This problem revolves around determining the LM curve, as we did earlier in the term such that money demand (M^D) equals money supply (M^S), however in this instance under differing conditions of the interest elasticity of money demand.  Suppose that money demand is given by:

M^D = [YF/2R_o]^½

Where Y is income, F is the transactions cost, and R_o is the opportunity cost of holding money.  Assume that R_o is given as:

R_o = q₁R - q₀

In the equation above, R is the market interest rate and q₁ and q₀ are interest elasticity parameters in the opportunity cost of holding money expression.

a.  Assume F = 2 and the parameters q₁ = 1 and q₀ = 0.06 initially.  What is the level of money demand, M^D if Y = 2,500 and R = 0.08?  (Hint:  Start with the R_o expression first, and then M^D). 

b.  Next, as we know in the determination of the LM curve (M^S = M^D), suppose that money supply is set equal to the value of M^D found in (a) to insure this equality.  Now find the two market interest rates (R₁ and R₂) at which money supply (M^S) equals money demand (M^D) when

Y = 1,000 and Y = 4,000.  Plot (roughly sketch) what this LM curve would look like graphically (call this LM₁).

c.  With F = 2 but assuming that the interest elasticity parameters of money demand change such

that q₁ = 0.25 and q₀ = 0, repeat the process from above.  Specifically, find the level of money demand (M^D) when Y = 2,500 and R = 0.08 (beginning with R_o).  Similarly, supposing that money supply is set equal to this value of M^D, find the market interest rates (R) for the values of Y = 1,000 and Y = 4,000 as you did in part (b), and then plot (roughly sketch) what this LM curve would look like graphically in the same quadrant (call this LM₂).

d.  For which values of q₁ and q₀ will the LM curve be steeper?  Explain (or provide) a brief economic interpretation.  How might the effectiveness of fiscal policy (i.e., ?IS) be impacted by these differing LM curves?  Briefly explain.