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Chapter 16: Q16.4 Learning Objectives (page 349)
Understand the equation of exchange and its importance in the quantity theory of money and prices.
Equation of exchange plays an important role in the economy as well as in the quantity theory of money and prices.
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Imagine working at the Trading Desk at the New York Fed. Explain whether you would conduct open market purchases or sales in response to each of the following events. Justify your recommendation.
a. The latest FOMC Directive calls for an increase in the target value of the federal funds rate.
b. For a reason unrelated to monetary policy, the Fed's Board of Governors has decided to raise the differential between the discount rate and the federal funds rate. Nevertheless, the FOMC Directive calls for maintaining the present federal funds rate target.
Suppose that, initially, the U.S. economy was in an aggregate demand-aggregate supply equilibrium at point A along with the aggregate demand curve AD in the diagram below. Now, however, the value of the U.S. dollar suddenly appreciates relative to foreign currencies. This appreciation happens to have no measurable effects on either the short-run or the long-run aggregate supply curve in the United States. It does, however, influence U.S. aggregate demand.
a. Explain in your own words how the dollar appreciation will affect net export expenditures in the United States.
b. Of the alternative aggregate demand curves depicted in the figure- versus which could represent the aggregate demand effect of the U.S. dollar's appreciation? What effects does the appreciation have on real GDP and the price level?
c. What policy action might the Federal Reserve take to prevent the dollar's appreciation from affecting equilibrium real GDP in the short run?
Let's denote the price of a non-maturing bond (called a consol) as . The equation that indicates this price is , where I is the annual net income the bond generates and r is the nominal market interest rate.
a. Suppose that a bond promises the holder 500$ per year forever. If the nominal market interest rate is 5 per cent, what is the bond's current price?
b. What happens to the bond's price if the market interest rate rises to 10 per cent?
You learned in an earlier chapter that if a recessionary gap occurs in the short run, then in the long run a new equilibrium arises when input prices and expectations adjust downward, causing the short-run aggregate supply curve to shift downward and to the right and pushing equilibrium real GDP per year back to its long-run value. In this chapter, you learned that the Federal Reserve can eliminate a recessionary gap in the short run by undertaking a policy action that increases aggregate demand.
a. Propose one monetary policy action that could eliminate the recessionary gap in the short run.
b. In what way might society gain if the Fed implements the policy you have proposed instead of simply permitting long-run adjustments to take place?
Suppose that the quantity of money in circulation is fixed but the income velocity of money doubles. If real GDP remains at its long-run potential level, what happens to the equilibrium price level?
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