Chapter 14: Money & The Economy

Question 1

Equation of Exchange

Answer 1

An identity stating that the money supply (M) times velocity must be equal to the price level (P) times Real GDP (Q) =
MV = PQ

Question 2

Velocity

Answer 2

The average number of times a dollar is spent to buy final goods and services in a year.

Question 3

Simple Quantity Theory of Money

Answer 3

The theory assuming that velocity and Real GDP (Q) are constant and predicting that changes in the money supply (M) lead to strictly proportional changes in the price level (P).

Question 4

Monetarists

Answer 4

Economists not content to rely on the simple quantity theory of money. They do not hold that velocity or output is constant.

Question 5

4 Monetarist Positions

Answer 5

• Velocity changes in a predictable way
• Aggregate demand depends on the money supply and on velocity
• SRAS-curve is upward-sloping
• The Economy is self-regulating (prices & wages are flexible)

Question 6

One-shot inflation

Answer 6

A one-time increase in the price level; an increase in the price level that does not continue.

Question 7

Continued Inflation

Answer 7

A continued increase in the price level.

Question 8

2 Assumptions regarding the simple quantity theory of money

Answer 8

• Changes in velocity are so small that for all practical purposes velocity can be assumed to be constant
• Real GDP - Q - is fixed in the short run

Question 9

4 Nonactivist monetary proposals:

Answer 9

1. Constant-money-growth-rate rule
2. Predetermined-money-growth-rate rule
3. The Taylor rule
4. Inflation Targeting

Question 10

Constant-money-growth rule

Answer 10

The annual money supply growth rate will be constant at the average annual growth rate of Real GDP.

Question 11

2 Assumptions made by the constant-money-growth-rate rule

Answer 11

• Velocity is constant

- The money supply is defined correctly

Question 12

Critics POV: Constant velocity assumptions in the constant-money-growth rule

Answer 12

Argue velocity has not been constant in some periods.

Question 13

Critics POV: Assumption that the money supply is defined correctly in the constant-money-growth rule

Answer 13

They argue that it is not yet clear which definition of money supply is the proper one and therefore which money supply growth rate should be fixed: M1, M2, or some broader monetary measure.

Question 14

Predetermined-Money-Growth-Rate Rule

Answer 14

The annual growth rate in the money supply will be equal to the average annual growth rate in Real GDP minus the growth rate in velocity.
%∆M = %∆Q - %∆V

Question 15

The Fed and the Taylor Rule

Answer 15

The federal funds rate target “should be one-and-a-half times the inflation rate plus one-half times the GDP gap plus one”.
Federal funds rate target = 1.5 (inflation rate) + 0.5 (GDP gap) + 1

Question 16

Inflation Targeting

Answer 16

Targeting that requires the Fed to keep the inflation rate near a predetermined level.

Question 17

3 Major issues surrounding inflation targeting

Answer 17

• Pondering over whether the inflation rate should be a specific percentage rate or a narrow range
• What the rate/range should be
• Whether the inflation rate target should be announced or not.