Module 18 - Quantity and Keynesian Monetary Theories

Question 1

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

Answer 1

The correct answer is D. The naïve theory suggests that changes in M affect only prices therefore neither I nor II is correct.

Question 2

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

Answer 2

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.

Question 3

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

Answer 3

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.

Question 4

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

Answer 4

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.

Question 5

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

Answer 5

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.

Question 6

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

Answer 6

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.

Question 7

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

Answer 7

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.

Question 8

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

Answer 8

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.

Question 9

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

Answer 9

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.

Question 10

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

Answer 10

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.

Question 11

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

Answer 11

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.

Question 12

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

Answer 12

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.

Question 13

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

Answer 13

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.

Question 14

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

Answer 14

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.

Question 15

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

Answer 15

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.

Question 16

Which of the following contains the correct description of the speculative demand for money?

Money balances held
A. as a medium of exchange
B. for short-term interest rate gains
C. in anticipation of favourable purchasing conditions
D. in the expectation of falling interest rate

Answer 16

The correct answer is C. This is a definitional question. If households and firms expect prices of goods/services/bonds to fall in the foreseeable future they may postpone purchases until such falls occur. The money balances held in anticipation of the falls are idle balances. They are non interest bearing and are known as speculative funds.

Question 17

A firm holding $100m in bonds expects the price of bonds to rise next month. Rational behaviour dictates that the firm

I. sell its bonds today to accumulate cash balances
II. postpone the purchase of bonds until the new equilibrium price established

Which of the following is correct?

A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 17

The correct answer is D. If a firm/household expects the price of bonds to rise in the near future it will delay the sale of bonds held until the price rises to realise the gain. In addition if a firm/household intends purchasing bonds it will gain by purchasing them now if it expects the price to be higher in the near future. Thus I and II are both wrong.

Question 18

Which of the following describes accurately the expression ‘liquidity preference’?

The desire on the part of households/firms to
A. have high disposable incomes
B. hold assets as money instead of interest bearing goods
C. have their college age sons/employees drink lots of lager
D. raise interest rates to increase the return on savings

Answer 18

The correct answer is B. A definitional question. When households/firms hold cash balances in preference to interest bearing assets they are expressing a desire for liquidity thus liquidity preference.

Question 19

The amount of money held for transaction purposes is a function of the level of national income as is the amount held for precautionary purposes. Which of the following is correct?

Both the transaction and precautionary demands for money are influenced also by

A. the speculative demand for money
B. the rate of interest
C. the supply of money
D. liquidity preference

Answer 19

The correct answer is B. There are three separable demands for money, the transaction demand, the speculative demand and the precautionary demand. Thus A is wrong. The demand for money is independent of the supply; thus C is wrong. Both demands are part of liquidity preference and thus D is wrong. High interest rates indicating high rates of return from interest bearing assets will encourage households to evaluate the opportunity cost of transactions and precautionary demands. Thus B is true.

Question 20

From the data it can be concluded that comparing Year t with Year t + 1

I. the transactions demand for money increased
II. the unemployment rate decreased
III. real income/capita increased

Which of the following is correct?

A. I only
B. III only
C. I and II only
D. I, II and III

Answer 20

The correct answer is B. Taking the second and third columns, real national income increased, the population decreased therefore real income per head of population increased. Thus III is true. Taking columns 3 and 4 real national income increased by 2%, i.e. the number of transactions increased, raising the transactions demand for money but the inflation decreased by 3% decreasing the transactions demand; the net affect being a decrease; thus I is wrong. Taking columns 3 and 5 since potential output grew faster (4%) than real output (2%) and since the unemployment rate is determined by the gap between potential and actual output the unemployment rate must have risen; thus II is wrong.

Question 21

According to the Quantity Theory, if real GNP is increasing at 2 per cent per annum, if potential GNP is increasing at 4 per cent per annum, and if the money supply is increasing at 4 per cent per annum, the rate of inflation per annum will be which of the following?

A. negative.

B. zero (approximately).

C. 2 per cent (approximately).

D. 4 per cent (approximately).

Answer 21

The correct answer is C. If V is constant and M is increasing at 4 per cent per annum, MV will be increasing at 4 per cent per annum. Given the equality MV = PY, PY must also be increasing at 4 per cent per annum. If Y is increasing at 2 per cent per annum then P must be increasing at approximately 2 per cent per annum also.

Question 22

If V and Y are held constant and M is increased, it follows that there will be which of the following?

A. an increase in real national output.
B. a reduction in real national output.
C. an increase in prices.
D. a reduction in prices.

Answer 22

The correct answer is C. Since Y is held constant, real national output cannot increase or decrease. In order to maintain the equality MV = PY, P, the price level, must increase as M increases.

Question 23

The Quantity Theory does not predict short-run changes in the economy because of which of the following?

A. Prices are fixed.
B. The government controls M.
C. All four variables in the equation can change.
D. The equality does not always hold.

Answer 23

The correct answer is C. If the economy has unemployed resources, real output (Y) may change. The level of prices can change in the short run. The efficiency with which money is used can change, hence V may change. The money supply variables can change at the same time but it is not possible to predict the value of MV or PY despite the fact that MV must equal PY.

Question 24

Which of the following is an accurate description of ‘liquidity preference’?

A. The desire to hold assets that can readily be converted into money at a fixed or near-fixed price.
B. The amount that businesses wish to borrow at a given interest rate.
C. The desire to save out of income as a protection against future uncertainties.
D. The desire to hold money as an asset in preference to any form of interest-bearing assets.

Answer 24

The correct answer is D. In deciding whether to hold cash, i.e. preference for liquidity, or interest-bearing assets, individuals will take into account:

(a) the return they would obtain from interest-bearing assets; and
(b) the prospective capital gain or loss from holding interest-bearing assets given a fall or rise in interest rate.

If investors believe that interest rates are going to rise, then this is equivalent to expecting the price of assets to fall; hence they will be reluctant to acquire interestbearing assets and will hold most of their assets in cash. The reverse applies if individuals expect the rate of interest to fall.

Question 25

Individuals will tend to move out of money and into long-term interest-bearing assets if they think which of the following is true?

A. The rate of interest is going to fall.
B. The rate of interest is going to rise.
C. The rate of interest is not going to change.
D. The price of goods and services is going to fall.

Answer 25

The correct answer is A. The price of long-term interest-bearing assets moves inversely to the rate of interest. If individuals expect that the rate of interest is likely to fall, then this is equivalent to expecting the price of long-term interest-bearing assets to rise. In these circumstances, they are likely to buy long-term interest- bearing assets. The price level will not affect this decision.

Question 26

Individuals hold cash, which yields no interest, in preference to assets, which do yield interest, because of

I. the needs of day-to-day transactions.
II. expectations concerning the future rate of interest.
III. a desire to maintain the level of savings out of income.

Which of the following is correct?

A. I only.
B. I and II only.
C. III only.
D. I and II and III.

Answer 26

The correct answer is B. Individuals hold some cash in order to finance day-to-day transactions. The convenience derived from these cash balances outweighs the cost of holding cash, that cost being interest forgone. If individuals believe that the rate of interest is likely to rise in the future, they are likely to retain their assets in cash rather than bonds, as the price of bonds will fall if the rate of interest rises. Option III is incorrect as savings may be held in the form of assets other than cash.

Question 27

In times of recession, interest rates tend to fall even when the Central Bank takes no specific action to affect interest rates.

Which of the following accounts for this?

A. The lower level of income that accompanies recession decreases the transac-tions demand for money.

B. The money supply automatically rises as national income decreases.

C. The velocity of circulation systematically follows the business cycle.

D. Individuals attempt to increase their savings during recessions.

Answer 27

The correct answer is A. Interest rates are determined by the demand for and the supply of money. In recessions, aggregate demand decreases and, as incomes fall, the demand for money for transactions purposes falls. As demand falls and supply remains unchanged, the rate of interest falls. The money supply never automatically increases; the velocity of circulation does not follow any particular pattern; savings do not affect the rate of interest directly.

Question 28

In response to increased levels of unemployment, a politician is reputed to have said: ‘The problem with the economy today is deficient aggregate demand. We need to decrease personal taxes in order to stimulate spending, and increase the rate of interest in order to make investing more attractive for businessmen.’ Would these measures reduce unemployment?

A. Yes, since both measures will result in increased spending.
B. No, since the speaker confuses increases in employment with increases in the deflationary gap.
C. No, since the proposals will tend to cancel each other out.
D. No, since both proposals aim to reduce spending instead of increasing it.

Answer 28

The correct answer is C. While a decrease in personal income tax would stimulate aggregate demand, an increase in the rate of interest would be deflationary in that it would discourage both investment and consumption expenditures. Thus the proposals would work in opposite directions and tend to cancel each other out.

Question 29

Faced with a substantial deflationary gap, a government used expansionary fiscal policy, i.e. it reduced taxes and increased government expenditure, kept the money supply constant, and discovered that the net outcome of such a policy was a decrease in private investment but no significant changes in either GNP or employment. This
outcome arose because

I. the economy was at full employment.

II. interest rates rose.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

Answer 29

The correct answer is B. The reduction of taxes and the increase in government expenditure would both increase aggregate demand and, through the multiplier process, increase GNP and decrease unemployment. However, both would also increase the demand for money, and in the absence of an increase in the money supply would raise interest rates. Businesses would be faced with two opposing forces: increased aggregate demand stimulating higher investment expenditure, and increased interest rates leading to less investment opportunities. Since private investment expenditure has fallen, the latter forces were obviously stronger. The decrease in private investment expenditure would, through the multiplier process, decrease GNP and employment, thus offsetting the increase due to the tax reduc- tion and increased government expenditure.

Question 30

The goals of a government are to reduce interest rates, stimulate private investment, and decrease unemployment. The policy strategy that would guarantee the achievement of all of those goals is

I. increasing the money supply.
II. increasing government expenditure.
III. reducing taxes.

Which of the following is correct?

A. I only.
B. II or III only.
C. I, II and III.
D. Not I nor II nor III.

Answer 30

The correct answer is D. This is a difficult question. If the economy were very depressed, an increase in the money supply would not necessarily stimulate invest- ment and consumption expenditure because of poor business expectations. An increase in government expenditure and/or a decrease in taxes with no increases in the money supply would increase the demand for money and increase interest rates; this in turn could cause investment expenditure to decrease, offsetting the positive effects and leaving unemployment unchanged. While the apparently correct policy is for fiscal and monetary expansion, if the increase in government expenditure and/or tax reduction caused interest rates to rise in spite of an increase in the money supply (i.e. the money supply increase was not large enough), the resultant increase in interest rates could cause investment and/or consumption expenditure to fall. Thus there is no guarantee of success.

Question 31

Give a short account of the difference between the Quantity Theory and the Keynasian theory.

Answer 31

The Quantity Theory suggests an immediate and close link between the money supply and the aggregate demand. Keynesian theory suggests that the change in the money supply only influences the securities (e.g. bond) market directly and that only the resulting changes in the interest rate will then influence the aggregate demand.

Question 32

Discuss difference between the Qantity and Modern Quantity theories.

Answer 32

Naïve’ Quantity Theory: If the number of transactions (T) is regarded as proportional to the level of national income (Y), they can be substituted. If one then assumes that V is constant and Y (at full employment) at the equilibrium point is also constant, it follows that: and thus that the relationship between money supply and prices is linear (higher money supply, higher prices).

Modern Quantity Theory: Changes in the money supply can influence prices as well as the level of income, the effect on those two variables being dependent on how far the economy is from full employment. Substantial unemployment: Increase M, household and firms have more money than they need for transactional purposes and will spend excess, leading to more demand, more income, more output, more employment. No unemployment: Increase in M, household and firms have more money than they need for transactional purposes and will spend excess, since there is no spare capacity only the prices will go up. The Quantity Theory does not predict short-run changes in the economy because all four variables of the equation can change.

Question 33

There are three types of demand for money (Keynesian Theory ). Discuss.

Answer 33

1. Transactions Demand for Money: money held to finance current transactions. Needed to bridge the time gap between receipt and expenditure of income. Demand is closely related to:
   a. Level of national income (Y) (high income, high demand for transactional money)
   b. Price levels (higher prices demand more money in order to finance transactions, thus there is a positive relationship to the inflation rate)
   c. Interest Rate (if the interest rate is high firms and households will try to minimize the amount of transactional money in favor of interest bearing)
2. Precautionary Demand for Money: money held to meet demand in the sudden arrival of unforeseen circumstances. Demand is related to:
   a. Level of national income (Y) (high income, high demand for precautionary money)
   b. Interest Rate (if the interest rate is high firms and households will try to minimize the amount of precautionary money in favor of interest bearing)
3. Speculative Demand for Money: money kept in cash in order to take advantage of developments in the capital market. Households and firms will hold some percentage of the wealth in cash in order to finance investment transactions. The ‘liquidity preference is not absolute’ as cash does not yield any interest. Demand is related to:
   a. Level of national income (Y) (high income, high demand for speculative money)
   b. Interest Rate (if the interest rate is high firms and households will try to minimize the amount of speculative money in favor of interest bearing)

The price of existing bonds and the market interest rate are inversely related. If the price of a bond is expected to fall (central bank or others are expected to sell bonds), it is the same as saying that the expected interest will rise. This is due to the fixed coupon payment and redemption value attached to a bond, and thus only the price of a bond can be changed due to demand and supply in the open market.