Lecture 13 - Money Demand

Question 1

What is the quantity theory of money?

Answer 1

a classical theory for money and inflation

Question 2

‘Classical’ assumes what about prices?

Answer 2

prices are flexible and markets clear

Question 3

Define the velocity of money

Answer 3

the rate at which money circulates, or the number of times the average bank note changes hands in a given time period

Question 4

What is the equation for the velocity of money in terms of V, T, & M?

Answer 4

• V=T/M
• V = velocity, T = value of all transactions, M = money supply

Question 5

What is the equation for the velocity of money in terms of V, P, Y, & M?

Answer 5

• V = T/M
• V = PY/M
• M x V = P x Y
• V = velocity, M = money supply, P = price of output (GDP deflator), Y = quantity of output (real GDP), PY = value of output (nominal GDP)

Question 6

What does M/P represent?

Answer 6

M/P = real money balances, the purchasing power of the money supply

Question 7

What is a simple money demand function? Define the terms, and interpret the model

Answer 7

• demand for real money (M/P) = kY
• k = how much money people wish to hold for each £ of income (k is exogenous)
• MV=PY, so k = 1/V
• when people hold lots of money relative to their incomes (k is high), money changes hands infrequently (V is low)

Question 8

Explain the quantity theory of money, the equations and the assumptions, how the price level is determined

Answer 8

• assumes V is constant and exogenous: V = V(bar)
• M x V(bar) = P x Y
• with V constant, the money supply determined nominal GDP (P x Y)
• real GDP is determined by the economy’s supplies of K and L and the production function
• the price level is P = (nom GDP)/(real GDP)

Question 9

Which variables in the quantity theory of money are exogenous and which are endogenous?

Answer 9

• exogenous: M, V, Y
• endogenous: P

Question 10

Use growth rate rules on the quantity theory of money

Answer 10

• ΔM/M + ΔV/V = ΔP/P + ΔY/Y
• growth rate of money supply + 0 (constant and exogenous) = inflation (π) + GDP growth
• π = growth(m) - growth(y)

Question 11

Make conclusions on the quantity theory of money, π = growth(m) - growth(y)

Answer 11

• normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions
• money growth in excess of this amount leads to inflation
• growth(y) depends on growth in the factors of production and on technological progress

Question 12

Define the real interest rate (r)

Answer 12

% return on real assets

Question 13

Define the nominal interest rate (i)

Answer 13

% rate of return on nominal assets

Question 14

Is the nominal interest rate, i, adjusted for inflation?

Answer 14

no

Question 15

What is the equation for the real interest rate, linking i and π? Where does this approximation come from?

Answer 15

• r = i - π (holds for relatively small numbers)
• (1 + π) x (1 + r) = (1 + i)

Question 16

What is the Fisher equation? Derive the Fisher effect

Answer 16

• i = r + π
• in the classical model: S = I determines r, thus r is effectively exogenous
• hence, an increase in π causes an equal increase in i
• this one-for-one relationship is called the Fisher effect

Question 17

What is the classical and Keynesian interpretation of the equation: i = r + π?

Answer 17

• classical theories (medium/long run), Fisher effect: r exogenous
• Keynesian theories (short run): i exogenous

Question 18

What is the classical and Keynesian interpretation of the equation: i = r + π?

Answer 18

• classical theories (medium/long run). Fisher effect: r exogenous (as r is determined by S = I)
• Keynesian theories (short run): i exogenous

Question 19

The quantity theory of money assumes that demand for real money balances depends only on what?

Answer 19

depends only on Y

Question 20

Why do we demand money?

Answer 20

to make purchases of goods (transactions motive)

Question 21

Compare what would happen if one held all their wealth in money compared with if one held all their wealth in bonds?

Answer 21

• all in money:
• lose interest (i)
• but have to go to the bank less frequently
• all in bonds:
• don’t lose interest
• have to go to the bank all the time

Question 22

If we view the nominal interest rate i as the opportunity cost of holding money (instead of bonds or other interest-earning assets), what is the relationship between i and money demand?

Answer 22

• negative relationship
• increase in i means a decrease in money demand

Question 23

Incorporating the nominal interest rate, what is the money demand function? Explain the relationship between the function and its arguments. Why is L used for the money demand function?

Answer 23

• (M/P)d (demand for real money) = L(i,Y)
• real money demand depends:
• negatively on i (i is the opportunity cost of holding money)
• positively on Y (higher Y, more spending, so need more money)
• L is used for the money demand function because money is the most liquid asset)

Question 24

What is the difference between π and π (subscript e)? What does i - π subscript e, and i - π mean?

Answer 24

• π = actual inflation rate
• π subscript e = expected inflation rate
• i - (π subscript e) = ex ante real interest rate (the real interest rate people expect at the time
  they buy a bond or take out a loan)
• i - π = ex post real interest rate (the real interest rate people actually end up earning on their bond or paying on their loan)

Question 25

When people decide whether to hold money or bonds, they don’t know what inflation will turn out to be. What is the Fisher effect with expected inflation? Hence, the nominal interest rate relevant for money demand is what? So how can we write the real money demand function?

Answer 25

• i = r + (π subscript e)
• the nominal interest rate relevant for money demand is r + (π subscript e)
• (M/P) subscript d = L(r + (π subscript e), Y)