Chapter 19: Demand For Money and Quantity Theory

Question 1

monetary theory

Answer 1

the study of the effects of money and monetary policy on the economy

Question 2

Quantity Theory of money

Answer 2

• explains how the nominal value of aggregate income is determined
• how much money is held for a given amount of aggregate income
• interest has no effect on Md
• P * Y = M * Constant V

Question 3

P x Y

Answer 3

• total spending
• aggregate nominal income

Question 4

velocity of money

Answer 4

average number of times per year that a dollar is spent
- V = P * Y/M

Question 5

equation of exchange

Answer 5

relates nominal income to the quantity of money and velocity
- V * M = P* Y

Question 6

What determines velocity?

Answer 6

institutions within an economy that affect the ways in which individuals conduct transactions

Question 7

Classical Theory (Fisher)

Answer 7

• V is fixed
• institutional and technological features of the economy would affect velocity slowly over time
• demand for money is a function of income
• interest rates have no effect on demand for money

Question 8

demand for money

Answer 8

the quantity of money that people want to hold onto

Question 9

demand for money equation

Answer 9

Md = k * PY

Question 10

relationship between quantity theory and price level

Answer 10

changes in the quantity of money lead to proportional changes in price level

Question 11

relationship between quantity theory and inflation

Answer 11

ΔP/P = Δm/m + Δv/v - ΔY/Y

Question 12

quantity theory of money in short run

Answer 12

• not a good theory in SR
• “inflation is always everywhere a monetary phenomenon” is only true in LR

Question 13

ways the government can pay for spending

Answer 13

1. raise revenue (tax)
2. borrow (debt)
3. create money

Question 14

government budget constraint

Answer 14

DEF = G(excess of gov spending) - T(tax) = change MB + change B (bonds)

Question 15

deficit financed by increased bond holdings by public

Answer 15

no change in MB and MS

Question 16

deficit not financed by bonds held by public

Answer 16

increase in MB and MS

Question 17

monetizing the debt

Answer 17

when government debt issued to finance government spending has been removed from the hands of the public and has been replaced by high powered money

Question 18

printing money

Answer 18

creation of high powered money

Question 19

what happens with persistent money creation

Answer 19

inflation

Question 20

hyperinflation

Answer 20

periods of extremely high inflation of more than 50% per month

Question 21

liquidity preference theory (Keynesian Theory)

Answer 21

three motives behinds the demand for money
1. transactions motive
2. precautionary motive
3. speculative motive

Question 22

transaction motive

Answer 22

individuals are assumed to hold money because it is a medium of exchange that can be used for everyday transactions

Question 23

payment technology

Answer 23

new methods of payment which affect the demand for money

Question 24

precautionary motive

Answer 24

people hold money as a cushion against unexpected oppotunities

Question 25

speculative motive

Answer 25

people hold money as a store of wealth
- As i increases, opportunity cost of money increases and the quantity of money falls

Question 26

real money balance

Answer 26

quantity of money in real terms

Question 27

liquidity preference function

Answer 27

Md/P = L(i,Y)
V = PY/M = Y/L(i,Y)
- demand for money has a negative relationship with nominal interest rate and positive relationship with real income

Question 28

theory portfolio choice and Liquidity preference

Answer 28

as i rises, expected return on money does not change, return on bonds rises

Question 29

dominated assets

Answer 29

currency and checkable deposits
- investors can hold other assets that pay higher returns and are safe

Question 30

inflation hedges

Answer 30

real returns are less affected than that of money when inflation rises

Question 31

liquidity trap

Answer 31

conventional monetary policy has no direct effect on aggregate spending b/c change in MS has no effect on i

Question 32

stability of Md

Answer 32

if Md is unstable, velocity is unpredictable, and the quantity of money is not tightly linked to aggregate spending
- the steady growth of MS is an ineffective way to conduct MP

Question 33

factors that shift Md curve

Answer 33

• interest rates -
• income +
• payment technology -
• wealth +
• riskiness of other assets +
• inflation -
• liquidity of other assets -

Question 34

velocity and interest rates

Answer 34

when i increases, v increases

Question 35

demand for real money and interest rates

Answer 35

Md increases, i decreases

Question 36

demand for real money and real income

Answer 36

Md increases, real income increases

Question 37

why did Keynes believe that interest rates affect the demand for money?

Answer 37

Interest rates affect the demand for other assets that may be preferred over money