PART M Calculation 40 points 1 Suppose that the money demand

PART M. Calculation (40 points) 1. Suppose that the money demand function is (MP) 1000-100 Where r is the interest rate in percent. the money supply M is 1000 and the price level P is 2. 1) Graph the supply and demand for real money balances. [2 points] 2) What is the equilibrium interest rate? 12 points] 3) Assume that the price level is fixed. What happens to the equilibrium interest rate if the supply of money is raised from 1000 to 1200? [2 points] 4) the central bank wishes to raise the interest rate to 7 percent, what money supply should it set? 12 points]

Solution

Q3.

1. Calculate nominal GDP in 2014 -

nominal GDP = Quantity of cars in 2014 * Price of cars in 2014 + Quantity of computers in 2014 * Price of computers in 2014 + Quantity of oranges in 2014 * Price of oranges in 2014

nominal GDP = 10 * $2,000 + 4 * $1,000 + 1,000 * $1

nominal GDP = $20,000 + $4,000 + $1,000

nominal GDP = $25,000

The nominal GDP in 2014 is $25,000.

Calculate nominal GDP in 2015 -

nominal GDP = Quantity of cars in 2015 * Price of cars in 2015 + Quantity of computers in 2015 * Price of computers in 2015 + Quantity of oranges in 2015 * Price of oranges in 2015

nominal GDP = 12 * $3,000 + 6 * $500 + 1,000 * $1

nominal GDP = $36,000 + $3,000 + $1,000

nominal GDP = $40,000

The nominal GDP in 2015 is $40,000.

Calculate percentage change in nominal GDP from 2014 to 2015 -

Percentage change = [Nominal GDP of 2015 - Nominal GDP of 2014]/Nominal GDP of 2014

                             = [$40,000 - $25,000]/$25,000

                             = 0.6 or 60%

Thus, nominal GDP has increased by 60% from 2014 to 2015.

2. Real GDP is calculated on the basis of base year prices. In the given case, 2014 has to be taken as base year.

It should be noted that real GDP and nominal GDP of base year are same.

As 2014 has been taken as base year, its nominal GDP and real GDP would be same.

Nominal GDP in 2014 is $25,000.

Thus, real GDP in 2014 is $25,000.

Calculate real GDP in 2015 -

real GDP = Quantity of cars in 2015 * Price of cars in 2014 + Quantity of computers in 2015 * Price of computers in 2014 + Quantity of oranges in 2015 * Price of oranges in 2014

real GDP = 12 * $2,000 + 6 * $1,000 + 1,000 * $1

real GDP = $24,000 + $6,000 + $1,000

real GDP = $31,000

The real GDP in 2015 is $31,000.

Calculate percentage change in real GDP from 2014 to 2015 -

Percentage change = [Real GDP of 2015 - Real GDP of 2014]/Real GDP of 2014

                             = [$31,000 - $25,000]/$25,000

                             = 0.24 or 24%

Thus, real GDP has increased by 24% from 2014 to 2015.

3. The two output growth rates constructed in (1) and (2) are different because output growth rate constructed in
(1) is based on nominal GDP which takes into account current year prices. This growth rate reflects both change in output as well as prices between years.

On the other hand, output growth rate constructed in (2) is based on real GDP which takes into account base year\'s prices. This growth rate reflects only change in output.

Output growth rate based on real GDP reflects real growth rate of economy as it shows how much actual production has changed between years.