Q.2 The demand for money in Oz (a closed economy) is given by: Md = P (600 – 200r + Y) where P is the aggregate price le

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Q.2 The demand for money in Oz (a closed economy) is given by:
Md = P (600 – 200r + Y) where P is the aggregate price level, r is
the (nominal) interest rate in percent and Y is aggregate income.
For this exercise treat Y and P as exogenous (given) variables.
a. Graph the money demand equation with M on the horizontal
axis, assuming P = 1 and Y = 200. Briefly explain how money demand
might vary with changes in P and Y, as suggested by the equation
above.
b. Assume that the Central Bank sets the money supply at Ms =
600. Add this to your graph. What is the equilibrium interest rate?
And the equilibrium level of money?
c. Suppose that the annual inflation rate is 20% and due to the
wise management of fiscal policy by the government, national
income, Y, grows 10% during the year. What values of P and Y should
you use to estimate the money demand equation next year? Assuming
that the money supply is constant, calculate the new equilibrium
level of interest rates and money and graph the new money demand
equation (along with the money supply equation).
d. If the Central Bank wants to restore the interest rate to its
original level (that in Part b) what should be the change in money
supply? Briefly explain the adjustment process; i.e. why does the
change in the money supply affect the interest rate?