The nominal money demand for the US is given by the following function: Mᵈ =L(i)YP where M
d denotes nominal money demand, L(i) is the liquidity preference function, Y denotes real output, and P the price level in the economy. At the same time we can define the liquidity preference function as L(i)= A /1+i
where A is a parameter and i denotes the nominal interest rate in the US. Assume that the US economy is initially in equilibrium and that P=100,M
s =100 (nominal money supply), Y=100, and A= 1/95
With this information answer the following questions:
(i) Plot the liquidity preference function with respect to the nominal interest rate i. You may do this in Excel, or in the software of your choice (make sure you attach supplementary files). What kind of relation do you observe for the two variables? use economic intuition to explain this relation.
(ii) What is the nominal interest rate for the US at the initial equilibrium?
(iii) Suppose real output contracts by 5%. If prices are rigid, what is the new equilibrium interest rate in the economy? Is your result intuitive?
