Answer to Question #219470 in Macroeconomics for Yogesh

Question

Q3 a)How do changes in money supply affect the
price level? Explain using the Cambridge
approach to the quantity theory of money. 5
(b ) How is revenue generated from money
creation? If the government chooses a constant
rate of nominal money growth and maintains it
forever, what would be its impact on
Seigniorage? Does it lead to hyperinflation? 5
c)Define LM- curve. Explain its derivation
graphically. Explain the factors causing shift in LM
curve. Use suitable diagram. 5
(d) Explain the effect of adverse supply shock on
price level and output in the following
conditions with suitable diagram:. 5
(i) When aggregate demand is held constant.
(ii) When aggregate demand can be increased.

Answer 1

(a)

According to Cambridge, an individual's demand for cash or money balances is proportional to his/her income. The larger the income, the greater the demand for cash of for money balances.

An increase or decrease in money supply leads to a proportional increase and decrease in money supply respectively.

(b)

The cost incurred in the production of currency is generally lower than the currency's face value itself. Governments invest the difference between the face value of the currency and the cost of production in order to earn interest.

When the rate of growth of nominal money is constant, the actual and expected inflation will be constant as well.

Since the rate of growth of nominal money is neither low nor high, real money balances will neither be affected. Seigniorage will remain the same.

This does not lead to hyperinflation.

(c)

LM- curve is a curve that shows all the sets of income levels and interest rates where supply of money equals demand for money.

Derivation

LM curve can be derived from the Keynesian theory from its analysis of money market equilibrium.

when the level of income is high, the amount of money held for transaction motive will also be high and hence the money demand curve level will also be high.

The LM curve slopes upwards. This is because with higher levels of income, demand curve for money will be higher and also the equilibrium of the money market. The equality of the money supply curve given and the money demand curve will occur at a rate of interest that is high.

factors causing a shift in LM curve

• changes in money demand
• changes in money supply

If money supply increase, the interest rate is lower at each level of income and the LM curve shifts to the right.

If money supply decreases, the interest rate is higher at each level of income and the LM curve will shift to the left.

(d)

1. output level will decrease but the price level will remain constant since aggregate demand does not change.
2. when aggregate demand is increased, price level will go up given the fact that the output level will be low there will be more demand.