This problem revolves around determining the LM curve, as we did earlier in the term such that money demand (MD) equals money supply (MS), however in this instance under differing conditions of the interest elasticity of money demand. Suppose that money demand is given by:
MD = [YF/2Ro]½
Where Y is income, F is the transactions cost, and Ro is the opportunity cost of holding money. Assume that Ro is given as:
Ro = q1R - q0
In the equation above, R is the market interest rate and q1 and q0 are interest elasticity parameters in the opportunity cost of holding money expression.
a. Assume F = 2 and the parameters q1 = 1 and q0 = 0.06 initially. What is the level of money demand, MD if Y = 2,500 and R = 0.08? (Hint: Start with the Ro expression first, and then MD).
b. Next, as we know in the determination of the LM curve (MS = MD), suppose that money supply is set equal to the value of MD found in (a) to insure this equality. Now find the two market interest rates (R1 and R2) at which money supply (MS) equals money demand (MD) when
Y = 1,000 and Y = 4,000. Plot (roughly sketch) what this LM curve would look like graphically (call this LM1).
c. With F = 2 but assuming that the interest elasticity parameters of money demand change such
that q1 = 0.25 and q0 = 0, repeat the process from above. Specifically, find the level of money demand (MD) when Y = 2,500 and R = 0.08 (beginning with Ro). Similarly, supposing that money supply is set equal to this value of MD, find the market interest rates (R) for the values of Y = 1,000 and Y = 4,000 as you did in part (b), and then plot (roughly sketch) what this LM curve would look like graphically in the same quadrant (call this LM2).
d. For which values of q1 and q0 will the LM curve be steeper? Explain (or provide) a brief economic interpretation. How might the effectiveness of fiscal policy (i.e., ?IS) be impacted by these differing LM curves? Briefly explain.