Chapter 11: Liquidity Function and Equilibrium Level of Real GDP

Understanding the Liquidity Function

Chapter 11

1) The Liquidity Function is given by L(Y,i) = Y1/3/(10i).5 . The real interest rate is 4%, the expected rate of inflation is 2.4%, the price level is 4 and the nominal money supply is 50.

a) What is the equilibrium level of real GDP in the economy.

b) What is the level of velocity in the economy (velocity is the average number of times a unit of currency is used in transactions in the economy. It measures the speed of circulation of a currency. For instance, if nominal GDP is 10,000 and there are 1000 one-dollar bills, then each dollar bill would be used ten times, on average.) For the questions on the following pages, call the initial pre-shock point: A; and call the after-shock point: B. I should see (only) points A and B in both graphs on the left side where you show the shock on the AE curve on the above graph, and on the Phillips curve on the lower graph (both drawn and labeled carefully). In the first part of each question illustrate the shock described in the question using the AE/PC model without time lags as shown in Ch.12 in the textbook (use the AE and PC graphs similarly to the textbook). For your analysis, choose as a starting point (marked A) an economy operating at potential GDP and at its inflation target. Also on the left side show point B where the economy is situated after the shock but prior to any Fed policy response.

There should be an A and B on BOTH the upper and lower graphs. If points A and B are the same point then just mark that point with both an A and a B. Using the two graphs on the right side you’ll show the Fed policy response. Start on the right side, showing starting-point B on the upper and lower graphs. Indicate where the economy is situated immediately after the described Fed response using a point C.

There should be a points B and C on both the upper and lower graphs, even if they are in the same location. If the response has a stable outcome (if Y=Y* and/or the economy no longer requires more intervention from the Fed) then you can stop your analysis there. If the economy hasn’t stabilized then you should continue showing the dynamic changes. If it’s appropriate use a D to show the final resting place of the economy. Some student may want to show an E but it isn’t strictly
necessary.

If the economy returns to its initial position then mark either C=A or D=A (or E=A) so that I can see that you have found that outcome. If the economy doesn’t return to
its final resting point then I shouldn’t see that marking. Note: If you have a letter on the top graph you must indicate the associated position using that letter on the bottom one (so if there is an ‘X’ on the top graph then there must be an ‘X’ on the bottom graph. As an example of a common error