Asset Market Equilibrium Assume the real money demand function is L(Y,i) = 2000 + 0.

Asset Market Equilibrium Assume the real money demand function is

L(Y,i) = 2000 + 0.3Y − 5000i

where Y is real output, P is the price level, i is the nominal interest rate on nonmonetary assets and monetary assets earn no interest.

a) Assuming that the asset market is in equilibrium at i = 0.05. Find equilibrium levels of real money supply, nominal money supply, and the velocity of money if P = 100, and Y = 2000.

b) Find the real income elasticity of money demand at the equilibrium level of money balances found in previous part.

c) The rate of inflation in this economy is defined as the growth rate of the nominal money supply minus an adjustment for the growth rate of real money demand arising from growth in real output:

π = (∆M/M) − ηy (∆Y/Y)

Assuming that real income is expected to grow by 5% over the next year, and the interest rate remain constant. Find out by how much should the central bank increase the money supply if pursuing an inflation targeting policy to maintain a zero inflation rate for next year.

d) Does the quantity theory of money hold in this economy? State your reason by considering above parts.

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