The interest rate were zero under the old government.The GDP is $700 and at that time people kept a total of $120 in cash stored as well as %50 worth of bonds. However, under new government the interest rate has risen to 36%. On average, cash is used five times in a year to buy and sell goods. Also on average, a change in the interest rate of 2% causes a change in money demand of one dollar. If the new government wants to keep the money supply fixed at a total of 260 cash:

Question

a) the demand for bonds will tend to decrease

b)total money demand equals $310 and the interest rate will tend to rise

c)there is a surplus of cash in the economy which will tend to force the interest rate to rise

d)the interest rate will tend to fall

could anyone figure out the right answer? I really don't know how to do this question. If you do know, please tell me the reasons as well..

much thanks..!

I think it might be D. I don't know if I am right.

The question doesnt make any sense to me as many parts of your "givens" do not balance. First, do you mean $50 in initial bonds??

Lets start with the basic equation MV=PQ. You are given that V=5 and M=120. So, PQ=GNP should be $600. You are told that GDP=700. Where is the missing $100. Is there a missing foreign sector we are not told about?? Or, are the bonds treated as "near money" with a velocity of 2?? Or is it the case that the given V=5 only applies under the new government?? And why would anybody hold bonds when the interest rate is zero??

So, then we are told that interest rate rises to a whopping 36%. Further for each 2 points of interest, the demand for money changes by 1 dollar. Since interest rates and the demand for money are inversely related, the demand for money should drop from 120 to 102.

Now we are told that the govt wants to keep the supply of money fixed at $260. Hummm, how will it do that when we are told that at zero interest rate, the demand for money is $120. To get to $260, interest rates would need to go negative. (which doesnt make any sense).

That said, Answer d is the only option that makes any sense.