Money and Macroeconomic Activity

Question 1

Irving Fisher’s __________ theory was one of the first major works in classical economics.

Answer 1

Money Demand.

This theory stated in the equation that MV = PY where M is the stock of money (which is assumed to be equal to the demand for money), V is the velocity of money, P is the price level and Y is the level of real output (income) in the economy.

Question 2

Fisher believed that the velocity of money (V) results from economic behavior that is determined by factors such as the number of times _________ are paid per year, the availability of credit and the speed of postal deliveries.

Answer 2

Employees. Velocity is the number of times a year that money changes hands.

Question 3

Fisher concluded that V is constant in the short run, and so classical demand for money equation, where Md is money demand, P is the price level and Y is the __________ in the economy is Md = PY/V.

Answer 3

Real output.

Question 4

Fisher assumed the level of output to be fixed, so that _________ would be directly proportional to money supply.

Answer 4

Prices.

Question 5

The Cambridge equation for the quantity of money theory was based on the premise that the demand for money is a function of the purchases people intend to make, and this is dependent on their ability to ________, which in turn is determined by their incomes.

Answer 5

Spend. The Cambridge theory based income as the prime determiner of money demand.

Question 6

The Cambridge equation states that where Md is the money demand, k is the ________ representing income people and businesses wished to hold as money and Y is total income of the people and businesses; then Md = k*Y.

Answer 6

Fraction.

Question 7

The analysis of the changes in demand or supply of money would be enhanced if _________ balances are used, as these figures have been adjusted for the effects of inflation.

Answer 7

Real money. Real balances are obtained by dividing prices by the quantity of nominal money. Nominal money simply means that it hasn’t been adjusted for inflation or decreased buying power. It’s important to work with real money balances because we can determine the real purchasing power of money.

Question 8

Keynes groundbreaking theory of money demand was called the _________ Preference Theory.

Answer 8

Liquidity.

Question 9

Keynes examined three motives for holding liquid money - the Transactions Motive(TM), the Precautionary Motive, and the _________ Motive(SM).

Answer 9

Speculative.

Question 10

The Transactions Motive (TM) referred to the desire to hold liquid money to meet __________ transactions.

Answer 10

Expected. This refers to payments of rent, transportation costs, food and other such regular payments.

Question 11

The Speculative Motive (SM), also known as the Portfolio Motive, describes the interaction between the changes in ______________, and the impact that would have in our preference to choose holding money over more illiquid assets such as bonds.

Answer 11

Interest rates. The interest rate plays a vital role in determining the value of assets and hence is a factor in the rationale for holding money.

Question 12

Keynes simplified his theory by grouping all ________ assets into one category and calling that group bonds.

Answer 12

Illiquid. This would mean that the portfolio decision for an investor would be to hold cash or bonds.

Question 13

Keynes believed that if an investor expected the _____________ to rise, then the preference would be to hold all the wealth in cash.

Answer 13

Interest rate. On the other hand, if the expectation was that interest rates would fall, then the preference would be to hold bonds.

This makes sense, because if interest rates rise, then the prices of bonds fall, and vice versa. When the expectation is for interest rates to fall, the investor will invest all wealth in bonds except for that portion reserved for the TM (Transactive Motive) and PM (Precautionary Motive).

This is a major pitfall in Keynes theory because it is highly unlikely that investors will choose to invest either only in bonds or only in cash.

Question 14

Keynes believed that the speculative ______ of money was affected by people’s beliefs in the Interest Rate level.

Answer 14

Demand. When interest rates seem to be unusually high, the public will react to this belief and demand will vary according to what they think the ‘normal’ interest rate should be. Therefore, velocity is also affected by these perceptions.

Note that this is completely different from Fisher’s theory–Fisher didn’t take into account interest rate as affecting money demand.

Question 15

Keynes assumed that interest rate has a normal value; if the interest rate is above this value, then people consider it to be ____, and when it’s below this value, people consider the value to be low and will expect it to rise in the future.

Answer 15

High. The normal value is just a hypothetical idea–an interest rate that people consider “normal.” When interest rate is below the “normal” value, people expect it to rise in the future, which would reduce bond prices and result in a capital loss. Knowing this, people will prefer to hold money rather than bonds when to avoid this loss.

Question 16

In the 1950s, Tobin and ______ formulated the Inventory theory of money demand.

Answer 16

Baumol. Interestingly, Tobin and Baumol developed their ideas independently of each other.

Question 17

According to the inventory theory of demand for money, people hold inventories of real money balances to pay for goods and services, and these inventories can be adjusted by converting interest-bearing assets to cash. However, the number of conversions carried out in any time period will depend on real income, the interest rate, and the ____ conversion fee.

Answer 17

Cash. This fee is the cost of converting interest-bearing assets such as bonds to cash.

Question 18

Tobin expanded on Keynes’ theory of speculative demand for money by contending that rational individuals who wanted to maximize their wealth would hold a mixed portfolio of interest-bearing assets as well as cash due to the ___________ of future interest rates.

Answer 18

Uncertainty. As interest rates were not easily predictable, he concluded this was the wisest form of action. Remember, Keynes’ theory assumed that investors will choose to invest either only in bonds or only in cash.

Question 19

According to Tobin’s theory on an individual’s speculative demand for money, when interest rates are at 10% people will invest a higher proportion of their wealth in _____ (instead of cash), but if interest rates are at 8%, the reverse would occur.

Answer 19

Bonds. The higher the interest rate, the more likely people are going to think it’s higher than normal. If they consider it high, then they’re going to keep more money invested in bonds. Remember, if interest rates go up, investors lose money on their bonds.

When interest rates are higher, the individual perceives less risk in non-cash assets and hence would be more willing to invest in such assets. The reverse is true, so that when interest rates go down, people are more likely to hold cash and view non-cash assets, such as bonds with more concern.

Question 20

The application of the speculative demand for money in today’s financial market is questionable because of inflation, and the existence of market _________ interest bearing assets.

Answer 20

Risk-free. Tobin and Keynes’ theory was based on two things: 1) that cash earned no interest and 2) bonds were risky investments. Today, checking accounts can bear interest and certain non-cash assets such as Treasury bills are virtually risk-free while providing the investor a reasonable return. Therefore, it is unlikely that the demand for money will be so sensitive to interest rates, as suggested by Tobin and Keynes.

Question 21

Keynes, Tobin, and ______ concluded that velocity of money would vary procyclically, so that when the economy was expanding, then velocity would rise but if the economy was contracting, then velocity would decrease.

Answer 21

Baumol. This pattern is evident as when the economy is expanding, interest rates normally rise and vice versa, and this impacts the velocity in the manner described in the question. Remember, interest rates are tied directly to velocity–when interest rates go up, velocity goes up, and vice-versa.

Question 22

Milton Friedman’s theory of money demand is based on the general theory of _____ demand.

Answer 22

Asset. Friedman believed that the demand for money, like the demand for any other asset, is a function of wealth and the returns of other assets relative to money. You will see in the next few questions how demand for money is related to the returns on assets relative to the return on money.

Question 23

According to Milton, the demand for money is __________ related to permanent income.

Answer 23

Positively. If two numbers are positively related, that means when one number goes up, the other goes up.

Permanent income is the current value of the anticipated income of an individual over a lifetime; in other words, an estimation of anticipated lifetime income. So, Friedman believed that investors asset choices were not solely based on their current income but on this longer term perspective.

Question 24

If investors were to follow Friedman’s theory of money demand, then when the returns on bonds, stocks, and goods are higher relative to the return on money, then the investors would have a _____ demand for money.

Answer 24

Lower. Friedman’s money demand function looks at the expected returns on bonds, stocks and goods RELATIVE to the expected return on money. These items are negatively related to money demand: the higher the returns of bonds, equity and goods relative to the return on money, the lower the quantity of money demanded.

Question 25

A key difference between the theories of Keynes and ________ is that the latter did not assume the return on money to be zero.

Answer 25

Friedman. He believed the return varied according to the bank service offered and this may have included interest on checking deposits.

Question 26

The various theories of money demand vary, but the modern theories generally agree that the demand for money depends on the relative returns between money and other assets, the _________ of other assets, the expected inflation rate, and the quantity of transactions.

Answer 26

Riskiness. The greater the number of transactions, the greater the quantity of money demanded.

Question 27

The rational expectations hypothesis states that individuals form expectations on market prices and returns based on available current and __________ data, and their understanding of how markets operate.

Answer 27

Historical. This is the term coined for this hypothesis and was developed by Muth, Lucas and other economists.

Question 28

The ________ expectations hypothesis allows individuals to also forecast economic variables.

Answer 28

Rational. Economic variables such as the inflation rate can be predicted using this theory. All past and current data could be used along with an understanding of what factors impact that economic variable.

Question 29

An ________ expectations hypothesis is different from the rational expectations hypothesis because the former only examines past information in addition to an understanding of markets operations.

Answer 29

Adaptive. The adaptive expectations hypothesis uses only past information, whereas rational expectations hypothesis uses both past and current data.

Question 30

Forecasts made using the _____________________ hypothesis are not always exactly accurate.

Answer 30

Rational expectations. These forecasts can never be perfectly correct because unexpected events occur to affect the market and there are so many variables to making a forecast that even one small miscalculation would mean an error.

Question 31

The efficient-markets hypothesis is a refinement of the rational expectations theory, and it states that prices of financial assets should reflect all available information as well as the _______’ perspective of how asset prices are determined in the financial market.

Answer 31

Traders. In order for the market to be efficient, the opinions of those who trade in these assets must be considered.

Question 32

There should be no unexploited opportunities for traders to earn ______ returns in an efficient financial market.

Answer 32

Higher. Any unused information would normally be very quickly exploited, which means traders may earn a larger profit temporarily until the information became widely known. Therefore, prices would readjust back to normal levels.

Question 33

The _____________ Theory was developed in the 1970s and it correlated rational expectations with monetary policy and the economy.

Answer 33

New Classical. This theory is also known as the Rational Expectations-Equilibrium theory. The economists who devised this theory felt that rational expectations were so vital that it should play a role in any theory of how monetary policy influenced the economy.

Question 34

The new classical theory assumed pure competition and perfectly flexible _____ and prices throughout the economy.

Answer 34

Wages. In this aspect, it retains the same assumption as made in the original classical theory.

Question 35

The new classical theory stated that forecasting behavior known as ____________ was essential to monitor monetary policy.

Answer 35

FED watching. This is a job where forecasts are created of FED monetary policy based on a detailed examination of FED policy decisions.

Question 36

The key monetary implication of the _____________ theory is that anticipated FED monetary policy changes will only lead to changes in price levels and inflation rate, but cannot affect the unemployment rate. However, unanticipated FED monetary policy changes can cause short term changes of real output.

Answer 36

New classical. Correctly anticipated changes will not change real output and therefore employment will not be affected.

Question 37

According to the new classical theory, all unemployment is _________.

Answer 37

Voluntary. These economists believe that in a free market with flexible wages, if the going wage was $6 an hour and someone was willing to work for $5.90 an hour, then the worker could work for this wage and the employer would want to hire this worker because of the better profit margin.

Other workers could then be fired if they did not want to work for $5.90 an hour, and therefore, his/her unemployment must be voluntary because he/she is waiting for a better wage.

Question 38

______ prices are prices that do not adequately adjust to equalize quantity demanded and quantity supplied.

Answer 38

Sticky. There also exists wage stickiness, which are wages that are affected by union deals or long-term contracts - so they do not adjust quickly with the market conditions.

Question 39

The combination of price and wage stickiness and rational expectations means that the money supply curve does not decrease as much as presumed by the New Classical Theory, and the overall effect in the short term is that employment and output ____.

Answer 39

Rise. The supply curve is affected by wage and price stickiness. Therefore, if the supply curve stays relatively strong when it should go down according to the New Classical economists, then output and employment rise in the short term.

Question 40

The modern Keynesian approach integrates the theory of _____________________ and proposes that workers and employers will select a wage guided by their rational expectations of conditions during the duration of the work contract.

Answer 40

Rational expectations. Some Keynesian economists have modified the original theory to include rational expectations but it retains the original features of wage stickiness and imperfect information.

Question 41

One key difference between the Friedman’s theory, and the later developed New Classical Theory and the New Keynesian Theory is that Friedman’s theory didn’t assume ________ expectations.

Answer 41

Rational. The New Classical Theory was the first to add the assumption of rational expectations (which need not be correct, but make the best use of available information, avoiding errors that could have been foreseen by knowledge of history). People make their best forecasts of the future based on all data currently available rather than having to learn and catch up to the current situation.

Rational expectations (RE) can be distinguished from adaptive expectations (in which expectations for the next period’s values are based on an average of actual values during the previous periods) such as Friedman’s model uses. In RE models, individuals are forward-looking and adjust their expectations to their best forecasts of the future. With RE, errors in expectations occur only randomly and independently.

Question 42

The main reasons why wages do not react quickly to market conditions are that long-term contracts exist between many employers and employees, many costs make it cost-ineffective to change wages, and efficiency wages are present to ________ employees and labor productivity.

Answer 42

Motivate. Efficiency wages maximize profits. They encourage workers to work better. Morale is high. Some economists believe that workers should be paid above the going rate as it spurs them on to work better.

Question 43

The product market, in macroeconomics, refers to the market in which goods and services are traded, and production for this market can be categorized as consumption goods, _____________ domestic investment (GPDI) goods, government purchases of goods and services, and exports.

Answer 43

Gross private. Consumption goods are goods and services bought for personal use, such as shoes, clothes, and food.

Question 44

Gross private domestic investment (GPDI) goods refers to the amount of new _______________ produced, such as factories, tools, machinery and investment properties.

Answer 44

Private capital. These are actual purchases by private individuals or companies of items that can produce a return on investment to the owners.

Question 45

Government purchases of goods and services refers to those items produced for _____, local, and federal governments, including capital and noncapital goods but excluding government spending.

Answer 45

State.

Question 46

The ______________________ of the US is made up of consumption goods, gross private domestic investment goods, government purchases of goods and services, as well as exports.

Answer 46

Gross National Product. The Gross National Product (GNP) measures the total US domestic production. It is the value, calculated using market prices, of all the final goods and services produced by a country’s residents in a particular period. It is also known as total output.

Question 47

The ______________________ of the US is made up of all the final goods and services produced within the country’s borders over a particular period of time.

Answer 47

Gross Domestic Product. GDP differs from GNP in that it excludes inter-country income transfers, in effect attributing to a territory the product generated within it rather than the incomes received in it.

To make this clearer: Under the Gross National Product, the earnings of a multinational firm were attributed to the country where the firm was owned and where the profits would eventually return. Under the Gross Domestic Product, however, the profits are attributed to the country where the factory or mine is located, even though they won’t stay there.

For example, if Ford, which is an American company, owns a factory in Canada, then under GNP, that factory’s earnings would be attributed to the United States. Under GDP, it would be attributed to Canada, because it is physically located and produced in Canada.

Question 48

Jim, a carpenter, will build a cabinet for John, a painter, in exchange for John painting Jim’s house; this _________ transaction will be excluded from the GDP calculation.

Answer 48

Nonmarket. This transaction is nonmarket and therefore not ‘valued’ in the calculation of GDP. Other examples would be cleaning your own home or hiring an illegal person to work for you.

Question 49

GDP can be calculated using either the product or ______ approach.

Answer 49

Income. The income approach calculates national income, which is the sum of all factor earnings, or net GNP minus indirect business taxes.

The product approach measures GDP using the four types of product that make up GNP (consumption goods, GPDI goods, government purchases of goods and services, exports).

Question 50

One key difference between GDP and GNP is that the latter ________ earnings of domestic residents overseas from domestic production.

Answer 50

Includes. GNP includes earnings of domestic residents overseas from domestic production; in other words, U.S. citizens working overseas would be included. On the other hand, GDP excludes earnings from domestic residents overseas but includes foreign residents’ earnings from domestic production.

For instance, in GNP, a German factory in the U.S. would count towards German GNP. The income for the German workers in that factory would also count towards German GNP, but the American workers in that factory would be added to the U.S. GNP.

Question 51

Aggregate income is the total income earned from producing the GNP, and aggregate demand, given constant prices, is the total amount of _______ expenditures on goods and services at varying income levels.

Answer 51

Planned. Aggregate demand is basically the total costs, whereas aggregate income is the total income.

Question 52

An exogenous variable is one whose value is not dependent on other economic variables, whereas a variable that is __________ does depend on economic variables.

Answer 52

Endogenous. An example is consumer spending. Its values depend on interest rates and income.

Question 53

Savings can be calculated by subtracting consumption expenditures from __________ income.

Answer 53

Disposable. Disposable income is the income available for spending by consumers after paying their taxes.

Question 54

The amount of investment–in plant and machinery, for example–would depend on the expected profits from using this equipment; therefore, the ______ the interest rate, the lower the expected profits as the cost of borrowing is higher.

Answer 54

Higher. Obviously the more interest you’re paying on the money you borrow, the less profit you’re going to make.

Question 55

Given constant prices, and other things being equal, the level of income and output will reach the ___________ level.

Answer 55

Equilibrium. This is the point where income and output will meet.

Question 56

Over the past 40 years, GDP has risen every year in the US because the economy has grown for most of those years, but in some years, the GDP has gone up even though business production has ________, and this is because GDP is calculated using the market prices.

Answer 56

Declined. Price rises in the economy will cause the measured output value to rise. Therefore, since the GDP calculation uses market prices, that means that it does not consider inflation. We will learn about GDP calculations that use real prices (prices that take into account inflation and reduced purchasing power).

Question 57

To measure true GDP, we must subtract inflation from the equation to produce ____ GDP.

Answer 57

Real. Real GDP makes calculations using price-adjusted figures. Nominal GDP is calculated in current dollars (market prices) with no inflation modification.

Question 58

The GDP deflator is the ___________ divided by the real GDP.

Answer 58

Nominal GDP. The GDP deflator is a flexible weight measure of the overall price level.

Question 59

The business-cycle expansion is a period where an economy undergoes a recession, trough, expansion and then ____.

Answer 59

Peak. This is the term used to describe the best time in the economic cycle. Real GDP is at its highest level relative to the long-run GDP level. An expansion in the business cycle is when actual GDP starts to rise and may even exceed the natural GDP long-term level.

If you visualize a wave–a recession is where the economy is going down, trough is the bottom of the wave, expansion is where it’s on its way back up, and peak is the top.

Question 60

A recession is a decline in GDP for more than ___ successive quarters, which may cause GDP to fall below its natural long-term flow, whereas a trough is when the GDP is at its lowest level relative to the long-term natural GDP level.

Answer 60

Two.