14.02 Principles of Macroeconomics
Problem Set 3(Suggested Solution): Spring 1998

1. a) Flow
b) Stock
c) Stock
d) Flow
e) Flow

2. Both credit cards and ATM machines have helped reduce money demand. For example, these financial innovations make it possible to carry out a given level of transactions while carrying less cash. Thus, the demand for money has fallen for given levels of nominal income and the interest rate. For example, we could allow for this phenomenon by writing money demand as

Md = c * \$Y * L(i), where c=1 is what we have seen so far.

Then the effect of the increased use of credit cards and ATM machines can be thought of as a reduction in the constant c.

3. a) For income level of \$30,000, demand for money at 5% interest rate is \$16,500, and at 10% interest rate \$15,000.
b) For income level of \$50,000, demand for money at 5% interest rate is \$27,500, and at 10% interest rate \$25,000.

4. a) [\$Y/M = ] Velocity = 1/(.6-i)
b) A higher interest rate leads to higher velocity.
c) financial innovation. (Look at Problem 2 of this problem set.)

5. a) i=10%. Price of bond=\$110/(1+i)=\$100.
b) i=12%
c) \$750 billion
d) In order to achieve the lower interest rate, the central bank has to increase the supply of money by buying bonds (and thus putting more money into circulation) through Open Market Operations. The price of the bond in question will increase to \$104.

6. a) i=10%. NO CALCULATIONS ARE NEEDED HERE. The bond market is in equilibrium because Money Demand = Money Supply.
b) demand-for-bonds = \$W - demand-for-money = \$3,000b - \$500b = \$2,500 billion

7. Money Supply = \$100b * (1/.2) = \$500 billion.