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| The equation MV=PY which relates nominal income to the quantity of money |
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| liquidity preference theory |
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| John Maynard Keynes's theory of the demand for money |
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the theory that relates changes in the quantity of money to changes in economic activity |
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the theory that nominal income is determined solely by movements in the quantity of money |
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the quantity of money in real terms |
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the rate of turnover of money |
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suppose nominal GDP is $15 trillion and the quantity of money is $5 trillion. Calculate the velocity of money. |
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$15 trillion/$5 trillion=3 V=3 |
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| suppose that the velocity is 5 and nominal GDP is $25 trillion. calculate the quantity of money. |
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| $25 trillion/5=$5 trillion |
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| what assumption transforms the equation of exchange into the quantity theory of money? |
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Definition
| velocity and output are constant |
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| according to the quantity theory of money, what will happen to the price level if the money supply increases from $1 trillion to $1.3 trillion? |
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| according to the quantity theory of money, what will the demand for money be if nominal income is $20 trillion and velocity is 2? |
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Definition
| $20 trillion/2=$10 trillion |
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suppose that people have come to expect that interest rates are nromally 2%, but the interest rates are currently 4%. what will people expect to happen to the price of bonds as the interest rate returns to normal? |
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suppose that people have come to expect that interest rates are nromally 2%, but the interest rates are currently 4%. what will happen to the return on bonds as the interest rate returns to normal? |
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suppose that people have come to expect that interest rates are nromally 2%, but the interest rates are currently 4%. according to Keynes, what will happen to the demand for money if interest rates are above normal? |
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Definition
| people will hold bonds instead of money because they will expect the interest rate to fall back to normal in the future, and as interest rates fall back to normal, the return on bonds will increase |
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suppose you earn $1,800 at the beginning of each month from your part-time job. initially you cash your entire paycheck and spend you money evenly throughout the month. what are your average cash balances? |
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| what is your velocity of money? |
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suppose you earn $1,800 at the beginning of each month from your part-time job. initially you cash your entire paycheck and spend you money evenly throughout the month. now suppose the interest reat increases and you decide to cash half of your paycheck at the beginning of the month, putting the remainder in bonds. Half way throught the month you convert the bonds to cash. what are your average cash balances in your case? |
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Definition
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suppose you earn $1,800 at the beginning of each month from your part-time job. initially you cash your entire paycheck and spend you money evenly throughout the month. now suppose the interest reat increases and you decide to cash half of your paycheck at the beginning of the month, putting the remainder in bonds. Half way throught the month you convert the bonds to cash. what is your velocity of money? |
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Definition
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Term
suppose you earn $1,800 at the beginning of each month from your part-time job. initially you cash your entire paycheck and spend you money evenly throughout the month. now suppose the interest reat increases and you decide to cash half of your paycheck at the beginning of the month, putting the remainder in bonds. Half way throught the month you convert the bonds to cash. what are the costs and benefits of holding money? why did you decide to reduce your average cash balance when the interest rate rose? |
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Definition
the cost of holding money is the forgone interest that you could earn by holding bonds. the benefit of holding money is that it reduces the transaction costs that you would have to incur by holding bonds. as the interest rate rose, the cost of holding money increased, and so you were willing to incur more transaction costs to hold bonds. |
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| what are the two major differences between Friedman's money demand function and the Keynesian money demand function? |
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Definition
| Freidman believed that changes in interest rates have little effect on the expected return on other assets relative to money, and as a result, money demand is insensitive to changes in the interest rate. in addition, Friedman believed that money demand is stable. |
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| suppose the rate of return on bonds rises. according to Friedman, what will happen to the rate of return on money? explain how the rate of return on money changes even when money does not pay an explicit interest rate. |
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Definition
| according to Friedman, if the rate of return on assets other than money increases, the rate of return on money will increase as well. even if money does not pay interest, banks compete to provide services to attract checking account balances. these services might include convenient banking hours, free checking, or a free toaster when you open up a checking account. |
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use Friedman's money demand function to explain why velocity is procyclical. |
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Definition
| by substituting Friedman's money demand equation into the equation of exchange we get the folling expression for the velocity of money: V=Y/f(Yp). in a business cycle expansion, permanent income (Yp) rises by less then income (Y). as a result, Y rises by more then f(Yp) and V increases. the opposite happens in a business cycle contraction (Y falls by more than Yp). therefore V is procyclical--rises in a business cycle expansion and falls in a business cycle contraction. |
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| What reasoning did Irving Fisher use to argue that the velocity of money is constant? |
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| Irving Fisher reasoned that velocity is determined by the institutions in an economy that affect the way individuals conduct transactions, and those institutions evolve slowly over time. therefore, velocity is roughly constant. |
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| why do classical economists believe that the level of output in the economy in normal times is at full employment? |
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Definition
| classical economists believed that wages and prices were perfectly flexible, and as a result, the economy will remain at full employment. |
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Term
| is the velocity of money constant? |
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Definition
| no, velocity is not constant. |
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Term
| according to Keynes, what are the threee motives for holding money? which of these motives is related to the interest rate? |
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Definition
| Keynes postulated three motives for holding money, the trasactions motive, the precautionary motive, and the speculative motive. Keynes reasoned that the speculative motive is related to the interest rate. |
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Term
| what is the difference between nominal money balances and real money balances and what was Keynes's argument for why people desire to hold a certain level of real money balances? |
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Definition
| nominal money balances refers to the actual dollars that you hold. real money balances equal the dollars you hold divided by the price level. Keynes reasoned that people desire to hold a certain amount of real money balances because real money balances meaure how much a person can buy with their money. if prices in the economy double, the same nominal quantity of money will buy only half as many goods. |
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Term
| why do people hold precautionary money balances and how are those money balances realted to income? |
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Definition
| people hold precautionary money balances in order to make unexpected purchases. precautionary money balances are positively related to income. |
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| what does Keynes's liquidity preference theory predict about the relationship between interest rates and the velocity of money? |
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Definition
| as interest rates rise, people will reduce their money holdings (because of the speculative motive) and therefore velocity will rise. interest rates and velocity will be positively related. |
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| explain why Keynes's liquidity preference theory predicts that the velocity of money is procyclical. |
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Definition
| earlier in the text you learned that interest rates are procyclical. in a business cycle expansion, interest rates, and velocity rise. in a business cycle contraction, interest rates, and velocity fall. velocity is procyclical. |
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why is it still unclear whether a speculative demand for money even exists? |
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| James Tobin formulated a theory for why poeple hold money even when it pays not interest, but that theory relied on the fact that money is risk free. the fact that government securities are also risk free and at the same time do pay interest presents a challenge for this theory. why do people hold money for speculative purposes when they could simply hold government securities? |
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| what is permanent income and how does it differ from current income? |
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Definition
| permanent income is expected average, long-run income. permanent income has much smaler short-run fluctuations than current income. |
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Term
T/F
A central question in monetary theory is whether, and to what extent the quantity of money demanded is affected by changes in interest rates. |
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T/F
Classical economists believed that wages and prices were inflexible. |
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T/F
The most important implication of the quantity theory of money is that interest rates affect the demand for money. |
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Definition
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T/F
Irving Fisher reasoned that velocity is constant after looking at the historical data. |
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Definition
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T/F
The velocity of money remained constant throughout the Great Depression. |
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Definition
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T/F
The demand for money and the velocity of money are positively related. |
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Definition
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T/F
According to the speculative demand for money, people will hold money instead of bonds when the interest rate is above normal. |
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T/F
The velocity of money has become more volatile since the early 1970s. |
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T/F
It is not clear whether the speculative demand for money even exists becuase Treasury securities pay interest and are risk free. |
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T/F
The expected return on money is influenced by the services that banks provide to depositors. |
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Definition
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T/F
Friedman's theory of money demand implies that interest rates should have little effect on the demand for money. |
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Definition
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T/F
In a boom, permanent income rises more than current income. |
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Definition
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T/F
The more sensitive the demand for money is to interest rates, the more predictable velocity will be. |
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Definition
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T/F
A liquidity trap exists when the demnad for money is ultrasensitive to interest rates. |
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Definition
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T/F
The fact that money demand has become unstable implies that setting rigid money supply targets to control aggregate spending in the economy may be an effective way to conduct monetary policy. |
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