L1056 Macroeconomics 1: Class Exercise 3.

1. Money Demand

Suppose that a person’s wealth is $50,000 and that her yearly income is $60,000. Also suppose that
her demand function is given by

Md = $Y(.35 – i)

a. What is her demand for money and her demand for bonds when the interest rate is 5%? 10%?
Answer: . Assume Wealth = Money + Bonds. For 5% interest rate, If M=60(.35-.05)=18. With i=.10,
M=15.
b. Describe the effect of the interest rate on money and demand for bonds. Is it consistent with the
theory in chapter 4 of Blanchard? Why? Answer: Yes, higher interest prompts substitution from money
to bonds. In the example with wealth at 50 and a 5% interest rate, money holdings are 18, so bonds
are 32, with interest are 10%, money is 15 and bonds are 35.
c. Suppose that the interest rate is 10%. In percentage terms, what happens to her demand for money if
her yearly income is reduced by 50%? Here M=(.35-.10)Y=0.25Y. If Y halves from 100 to 50, M halves
from 25 to 12.5. Money demand in proportional to income, or, in the jargon, unit-elastic.
d. Summarize the effect of income on money demand. How does it depend on the interest rate? M is
unit elastic with respect to Y and declining in i.

2. Bonds and the Interest Rate

A bond promises to pay $100 in one year.

a. What is the interest rate on the bond if its price today is $75? $85? Answer you need to know that i=[100-
P]/P, so, P(1+i)=100. Then the calculations are then easy. P=75, I= 25/75=.33 (33%), P=85, i=15/85= .176
(17.6%)

b. If the interest rate is 8%, what is the price of the bond today? P=100/(1+i)=100/1.08 = 92.6

3. Financial Markets Equilibrium

Suppose that money demand is given by:

Md = $Y(.25 – i)

Where $Y is $100. Also, Suppose that the supply of money is $20. Assume equilibrium in financial
markets. What is the interest rate? Answer: put the numbers in money demand: 20=100(.25-i)
implying that I must be 0.05 (5%)
a. If a Central Bank wants to increase i by 10% (from, say, 2% to 12%), at what level should it set the
supply of money? This question assumes the Central Bank can manipulate the money supply. So,
just put the numbers in the equation and work it out. At i=2% we have M 1=100(.25-.02). At
i=12% we have M2=100(.25-.12). Now M2- M1= 100(.25-.12)-100(.25-.02)=100(.02-.12)=-10.

In practice, how can the Central Bank manipulate the money supply? The CB does not control the money
supply. It sets its rate on bank deposits at the CB and thereby influences bank lending and lending rates