Consider the following model of the economy

Production function: Y = A·K·N – N²/2
Marginal product of labor: MPN = A·K – N.

where the initial values of A = 6 and K = 10.

The initial labor supply curve is given as: N^S = 30 + 4w

Initial conditions in the goods market

C^d = 120 + .50(Y-T) – 500r
I^d = 800 – 500r
G = 100
T = 100

M^d/P = 218 + 0.5Y- 1000(r + π^e)

Nominal Money supply M = 3000

Expected inflation is equal to 3% (π^e = 0.03)

a)  Now suppose that there is a shock to real money demand so that the new real money demand function is:

M^d/P = 248 + 0.5Y- 1000(r + π^e)

Name and support two reasons why the nominal money stock might change like this - please do your best to relate your answer to real world events.

b)  What is the new, short run (fixed price level) expression for the LM curve?

Answer rating: 100% (QA)

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