Module 18 - Quantity and Keynesian Monetary Theories Flashcards
The naïve or traditional quantity theory of money suggested that an increase in the money supply will lead to
I. an increase in spending.
II. an increase in aggregate demand.
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
The correct answer is D. The naïve theory suggests that changes in M affect only prices therefore neither I nor II is correct.
Which of the following explains what Keynesian Theory suggests households/businesses will do immediately if they have excess money balances?
They will
A. reduce interest rates and increase spending
B. reduce interest rates and increase saving
C. use the excess to purchase bonds
D. use the excess to purchase goods and services
The correct answer is C. Keynesian Theory suggests that changes in the demand for and supply of money are reflected immediately in the market for securities; excess money balances will lead households/businesses to purchase bonds and vice versa and not affect purchases of goods and services. Thus D is wrong. Forces of demand and supply in money markets affect interest rates; they are not set by households/consumers. Thus A and B are wrong.
Which of the following explains why in Keynesian Theory, monetary policy may be unable to raise aggregate demand even indirectly?
An increase in the money supply
A. leads to higher interest rates and lower investment expenditure
B. leads to higher interest rates and lower consumption expenditure
C. fails to encourage higher investment expenditure because of unfavourable business expectations
D. fails to encourage higher investment expenditure because banks increase reserve requirements
The correct answer is C. If investment opportunities are poor because the unemployment rate is high and concomitantly there is under utilisation of the existing capital stock, businesses may be unwilling to undertake new investments no matter how low the cost of borrowing, i.e. the rate of interest. Thus C is true. Increasing the money supply in the absence of any offsetting factors would lower interest rates; thus A and B are wrong. Increasing the money supply does not lead to banks altering reserve requirements; thus D is wrong.
The ‘naïve’ Quantity Theory assumed that
I. the velocity of circulation of money was stable
II. changes in the money supply affected only interest rates
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
The correct answer is A. The proponents of the Quantity Theory believed that the velocity of circulation of money depended upon habit and institutional arrangements which changed only slowly over time and as a result the velocity was if not constant very close to being constant. Thus I is true. They believed also that national income in equilibrium would be full employment national income because of market forces. In other words in the MV = PY equation, V and Y were given, and as a consequence changes in M resulted in changes in P, the price level, only. Thus II is wrong.
Which of the following is correct?
The difference between the ‘naïve’ and ‘modern’ Quantity Theory is that, only in the latter, changes in the money supply affect
A. the velocity of circulation of money
B. the level of real income
C. the price level
D. the growth rate of potential output
The correct answer is B. In the naïve version changes in the money supply affect only the price level. In the modern version more than the price level is affected; thus C is wrong. In neither version is the velocity of circulation or the growth rate of potential output affected; thus A and D are wrong. In the modern version changes in the money supply affect the demand for bonds, which in turn affects the rate of interest, possibly investment/consumption expenditure and consequently the level of aggregate demand and real income. Thus B is true.
Which of the following contains the correct description of the transaction demand for money?
Money balances are held
A. to bridge the gap between receipt and expenditure of income
B. to take advantage of unexpected transactions
C. to insure against accidents such as fire and floods
D. as a precaution against financial institutions going bankrupt
The correct answer is A. This is a definitional question. Households need money to finance current transactions. They hold money balances since typically a time lag exists between the receipt of income (pay day) and work done whereas the act of consumption is continuous.
Speculative activity
I. occurs when uncertainty about future events exists
II. in economics applies only in financial assets market
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
The correct answer is A. If an individual expects the price of any good, service and or asset he/she is considering buying is going to fall in the near future the purchase will be postponed. In so doing the individual is speculating about the future course of events and is indulging in speculative activity. Were the future certain such activities would cease since there would be no potential gain with perfect knowledge. Thus I is true. Speculative activity can apply to anything someone is considering buying. Thus II is wrong.
A firm holding $100m in bonds expects the interest rates to fall significantly next month. Rational behaviour dictates that the firm
I. sell its bonds today
II. postpone the purchase of bonds until the new interest rate is determined
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
The correct answer is D. Suppose each $100 bond held by the firm currently yields 5% per annum. If the rate of interest falls from 5% to 4% the $100 bond’s market price will rise to $125, i.e. 4% of 125 = $5 = 5% of $100. Thus the firm will not sell its bonds today; indeed the incentive is to buy today since the lower interest rate means higher bond prices. Thus I and II are both wrong.
Which of the following is correct?
The strength of the demand for liquidity preference varies inversely with
A.the supply of money
B. the rate of interest
C. speculative balances held
D. the price of bonds
The correct answer is B. Speculative balances are wealth held in the form of money in preference to interest bearing assets when interest rates are very low households/firms are reluctant to tie up cash since expectations are for interest rates to rise. As a consequence the demand for liquidity (cash) varies inversely with the rate of interest, and therefore, directly with the price of bonds since the price of bonds is inversely related to the rate of interest. Thus B is true and D is wrong. The larger the supply of money, in the absence of offsetting factors, the lower the interest rate, which is inversely associated with liquidity preference. Thus A is wrong. Speculative balances held correlate directly with the demand for liquidity preference. Thus C is wrong.
The data indicate that comparing year t with year t + 1
. real national output increased by 4%
II. the inflation rate was negative
III. the unemployment rate fell
Which of the following is correct?
A. I only
B. II only
C. I and II only
D. I, II and III
The correct answer is C. In constant prices (i.e. Yt prices) national income increased from 100 to 104, i.e. 4%, thus I is true. National income in current prices captures both the quantity of transactions and price change effects. Since the change was only 3% [(103 − 100)/100] which was less than the change in real output of 4% the inflation rate must have been negative – approximately −1% and thus II is true. Unemployment would fall if, and only if, the increase in real output exceeds the increase in potential output. Since there is no information on potential output we do not know if the unemployment rate fell. Thus III is wrong.
The naïve or traditional quantity theory of money suggested a close link between the money supply and the level of aggregate demand. A decrease in the money supply will lead to
I. a decrease in interest rates
II. an increase in investment expenditure
III. a decrease in the unemployment rate
Which of the following is correct?
A. I and II only
B. II and III only
C. I, II and III
D. Not I, not II, not III
The correct answer is D. With a reduction in the money supply households and business will find they have less money than they wish to hold in transaction balances; to build up these balances they will reduce their expenditure on goods and services causing aggregate demand to decrease and national output to fall. Thus I, II and III are wrong.
Keynesian Theory suggests that if households/businesses discover their money balances are less than the money balances they wish to hold they will
I. sell bonds.
II. increase savings and decrease consumption.
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
The correct answer is A. Keynes argued that changes in the demand for and supply of money are reflected directly only in securities markets. Thus if money balances are inadequate businesses/households will augment current holdings by selling securities, receiving cash and boosting money balances. Thus I is true. They will not adjust purchases of goods and services and thus consumption and savings will be unaffected. Thus II is wrong.
Which of the following explains how, in Keynesian Theory, monetary policy can have an indirect effect on employment?
An increase in the money supply
A. can affect the price of bonds, the interest rate and aggregate demand
B. may be held in idle money balances which will stimulate investment expenditure
C. may be held in idle money balances which will stimulate consumption expenditure
D. can affect the amount of money banks can loan independent of the reserve requirement
The correct answer is A. If increases in the money supply are held in idle balances rather than being used to purchase bonds there will be no stimulus to aggregate demand through additional investment/consumption expenditure and consequently no change in employment. Thus B and C are wrong. The reserve requirement always limits the amount banks can lend; thus D is wrong. If increases in the money supply are used to purchase bonds, the price of bonds will be affected as well as the rate of interest. The change in the rate of interest may affect some investment expenditures which in turn will affect aggregate demand and employment; thus A is true.
In the ‘naïve’ Quantity Theory it is alleged that changes in the money supply affect only
I. the level of national income
II. the velocity of circulation of money
III. the rate of interest
Which of the following is correct?
A. I only
B. I and III only
C. I, II and III
D. Not I, not II, not III
The correct answer is D.
In the naïve Quantity Theory MV = PY
It is assumed that V and Y are fixed and changes in M, the money supply, affect P, the price level only. Thus I, II and III are wrong.
In the ‘modern’ version of the Quantity Theory under a certain circumstance an increase in the money supply will have the same effect as it would have under the ‘naïve’ version.
Which of following describes that circum-stance?
A. When the velocity of circulation is constant
B. When investment expenditure is a function of the rate of interest
C. When the number of transactions in a year equals national income
D. When the economy is at full employment
The correct answer is D. In the ‘naïve’ version an increase in the money supply will cause an increase in the price level. In the ‘modern’ version an increase in the money supply can cause an increase in the level of real income unless the economy is at full employment; than and only then will an increase in the money supply be reflected only in an increase in the price level. Thus the circumstance in which both versions yield the same outcome is ‘full employment’. Thus D is true. Both versions assume a constant velocity of circulation and thus A is wrong. A difference between the versions is the rate of interest is affected by changes in the money supply but not the interest elasticity of investment expenditure; thus B is wrong. A common assumption in both versions is that the number of transactions is correlated with level of real income; the number of transactions being a physical number cannot equal national income, the number of final transactions times price, a monetary sum. Thus C is wrong.