Chapter 19: Quantity Theory, Inflation, and the Demand for Money

Question 1

Quantity Theory of Money (Equation of Exchange)

Answer 1

M x V = P x Y
M = the money supply
P = price level
Y = aggregate output (income
V = velocity of money (average number of times per year that a dollar is spent)

Question 2

Quantity Theory of Money (Explanation)

Answer 2

• Velocity fairly constant in short run
• Aggregate output at full-employment level
• Changes in money supply affect only the price level
• Movement in the price level results solely from change in the quantity of money
• Good theory in the long run but not the short run

Question 3

Quantity Theory and the Price Level

Answer 3

P = (M x Average V) / Average Y
-Classical economists believed that the level of aggregate output Y produced in the economy during normal times would remain at the full-employment level

Question 4

Quantity Theory and Inflation

Answer 4

Inflation (pi) = % change M - % change Y

• Inflation rate is the growth rate of the price level
• Assume velocity is constant => growth rate is 0

Question 5

Two ways the government can pay for spending

Answer 5

1) Raise revenue by levying taxes
2) Go into debt by issuing government bonds
* can also create money to pay for goods and services

Question 6

Gov’t budget constraint reveals two important facts

Answer 6

1) If the government deficit is financed by an increase in bond holdings by the public, there is no effect on the monetary base and hence on the money supply
2) But, if the deficit is not financed by increased bond holdings by the public, the monetary base and the money supply increase

Question 7

Hyperinflation

Answer 7

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

• U.S. hasn’t experienced this
• One of worst cases in Zimbabwe in the 2000s

Question 8

Keynesian Theories of Money Demand

Answer 8

Three motives why individuals hold money:

1) Transactions motive
2) Precautionary motive
3) Speculative motive
* Distinguishes between real and nominal quantities of money

Question 9

Transactions motive

Answer 9

• Keynes initially accepted the quantity theory view that the transactions component is proportional to income
• Later, he and other economists recognized that new methods for payment, referred to as payment technology, could also affect the demand for money

Question 10

Precautionary motive

Answer 10

• Keynes also recognized that people hold money as a cushion against unexpected wants.
• Keynes argued that the precautionary money balances people want to hold would also be proportional to income

Question 11

Speculative motive

Answer 11

Keynes also believed people choose to hold money as a store of wealth

Question 12

Putting the three motives together

Answer 12

Velocity is not constant:

• The procyclical movement of interest rates should induce procyclical movements in velocity.
• Velocity will change as expectations about future normal levels of interest rates change

Question 13

Theory of portfolio choice and Keynesian liquidity preference

Answer 13

The theory of portfolio choice can justify the conclusion from the Keynesian liquidity preference function that the demand for real money balances is positively related to income and negatively related to the nominal interest rate

Question 14

Other factors that affect the demand for money

Answer 14

1) Wealth
2) Risk
3) Liquidity of other assets
SEE SUMMARY TABLE 1

Question 15

Interest rates and money demand

Answer 15

• If interest rates do not affect the demand for money, velocity is more likely to be constant so the view that aggregate spending is determined by the quantity of money is more likely to be true
• However, the more sensitive the demand for money is to interest rates, the more unpredictable velocity will be, and the less clear the link between the money supply and aggregate spending will be

Question 16

Stability of money demand

Answer 16

• If the money demand function is unstable, then velocity is unpredictable, and the quantity of money may not be tightly linked to aggregate spending
• The stability of the money demand function is also crucial to whether the Federal Reserve should target interest rates or the money supply