decrease, implying a lower
short-run real interest rate. This is shown below
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But with the target, the central bank would need to lower the money supply, and buy doing
so would bring out a decrease in AD. The final result will be a lower price level and a not as
large increase in output.
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