a) Let us consider a portfolio shock that increases money demand, say due to non-monetary assets becoming riskier and less liquid. Draw a real money demand and real money supply diagram locating the initial equilibrium point as point A and then locate the new equilibrium, assuming the Fed did nothing as point B. Employing our general equilibrium framework, what would happen to output in the short run and why? Be specific.
b) Now comment on what would happen to the general price level and why in the long run. Is this long run result desirable or not? Please explain in detail (hint: its a central banking nightmare!). Feel free to use the Fisher equation to support your argument.
c) Now connect this portfolio shock to the quantity theory of money in percent change form. In particular, given the increase in money demand due to the portfolio shock as outlined above, what are the implications on the growth rate of the velocity of money? Using the quantity theory of money in percent change form, what is likely to happen if the Fed does nothing (i.e., does not accommodate the shock to money demand). Assume we are in a Classical world so that output growth is unaffected by the portfolio shock. Is your answer similar or different than your answer in part b?
d) We now consider the appropriate response of the Federal Reserve. Referring to the quantity theory of money in percent change form, explain what the Fed should do and why. Locate this as point C on your diagram.