Lecture 3 problem set:

Question 1

In his liquidity preference framework, Keynes assumed that money has a
zero rate of return; thus, when interest rates ________, the expected
return on money falls relative to the expected return on bonds, causing
the demand for money to ________

Answer 1

A) rise; fall

Question 2

n the liquidity preference framework, when the price level ________, the
demand curve for money shifts to the ________ and the interest rate
________, everything else held constant.

Answer 2

D) rises; right; rises

Question 3

In Keynes’s liquidity preference framework, as the expected return on
bonds increases (holding everything else unchanged), the expected return
on money ________, causing the demand for ________ to fall

Answer 3

B) falls; money

Question 4

In Keynes’s liquidity preference framework, ________ in the money
supply in the market for money creates excess demand for ________,
causing interest rates to ________, everything else held constant

Answer 4

B) an increase; bonds; fall

Question 5

According to Keynes’s theory of liquidity preference, velocity increases
when…
– A) …income increases.
– B) …wealth increases.
– C) …brokerage commissions increase.
– D) …interest rates increase.

Answer 5

D) …interest rates increase

Question 6

According to the quantity theory of money demand…
A) …an increase in interest rates will cause the demand for money to
fall.
– B) …a decrease in interest rates will cause the demand for money to
increase.
– C) …interest rates have no effect on the demand for money.
– D) …an increase in money will cause the demand for money to fall

Answer 6

C) …interest rates have no effect on the demand for money.

Question 7

Cutting the money supply by one-third is predicted by the quantity theory
of money to cause…
– A) …a sharp decline in real output of one-third in the short run, and a
fall in the price level by one-third in the long run.
– B) …a decline in real output by one-third.
– C) …a decline in output by one-sixth, and a decline in the price level
of one-sixth.
– D) …a decline in the price level by one-third.

Answer 7

D) …a decline in the price level by one-third

Question 8

The portfolio theories of money demand state that when income (and
therefore, wealth) is higher, the demand for the money asset will
________ and the demand for real money balances will be ________

Answer 8

A) rise; higher

Question 9

Considering Friedman’s modifications to the liquidity preference
framework, if the liquidity effect is smaller than the other effects, and the
adjustment to expected inflation is immediate, then the interest rate will…
A) …fall.
– B) …rise.
– C) …fall immediately below the initial level when the money supply
grows.
– D) …rise immediately above the initial level when the money supply
grows

Answer 9

D) …rise immediately above the initial level when the money supply
grows

Question 10

Considering Friedman’s modifications to the liquidity preference
framework, when the growth rate of the money supply is increased,
interest rates will fall immediately if the liquidity effect is ________ than
the other money supply effects and there is ________ adjustment of
expected inflation.
– A) larger; fast
– B) larger; slow
– C) smaller; slow
– D) smaller; fast

Answer 10

B) larger; slow

Question 11

The Baumol-Tobin analysis suggests that an increase in the brokerage fee
for buying and selling bonds will cause the demand for money to
________ and the demand for bonds to ________.

Answer 11

B) increase; decrease

Question 12

In the Baumol-Tobin analysis of transactions demand, scale economies
imply that an increase in real income increases the quantity of money
demanded ________, while an increase in the price level increases the
quantity of money demanded ________.

Answer 12

C) less than proportionately; proportionately

Question 13

Describe the implications of an increase in the money supply on
interest rates through the expected inflation effect introduced by
Friedman. Is this an immediate effect or not? Draw the necessary
graph(s)

Answer 13

An increase in the money supply may cause the overall price level to rise.
■ Higher prices means inflation; the public anticipates a rise in expected
inflation.
■ Expected-inflation effect; demand/supply for bonds framework:
– Demand for bonds ↓ + supply of bonds ↑ → interest rates ↑
■ For graph and analysis, please see Lecture 2, presentation slide 20.
■ It can be slow or fast; speed of expectations adjustment.

Question 14

What factors determine the demand for money in the Baumol-Tobin
analysis of transactions demand for money? How does a change in
each factor affect the quantity of money demanded?

Answer 14

The factors are income, interest rates, and the brokerage cost of shifting
between money and bonds.
■ Negative relation between the demand for money and the interest rate;
■ positive relation between the demand for money and income, but there
are economies of scale in money holdings;
■ positive relation between the demand for money and the brokerage fee;
technological improvements that reduce the brokerage fee decrease the
demand for money;
■ there is no money illusion in the demand for money.