An economy begins in the long-run equilibrium, and then a change in government regulations permits the banks to start paying interest on checking accounts. Recall that the money stock is demand deposits and the sum of currency, including the checking accounts, so this regulatory change makes holding money more attractive.
1. Discuss how does this change affect the demand for money?
2. Explain what happens to the velocity of money?
3. What will happen to output and prices in the short run and in the long run if the Fed keeps the money supply constant?
4. If the goal of the Fed is to even out the price level, should the Fed keep the money supply constant in response to this regulatory change? If not, what should it do? Why?