Money Demand and Supply

Question 1

What are the three main motives for holding money?

Answer 1

1. Transactions demand: To facilitate everyday transactions.
2. Precautionary demand: For unforeseen expenses or emergencies.
3. Speculative demand: Holding money to take advantage of future investment opportunities (like changes in interest rates or bond prices).

Question 2

Briefly describe the Quantity Theory of Money

Answer 2

General price level of goods and services is directly proportional to the amount of money in circulation.

Assumes that the velocity of money (how often money changes hands) and the level of output are relatively stable.

Question 3

What is the equation for the Quantity Theory of Money and what do the variables represent?

Answer 3

The equation is MV = PY, where:

M = Money supply
V = Velocity of money

P = Price level
Y = Aggregate output (real GDP)

PY = Aggregate nominal income (nominal GDP)

Question 4

How does the Quantity Theory of Money relate to inflation?

Answer 4

Theory states that the inflation rate = the growth rate of the money supply - the growth rate of aggregate output.

This implies that if the money supply grows faster than the economy’s production capacity, it will lead to inflation.

Question 5

Explain the Keynesian Liquidity Preference Theory

Answer 5

This theory focuses on the demand for money as a function of income and interest rates. It suggests that people hold money for three motives: transactions, precautionary, and speculative. The speculative motive emphasizes that people will hold more money when interest rates are low, as they expect bond prices to fall and thus prefer to hold liquid assets.

Question 6

What is the Baumol-Tobin Model?

Answer 6

This model views holding money as an inventory-theoretic problem.
Individuals balance the cost of holding money (lost interest) against the cost of converting other assets into money (transaction costs).

It predicts that higher interest rates lead individuals to hold less cash, as they make more frequent trips to the bank (or ATM) to minimize lost interest.

Question 7

Summarize the Cambridge Theory of Money Demand.

Answer 7

This theory proposes that an individual’s demand for money is a stable proportion of their nominal income.

It highlights money’s function as a store of value and suggests that people hold a certain percentage of their income in the form of cash for ease of transactions.