An economy begins in long-run equilibrium, and than a change in government regulations allows banks to start paying interest on chequing accounts. Recall that the money stock is the sum of currency and demand deposits, including chequing accounts, so this regulatory change makes holding money more attractive.
a. How does this change affect the demand for money?
b. What happens to the velocity of money?
c. If the central bank keeps the money supply constant, what will happen to output and prices in the short run and in the long run?
d. If the goal of the central bank is to stabilize the price level, should the bank keep the money supply constant in response to this regulatory change? If not, what should it do? Why?
e. If the goal of the central bank is to stabilize out-put, how would your answer to part (d) change?