2. Money supply, money demand, and adjustment to monetary equilibrium

The following table shows a money demand schedule, which is the quantity of money demanded at various price levels (P

P).

Fill in the Value of Money column in the following table. Quantity of Money Demanded Price Level (P) Value of Money (1/ P) (Billions of dollars) 1.00 1.00 v 1.5 1.33 0.75 V 2.0 2.00 0.50 v 3.5 4.00 0.25 V 7.0 Now consider the relationship between the price level and the quantity of money that people demand. The lower the price level, the less 7 money the typical transaction requires, and the less 7 money people will wish to hold in the form of currency or demand deposits. Assume that the Fed initially xes the quantity of money supplied at $3.5 billion. Use the orange line (square symbol) to plot the initial money supply ( MS, ) set by the Fed. Then, referring to the previous table, use the blue connected points (circle symbol) to graph the money demand curve. 1.25 1.00 MS O VALUE OF MONEY 0.75 Money Demand 0.50 MS2 0.25 1 2 3 5 6 7 8 QUANTITY OF MONEY (Billions of dollars)According to your graph, the equilibrium value of money is V , therefore the equilibrium price level is V . Now, suppose that the Fed reduces the money supply from the initial level of $3.5 billion to $2 billion. In order to reduce the money supply, the Fed can use open market operations to buy bonds from v the public. Use the purple line (diamond symbol) to plot the new money supply (MS2 ). Immediately after the Fed changes the money supply from its initial equilibrium level, the quantity of money supplied is greater 7 than the quantity of money demanded at the initial equilibrium. This contraction in the money supply will increase v people's demand for goods and services. In the long run, since the economy's ability to produce goods and services has not changed, the prices of goods and services will rise 7 and the value of money will fall 7