An economy begins in long-run equilibrium, and then a change in government regulations allows the banks to start paying interest on checking accounts. Recall that the money stock is the sum of currency and demand deposits, including checking accounts, so this regulatory change makes holding money more attractive.
1. Explain how does this change affect the demand for money?
2. 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 central bank keeps the money supply constant?
4. Should the central bank keep the money supply constant in response to this regulatory change if the goal of the central bank is to stabilize the price level? If not, what should it do? Why?
5. How would you answer to part change if the goal of the central bank is to stabilize output?