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C h a p t e r
11
MONEY, INTEREST,
REAL GDP, AND
THE PRICE LEVEL**
C h a p t e r Key I d e a s
Ripple Effects of Money
A. There is enough money in the United States for everyone to have $2,300 in notes and coins and
another $19,000 in the bank. Why do we hold all this money?
B. Starting in 2001 and continuing in 2002 and 2003, the Fed lowered interest rates, but just a few
years earlier in 1999 and 2000, the Fed was more concerned about inflation and had raised
interest rates.
C. How does the Fed change interest rates, and how does that influence real GDP and inflation?
Outline
I.
*
The Demand for Money
A. The Influences on Money Holding
1. Four factors influence the quantity of money that people plan to hold: the price level, the
interest rate, real GDP, and financial innovation.
2. A rise in the price level increases the nominal quantity of money but doesn’t change the real
quantity of money that people plan to hold.
a) Nominal money is the amount of money measured in dollars.
b) The quantity of nominal money demanded is proportional to the price level — a 10
percent rise in the price level increases the quantity of nominal money demanded by 10
percent.
3. The interest rate is the opportunity cost of holding wealth in the form of money rather than
an interest-bearing asset. A rise in the interest rate decreases the quantity of money that
people plan to hold.
4. An increase in real GDP increases the volume of expenditure, which increases the quantity
of real money that people plan to hold.
* This is Chapter 27 in Economics.
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CHAPTER 11
5.
Financial innovation that lowers the cost of switching between money and interest-bearing
assets decreases the quantity of money that people plan to hold.
B. The Demand for Money Curve
1. The demand for money curve is the
relationship between the quantity of
real money demanded, M/P, and the
interest rate when all other influences
on the amount of money that people
wish to hold remain the same.
2. Figure 11.1 illustrates the demand for
money curve.
3. The demand for money curve slopes
downward—a rise in the interest rate
raises the opportunity cost of holding
money and brings a decrease in the
quantity of money demanded, which
is shown by a movement up along the
demand for money curve.
C. Shifts in the Demand for Money Curve
1. The demand for money changes and
the demand for money curve shifts if
real GDP changes or if financial
innovation occurs. Figure 11.2
illustrates an increase and a decrease in
the demand for money.
2. An increase in real GDP increases the
demand for money and shifts the
demand curve rightward.
3. A decrease in real GDP or a financial
innovation decreases the demand for
money and shifts the demand curve
leftward.
MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL
245
D. The Demand for Money in the United States
Figure 11.3 shows scatter diagrams of the interest rate against real M1 and real M2 from 1970
through 2003 and interprets the data in terms of movements along and shifts in the demand for
money curves.
II. Interest Rate Determination
A. An interest rate is the percentage yield on a financial security such as a bond or a stock.
1. The price of a bond and the interest rate are inversely related. If the price of a bond falls, the
interest rate on the bond rises. If the price of a bond rises, the interest rate on the bond falls.
2. We can study the forces that determine the interest rate in the market for money.
B. Money Market Equilibrium
1. The Fed determines the quantity of
money supplied and on any given
day, that quantity is fixed. The real
quantity of money supplied is equal
to the nominal quantity supplied
divided by the price level.
2. The supply of money curve is vertical
at the given quantity of money
supplied.
3. Money market equilibrium
determines the interest rate, as Figure
11.4 illustrates.
4. If the interest rate is above the
equilibrium interest rate, the
quantity of money that people are
willing to hold is less than the
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CHAPTER 11
quantity supplied. They try to get rid of their “excess” money by buying financial assets.
This action raises the price of these assets and lowers the interest rate.
5. If the interest rate is below the equilibrium interest rate, the quantity of money that people
want to hold exceeds the quantity supplied. They try to get more money by selling financial
assets. This action lowers the price of these assets and raises the interest rate.
C. Changing the Interest Rate
1. When the Fed changes the quantity
of money, the interest rate changes.
Figure 11.5 shows how the Fed
changes the interest rate.
2. If the Fed conducts an open market
sale of securities, the quantity of
money decreases, the money supply
curve shifts leftward, and the
interest rate rises.
3. If the Fed conducts an open market
purchase of securities, the quantity
of money increases, the money
supply curve shifts rightward, and
the interest rate falls.
III. Short-Run Effects of Money on Real GDP and the Price Level
A. Ripple Effects of the Interest Rate
1. If the Fed raises the interest rate, three
events follow:
a) Investment and consumption
expenditures decrease, because the
interest rate is the opportunity cost
of funds used to finance investment
and big-ticket consumer purchases.
b) With interest rates in other
countries unchanged, funds move
into the United States, the exchange
rate rises, and net exports decrease.
c) These changes in the components of
aggregate expenditure set off a
multiplier process that magnifies the
initial effects.
2. Figure 11.6 summarizes these ripple
effects.
MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL
247
B. The Fed Tightens to Avoid Inflation
1. Figure 11.7 illustrates the effect of fighting inflation with monetary policy in three panels.
The first shows the money market, the second interest-sensitive expenditure, and the third
shows the aggregate supply and aggregate demand curves.
2.
A decrease in the quantity of money in part (a) raises the interest rate. The rise in the
interest rate decreases expenditure in part (b). The decrease in expenditure shifts the AD
curve leftward with a multiplier effect in part (c). Real GDP decreases and the price level
falls.
C. The Fed Eases to Fight Recession
1. Figure 11.8 illustrates the effect of fighting recession with monetary policy in three panels.
The first shows the money market, the second interest-sensitive expenditure, and the third
shows the aggregate supply and aggregate demand curves.
2.
An increase in the quantity of money in part (a) lowers the interest rate. The fall in the
interest rate increases expenditure in part (b). The increase in expenditure shifts the AD
curve rightward with a multiplier effect in part (c). Real GDP increases and the price level
rises.
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CHAPTER 11
IV. Long-Run Effects of Money on Real GDP and the Price Level
A. An Increase in the Quantity of Money at Full Employment
1. Figure 11.9 illustrates the effect of an increase in the quantity of money at full employment
in two panels. The first shows the money market and the second shows the SAS, LAS, and
AD curves.
2.
An increase in the quantity of money in part (a) lowers the interest rate. The fall in the
interest rate shifts the AD curve rightward in part (b). The inflationary gap brings a rise in
the money wage rate and a leftward shift in the SAS curve. In the long run, an increase in
the quantity of money leaves real GDP unchanged but raises the price level.
MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL
249
B. The Quantity Theory of Money
1.
2.
The quantity theory of money is the proposition that in the long run, an increase in
the quantity of money brings an equal percentage increase in the price level.
The quantity theory of money is based on the velocity of circulation and the equation of
exchange.
a)
The velocity of circulation is the average number of times a dollar of money is used
annually to buy goods and services that make up GDP. Calling the velocity of
circulation V, then V = PY/M. Figure 11.10 graphs the velocity of circulation for M1
and M2 for 1963–2003.
b) The equation of exchange states that the quantity of money, M, multiplied by the
velocity of circulation, V, equals the price level, P, multiplied by real GDP, Y. That is:
3.
4.
MV = PY.
The quantity theory assumes that velocity and potential GDP are not affected by the
quantity of money. So
P = (V/Y)M.
Because (V/Y) does not change when M changes, a change in M brings a proportionate
change in P. That is, the change in P, ∆P, is related to the change in M, ∆M, by the
equation:
∆P = (V/Y)∆M.
Divide this last equation by the previous one and the term (V/Y) cancels to give:
∆P/P = ∆M/M.
∆P/P is the inflation rate and = ∆M/M is the growth rate of the quantity of money.
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C. The Quantity Theory and the AS-AD Model
1.
The quantity theory of money can be interpreted in terms of the AS-AD model. In the long
run, real GDP equals potential GDP and according to the AS-AD model, an increase in the
quantity of money brings an equal percentage rise in the price level.
2. The AS-AD model also makes clear why the quantity theory is a long-run theory. In the
short run, an increase in the quantity of money brings an increase in real GDP and a
smaller than proportionate rise in the price level.
D. Historical Evidence on the Quantity Theory of Money
1. Historical
evidence shows
that U.S. money
growth and
inflation are
correlated, more
so in the long run
than the short
run, which is
broadly consistent
with the quantity
theory.
2. Figure 11.11
graphs money
growth and
inflation in the
United States
from 1963 to
2003.
MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL
251
E. International Evidence on the Quantity Theory of Money
1. International evidence shows a
marked tendency for high money
growth rates to be associated with
high inflation rates.
2. Figure 11.12 shows scatter
diagrams of money growth and
inflation for various countries and
regions during the 1980s and
1990s.
F. Correlation, Causation, and Other
Influences
1. Correlation is not causation;
money growth and inflation could
be correlated because money
growth causes inflation, or
because inflation causes money
growth, or because a third factor
caused both. But the combination
of historical, international, and
other independent evidence gives
us confidence that in the long
run, money growth causes
inflation.
2. In the short run, however, the
quantity theory is not correct. To
understand the short-term
fluctuations in inflation, we need
the AS-AD model.
Reading Between the Lines
The news article reports the fears of renewed inflation in Argentina following its currency crises of 2001.
The analysis examines the history of money growth and inflation in Argentina between 1971 and 2000
and shows that the quantity theory of money provides a good explanation for Argentina’s inflation of the
1970s and 1980s and price stability of the 1990s and why people fear renewed inflation.
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CHAPTER 11
New in the Seventh Edition
This chapter combines material from Chapters 27 and 28 in the sixth edition to focus on the economic
theory of money demand and how the Fed uses monetary policy to influence interest rates, real GDP, and
the price level. The material on how the Fed controls the quantity of money is moved to Chapter 26. The
updated discussion and organization makes a clear distinction between the short-run and long-run effects
of monetary policy.
Data and figures are updated to 2003.
Te a c h i n g S u g g e s t i o n s
1.
2.
3.
4.
The Demand for Money
It is worth reminding students that “money” has a jargon sense in economics; students are often
confused by the phrase “demand for money” and it is worth tackling it head-on by emphasizing this
does not equate to “wanting to be rich,” but refers to how much of total wealth (assets) the public
want to hold in the particular form “money.” Students often try to understand ideas in terms of their
own lives; few will make a clear connection between interest rates and demand for money from their
own introspection. There are two ways to overcome this: one is to ask them to think in terms of
extreme situations (get what short-term interest rates are in a high-inflation country); the other is to
get them to imagine themselves in the job of treasurer of a corporation with large liquid resources,
and to think how their behavior with respect to those funds might differ according to the short-term
interest rates available.
Interest Rate Determination
The reason that an increase in the money supply lowers the interest rate can be easily developed by
focusing on banks. To increase the money supply, the Fed increases excess reserves. Banks want to
loan these new excess reserves, and thus the supply of loans increases. As a result, the interest rate on
loans falls as they struggle to make more loans. This type of intuitive explanation often can be quite
helpful in supplementing the formal analysis.
Short-Run Effects of Money on Real GDP and the Price Level
We bring in here the expenditure multiplier; it is important to ensure that students do not get
confused between the multiplier impact of open market operations on money supply, and the
multiplier process that magnifies autonomous expenditure changes. In using the AS-AD model to
explain the impact of deflationary monetary policy, it is important to stress the text’s point that the
model is a stationary simplification, whereas in reality output and the price level both tend to grow,
so that rather than reducing real GDP and the price level, the Fed’s anti-inflation policy would slow
their growth.
Long-Run Effects of Money on Real GDP and the Price Level
This section of the chapter has a lot of analytic content, and includes a number of things that can
easily confuse students.
Velocity of circulation. Emphasize that velocity is defined by the equation V = PY/M, and is not the
average number of times a given piece of paper changes hands in a year. Nor is V the transactions
velocity because most transactions are not payments for goods and services. (Transactions are twice
PY because they also include payments for the services of factors of production, which equals PY,
plus all the purely financial transactions such as buying and selling stocks, bonds, foreign currency,
and real estates.)
The quantity theory of money. Given that V is defined as PY/M, the equation of exchange, MV = PY
is an identity. The quantity theory is not the equation of exchange but the propositions that (1) V is
MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL
253
independent of M and (2) Y equals potential GDP, which is independent of M. Given these
assumptions, the inflation rate equals the growth rate of the quantity of money.
The quantity theory of hyperinflation. A possible exercise is to ask students whether we would expect
the correlation between money growth and inflation to remain strong in a hyperinflation. Most will
see that in a hyperinflation, velocity will increase. Emphasize that the level of velocity is greater in
hyperinflation but if the inflation rate remains constant (and high) velocity also is constant (and
high), so the quantity theory still holds. It does not hold in the move from low inflation to high
inflation. The inflation rate overshoots the growth rate of the quantity of money.
The Big Picture
Where we have been
Chapter 11 presumes knowledge on the part of the students about the role played by Fed in creating
money. This topic was discussed extensively and was one of the key points in Chapter 10. It also
briefly utilizes the notion of GDP, covered in depth in Chapter 5; investment demand, from Chapter
8; and the AS-AD model of Chapter 7. But it does not directly draw on much material except for
that in Chapter 26.
Where we are going
Chapter 11 is the second of three chapters that examine money, aggregate demand, and inflation.
The material presented in this chapter (and in the closely related Chapter 10) is used in Chapter 12
when the relationship between money and inflation is more fully developed. It also is necessary in
Chapter 16 wherein the government’s monetary policy is discussed. Finally, without a thorough
grasp from this chapter of how a change in the money supply affects the equilibrium interest rate, the
students will be unable to understand key points in Chapter 12 about the relationships among
monetary growth, the inflation rate, and the nominal interest rate. Therefore this chapter is crucial
because of its underpinning of topics in succeeding chapters.
O v e r h e a d Tr a n s p a r e n c i e s
Transparency
63
64
65
66
67
68
69
Text figure
Figure 11.1
Figure 11.2
Figure 11.4
Figure 11.5
Figure 11.7
Figure 11.8
Figure 11.9
Transparency title
The Demand for Money
Changes in the Demand for Money
Money Market Equilibrium
Interest Rate Changes
Monetary Stabilization: Avoiding Inflation
Monetary Stabilization: Avoiding Recession
Long-Run Effects of a Change in the Quantity of Money
254
CHAPTER 11
Electronic Supplements
MyEconLab
MyEconLab provides pre- and post-tests for each chapter so that students can assess their own
progress. Results on these tests feed an individualized study plan that helps students focus their
attention in the areas where they most need help.
Instructors can create and assign tests, quizzes, or graded homework assignments that
incorporate graphing questions. Questions are automatically graded and results are tracked using
an online grade book.
PowerPoint Lecture Notes
PowerPoint Electronic Lecture Notes with speaking notes are available and offer a full summary of
the chapter.
PowerPoint Electronic Lecture Notes for students are available in MyEconLab.
Instructor CD-ROM with Computerized Test Banks
This CD-ROM contains Computerized Test Bank Files, Test Bank, and Instructor’s Manual files
in Microsoft Word, and PowerPoint files. All test banks are available in Test Generator Software.
Additional Discussion Questions
1.
“Ask anyone if he or she has enough money. No one ever has enough money, that is, everyone
demands more money. Thus theorizing about the demand for money makes no sense because this
demand obviously is infinite.” Correct and comment on the error in this assertion.
2. If the interest rate exceeds the equilibrium interest rate, what forces drive the interest rate back to its
equilibrium level?
3. What is the effect on the interest rate of a decrease in the supply of money? No credit will be given
unless the correct diagram is used to support your answer.
4. What is the effect on the interest rate of an increase in the demand for money? No credit will be
given unless the correct diagram is used to support your answer.
5. How should the Fed behave if it fears recession is about to begin? Illustrate with diagrams showing
effects in the money market, the investment market, and AS-AD.
6. Suppose non-economic events in the rest of the world cause the exchange rate of the dollar to fall
when the U.S. economy is at full employment. How should the Fed react in order to maintain
macroeconomic stability? Why?
17. Why is there a difference between the short-run and long-run effects from an increase in the quantity
of money?
18. What is velocity? Why might it be an important concept?
9. What is the relationship between the quantity theory and the AD/AS model?
10. If the price level was already doubling every month and inflation accelerating, what would you expect
to happen to the velocity of circulation and why? How close would you expect the relation between
the quantity of money and the price level to be?
MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL
255
Answers to the Review Quizzes
Page 261
(page 633 in Economics)
1.
2.
3.
4.
5.
Page 262
The quantity of money demanded depends on four factors: the price level, the interest rate, real
GDP, and financial innovation. An increase in the price level increases the nominal demand for
money but does not change the real quantity demanded. An increase in the interest rate decreases
the quantity of money demanded, because the interest rate is the opportunity cost of holding assets
in the form money. An increase in real GDP increases the demand for money, because more GDP
implies more transactions and therefore a demand for more money to finance the transactions.
And, financial innovations that make it less costly to get by with less money on hand decreases the
demand for money.
The demand for money curve shows how the quantity of money demanded depends on the
interest rate. The demand for money curve is downward sloping, showing that an increase
(decrease) in the interest rate decreases (increases) the quantity of money demanded.
An increase in the interest rate decreases the quantity of money demanded. An increase in the
interest rate creates an upward movement along the demand curve for real money.
An increase in real GDP increases the demand for money. An increase in real GDP shifts the
demand for curve for real money to the right.
Financial innovations have generally decreased the demand for M1. These same innovations (for
instance, increased usage of credit cards) initially either increased or had no effect on the demand
for M2 but later financial innovations have decreased the demand for M2.
(page 634 in Economics)
1.
2.
3.
Page 265
The short-term interest rate is determined by the demand for and supply of money. When the
quantity of money demanded equals the quantity supplied, the interest rate is at its equilibrium
level.
If people are holding more money than they plan to hold, the interest rate is above its equilibrium
level. In this case people use their “excess” money to buy financial securities such as bonds. As
people buy more bonds, the price of bonds rises and the interest rate falls to its equilibrium level.
If the Fed wants to increase the interest rate, the Fed sells securities and decreases the quantity of
money. If the Fed wants to decrease the interest rate, the Fed buys securities and increases the
quantity of money.
(page 637 in Economics)
1.
2.
3.
To decrease the quantity of money, the Fed sells securities. Bank reserves and the quantity of
money contract; the interest rate rises; the value of the dollar increases; net exports, investment,
and consumption fall; Aggregate demand decreases, and real GDP growth and inflation slow.
Investment, consumption, and net exports decrease when the interest rate rises and they increase
when the interest rate falls.
A change in the U.S. interest rate means that the interest rate differential with other countries
changes. For example, a rise in the U.S. interest rate, other things remaining the same, means that
the differential increases. As a result, people will want to move funds from other countries into the
United States in order to obtain the higher returns on U.S. assets implied by the higher interest
rate. To move funds into the United States, people buy dollars and sell other currencies, driving
the price of the dollar up. A higher dollar means that foreigners must pay more for U.S.-made
goods and services and Americans pay less for foreign goods and services. Thus, the rise in the
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CHAPTER 11
4.
interest rate means that exports decrease and imports increase, corresponding to a fall in net
exports.
The answer should look like panel (c) in Figure 11.8; or even better, should show the AD curve
tending to move leftward and the Fed’s actions attempting to counter that and hold the AD curve
at a level consistent with the LAS curve.
5.
The answer should look like panel (c) in Figure 11.7.
Page 71
(page 643 in Economics)
1.
2.
3.
In the short run, an increase in the quantity of money increases aggregate demand and increases
both the price level and real GDP. In the long run, however, an increase in the quantity of money
increases only the price level and has no effect on real GDP. The difference between the short-run
and long-run effects reflects the economy’s adjustment back to potential GDP. In the short run,
money wages do not immediately change to reflect the higher price level so that real wages fall.
Real GDP exceeds potential GDP. But, as time passes, money wages rise, thereby decreasing shortrun aggregate supply. In the long run, money wages rise in the same proportion as the price level
so that real wages return to their initial level. At this time, short-run aggregate supply has decreased
so that real GDP has decreased to equal potential GDP. The long-run change in real GDP is zero.
The quantity theory of money is the proposition that in the long run an increase in the quantity of
money causes an equal percentage increase in the price level. Put in terms of growth rates, the
quantity theory of money asserts that the inflation rate (the percentage change in the price level)
equals the growth rate of money (the percentage change in the quantity of money), so long as
velocity does not change.
Yes, the long-run historical and international evidence on the relationship between money growth
and the inflation rate supports the quantity theory. The data suggest a marked tendency for
nations with high money growth rates to have high inflation rates. Thus the long-run cause of
inflation is growth in the quantity of money.
MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL
257
Answers to the Problems
1.
a.
b.
c.
People buy bonds, and the interest rate falls.
People sell bonds, and the interest rate rises.
People neither buy nor sell bonds, and the interest rate remains constant at 4 percent a year.
With real GDP of $20 billion (Y1 in the spreadsheet), column C shows the demand for money
schedule. The quantity of money supplied is $3 billion, so the equilibrium interest rate is 4
percent a year.
If the interest rate exceeds 4 percent a year, people are holding more money than they demand.
So they try to decrease the amount of money held by buying bonds. The prices of bonds rise,
and the interest rate falls.
If the interest rate is less than 4 percent a year, people are holding less money than they demand.
So they try to increase the amount of money held by selling bonds. The prices of bonds fall, and
the interest rate rises.
If the interest rate equals 4 percent a year, people are holding exactly the quantity of money that
they demand. So they take no actions to try to change the amount of money held. The interest
rate remains constant.
2.
a.
b.
People buy bonds, and the interest rate falls.
The equilibrium interest rate is 3 percent a year.
If the interest rate equals 3 percent a year, people are holding exactly the quantity of money that
they demand.
When real GDP falls to $10 billion, the interest rate falls.
With real GDP of $20 billion (Y1 in the spreadsheet), column C shows the demand for money
schedule. The quantity of money supplied is $3 billion, so the equilibrium interest rate is 4
percent a year.
With real GDP of $10 billion (Y0 in the spreadsheet), column B shows the demand for money
schedule. The quantity of money supplied is $3 billion, so the equilibrium interest rate is 3
percent a year.
When real GDP decreases from $20 billion to $10 billion, the demand for money decreases.
The demand for money curve shifts leftward and the real interest rate falls.
c.
3.
a.
b.
The interest rate rises to 5 percent a year.
The interest rate falls to 3 percent a year.
When real GDP increases in an expansion to $30 billion (Y2 in the spreadsheet), column D
shows the demand for money schedule. The quantity of money supplied is $3 billion, so the
equilibrium interest rate is 5 percent a year.
When real GDP decreases in a recession to $10 billion (Y0 in the spreadsheet), column B shows
the demand for money schedule. The quantity of money supplied is $3 billion, so the
equilibrium interest rate is 3 percent a year.
4.
a.
b.
The interest rate falls to 3 percent a year.
The interest rate remains at 4 percent a year.
Initially when real GDP is $20 billion (Y2 in the spreadsheet), column D shows the demand for
money schedule. When people plan to hold $0.5 billion less than the numbers in the
spreadsheet, the demand for money when real GDP is $20 billion becomes column C. The
quantity of money supplied is $3 billion, so the equilibrium interest rate is 3 percent a year.
When the central bank decreases the quantity of money by $0.5 billion the quantity of money
supplied decreases to $2.5 billion. When the demand for money as shown by column C is $2.5
billion, the real interest rate is 4 percent a year.
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CHAPTER 11
5.
a.
b.
6.
7.
The money supply curve is vertical at 1 trillion 1990 yaks.
When the real money supply is 1 trillion 1990 yaks, the equilibrium interest rate is 3 percent a
year at the intersection of the demand for money and supply of money curves.
Must increase the quantity of real money by 0.5 trillion 1990 yaks.
When the quantity of real money increases to 1.5 trillion 1990 yaks, the equilibrium interest
rate falls to 2 percent a year.
a.
The demand for money curve shifts rightward, leftward, or remains the same.
The new smart card decreases the demand for money and the demand for money curve shifts
leftward. The new smart card also causes business to boom and real GDP increases. The demand
for money increases and the demand for money curve shifts rightward. The direction in which
the demand for money curve shifts depends on the overall effect of the new smart card. If the
decrease in demand equals the increase in demand, the demand for money curve does not
change.
b. If the demand for money changes then the supply of money must change to keep the interest
rate from changing.
If the demand for money increases, then the supply of money must also increase. If the demand
for money decreases, then the supply of money must also decrease. If the demand for money
does not change, then the supply of money must remain the same.
c. If the demand for money increases, then to increase the supply of money, the Upland Fed must
make an open market purchase. If the demand for money decreases, then to decrease the supply
of money the Upland Fed must make an open market sale. If the demand for money does not
change, then the supply of money must remain the same so the Upland Fed makes no open
market operation.
The AD and SAS curves intersect at a real GDP that exceeds potential GDP and there is an
inflationary gap. An open market sale decreases the quantity of money and decreases aggregate
demand. The AD curve shifts leftward and the inflationary gap shrinks. If the size of the open market
sale is appropriate, this monetary policy action can avoid inflation. Real GDP in the long run is
determined by potential GDP and the decrease in the quantity of money has no effect on real GDP
in the long run.
8.
The AD and SAS curves intersect at a real GDP that is below potential GDP and there is a
recessionary gap. An open market purchase increases the quantity of money and increases aggregate
demand. The AD curve shifts rightward and the recessionary gap shrinks. If the size of the open
market purchase is appropriate, this monetary policy action restores full employment. The price level
rises but there is no inflation. Real GDP in the long run is determined by potential GDP and the
increase in the quantity of money has no effect on real GDP in the long run.
9.
a.
b.
c.
10. a.
b.
c.
d.
Aggregate demand increases.
The price level rises and real GDP increases in the short run.
In the long run, real GDP returns to potential GDP and the price level is higher than it
otherwise would have been by the same percentage as the percentage increase in the quantity of
money.
The quantity of money decreases because deposits decrease.
Aggregate demand decreases.
In the short run, the decrease in aggregate demand causes the price level to fall and real GDP to
decrease.
In the long run, real GDP returns to potential GDP and the price level is lower than it otherwise
would have been by the same percentage as the percentage decrease in the quantity of money.
MONEY, INTEREST, REAL GDP, AND THE PRICE LEVEL
11. a.
b.
c.
d.
e.
12. a.
b.
c.
d.
e.
259
$40 million.
Because the equation of exchange tells us that MV = PY, we know that M = PY/V. Then, with
P = 200, Y = $400 million, and V = 20, M = $40 million.
$48 million.
Money grows by 20 percent, which is $8 million.
240.
Because the quantity theory holds and because the factors that influence real GDP have not
changed, the price level rises by the same percentage as the increase in money, which is 20
percent.
$400 billion.
Because the factors that influence real GDP have not changed, real GDP is unchanged.
20.
Because the factors that influence velocity have not changed, velocity is unchanged.
$9.6 million.
From solution 11b, the quantity of money in year 2 was $48 million. Therefore the quantity of
money in year 3 is $48 million/5 = $9.6 million.
The price level is 48.
Because the quantity theory holds and because the factors that influence real GDP have not
changed, the price level falls by the same percentage as the decrease in money, which is 80
percent.
$400 billion.
Because the factors that influence real GDP have not changed, real GDP is unchanged.
20.
Because the factors that influence velocity have not changed, velocity is unchanged.
If the quantity theory results are obtained only with a lag, then in the short run—the first year—
real GDP will decrease and the price level will fall, though it will not fall all the way to its longrun value of 48.