Money markets

Question 1

Name two characteristics of fiat money

Answer 1

1. intrinsically useless

2. unbacked

Question 2

State the primitives of the money-markets section

Answer 2

Consumption as young: P(t) * C(yt)
Consumption as old: P(t+1) * C(ot+1)
Nominal bonds: b(t)
Nominal interest rate: 1+R
Price period t: P(t)
Nominal wage period t: W(t)
Change in money supply: µ
Change in money supply: π

Question 3

State the “household’s maximization problem” budget constraints in the first period

Answer 3

P(t) * C(yt) + b(t+1) = W(t)

Question 4

State the “household’s maximization problem” budget constraints in the second period

Answer 4

P(t+1) * C(ot+1) = (1+R) * b(t+1)

Question 5

What constitutes the slope in the diagram with C(yt) and C(ot+1)?

Answer 5

-(1+r) i.e. negative real interest rate

Question 6

Explain why the slope in the diagram with C(yt) and C(ot+1) gets steeper as real interest rate increases

Answer 6

Because the higher the interest rate, the more disproportionate the trade-off between consuming now and consuming later. The steeper slope indicates that more utility can be extracted by waiting, letting the money grow, and consuming when you are old.

Question 7

What is the basic formula for the quantity theory of money?

Answer 7

M / P = (1 / V) * Y

i.e. real money supply = real money demand

Question 8

State the formula defining velocity of money

Answer 8

M * V = P * Y

Question 9

State the approximate formula for nominal interest rate

Answer 9

R ≈r + π

Question 10

When does Fischer’s approximate formula not work?

Answer 10

When levels of inflation are very high

Question 11

Explain the trade-off between transaction costs and interest foregone

Answer 11

High interest –> it’s good to have money in the bank –> you make many small withdrawals (instead of one big one –> high transaction costs (but interest revenue intact)

Question 12

Why does demand for real money decrease as interest rates increase?

Answer 12

High interest –> it’s good to have money in the bank (as opposed to having cash i.e. real money)

Question 13

State the two definitions of real money demand

Answer 13

Φ(Y,R) = (1 / V) * Y

Question 14

State the formula for opportunity cost of saving / not saving, in both real and nominal terms

Answer 14

Opportunity cost = return on alternative – return on money

Nominal: R(t) – 0 = R(t)
Real: r(t) – (–π(t)) = R(t)

Question 15

How do you know there is a money-market equilibrium?

Answer 15

M(t) / P(t) = Φ(Y,r + expected π(t))

Question 16

Name two assumptions of the money-markets section

Answer 16

1. The future is non-stochastic

2. Agents forecast perfectly

Question 17

State the formula for the present value of budget constraints

Answer 17

P(t) * c(yt) + (P(t+1) * c(ot+1)) / (1+ R) = W(t)

Question 18

State the formula (using nominal interest rate) for real interest rate

Answer 18

(1+R) / (1+π)

Question 19

Define velocity of money

Answer 19

Velocity of money is the frequency at which one unit of currency is used to purchase domestically-produced goods and services within a given time period

Question 20

What are the aims of citizens and firms, respectively, in the market economy?

Answer 20

Citizens maximize utility, firms maximize profits

Question 21

State Fischer’s theory of interest rates and inflation

Answer 21

R = r + π(e)

Question 22

According to the Baumol-Tobin money model, what is an individual’s real money demand in response to increased interest rate?

Answer 22

• economize on money holdings (more frequent but smaller withdrawals)
• lower average real money holdings

Question 23

State the equilibrium condition of the Baumol-Tobin money model

Answer 23

Φ(Y,R) = M / P

Question 24

What is the nominal return on money in the Baumol-Tobin money model?

Answer 24

Zero

Question 25

What is the real return on money in the Baumol-Tobin money model?

Answer 25

-π(t) / (1 + π(t)) ≈ -π(t)