Question

1. If the speculative motive of money demand is such that changes in interest rates lead to major changes in the amount of money demanded, is the money demand function relatively steep or flat?
2. Graphically illustrate using the Theory of Liquidity Preference how interest rates are determined. Starting from an initial equilibrium interest rate, show what happens to equilibrium if the money supply is increased.
3. Is the demand for money function a stable relationship that we can count on during any two-quarter period, or is it unstable? Why would we care about this stability or instability? Illustrate and explain.
4. If we find that a change in interest rates leads to almost no change at all in the demand for money, what will be the shape of the LM curve?
5. If the size of RGDP changes, do we move along an existing LM curve, or do we shift the entire LM curve? Explain.

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1.
In the money demand function, the intercept of the function depends on k times the size of GDP and the speculative motive of money determines the slope which depends on the size of h, where h depends on the rate of interest. If h is larger, (such that changes in interest rates lead to major changes in the money demanded, then the money demand function is relatively flat as shown in the diagram below....

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