Question 13: Let’s go back to the fall of 2008 when we were at the height of the financial crisis.

Question 13:

Let’s go back to the fall of 2008 when we were at the height of the financial crisis. Pretend you are steering the cruise ship and your goal is to keep interest rates steady in the money market.

For simplicity, we hold the price level fixed at 1 and assume that inflationary expectations are fixed at 2%.

Initial Conditions before the fall of 2008

mm = money multiplier = 1.6

MB = monetary base = 900

Money Demand

Md = P X [ a0 + .5 (Y) – 200 (i) ]

Md = 1 X [ 200 + .5 (3600) – 200 (i) ]

Solve for the money market clearing rate of interest (show your work on your exam sheet). Now draw a money market diagram labeling this initial equilibrium in the money market as point A on your exam sheet.

Question 14:

We now experience a shock to the money multiplier so that the new value of the money multiplier is now 0.8. Given that we are in the fall of 2008, what caused such a shock to the money multiplier?

Question 15:

In addition to the shock to the money multiplier as in Question 14, we experience two more shocks that influence the money demand curve: The new, money demand curve is now equal to:

Md = 1 X [ 500 + .5 (3400) – 200 (i) ]

Explain why we would expect this to happen to the money demand function during the fall of 2008. Be sure to discuss both of the shocks to money demand.

Question 16:

Given that your job is to keep interest rates constant at their level in Question 13, what must you do in terms of open market operations given the shock to the money multiplier and the two shocks to money demand? Show all your work on your exam sheet.

Label this point as point B on the diagram on your exam sheet.

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