Week6

Question 1

The quantity theory of money equation

Answer 1

MV = PY
M = money supply
V = velocity of money (how many times is £1)
P = Price index
Y = real GDP

Question 2

What do monetarists think about the quantity theory of money?

Answer 2

They believe inflation is caused by monetary changes by the central bank. they think V = constant
and Y (real GDP) isn’t relative to money supply

Question 3

endogenous money supply

Answer 3

Endogenous money supply is the theory that the amount of money in an economy is determined by the needs of the economy itself. It’s a key part of Post Keynesian economics.

Question 4

What do Keynesians believe in the quantity theory of money?

Question 5

Interest-rate transmission mechanism stages

Answer 5

stage 1: money supply changes leading to interest rate link
stage 2: interest rates change leading to a change in investments
stage 3: aggregate demand changes as a result and so does the multiplier effect

Question 6

What is injections = Widthdrawals

Answer 6

Aggregate demand

Question 7

Possible problems for stage 1 of the interest rate transmission mechanism

Answer 7

• elastic demand for money.
  if L is extremely elastic = liquidity trap.
• unstable demand for money (shifts in L curve), With a fixed money supply,
  fluctuations in money demand
  can lead to substantial
  fluctuations in interest rates.

Question 8

Liquidity trap

Answer 8

The liquidity trap
Interest rates are
believed to have a
floor. Once they are
this level, any rise in
money supply will
simply be held in idle
balances, financial institutions do not deploy it as an investment into the economy, it just gets held on balance sheets.

Question 9

Possible problems for stage 2 of the interest rate transmission mechanism

Answer 9

• inelastic investment demand, depending on the elasticity of investment depends on the change of interest rates and their effect
• unstable investment demand, (shifts in investment curve), A increase in interest rates is
  accompanied by an increase
  in business confidence, A fall in interest rates is
  accompanied by a decrease
  in business confidence.

Question 10

Limitations of the interest rate transmission mechanism, considering balance sheets

Answer 10

• precautionary effects, when a recession is anticipated, more people save even if interest rates decrease because they might need the money in the future
• cash flow effects, if interest rates are lowered households in debt may utilise the time to pay of their debt and/or refinance and they will have less interest payments, don’t use the money for consumption.
  Companies refinancing their debt, savings increase, consumption and investment decrease.

Question 11

the hurdle rate of investment interest rate return needed.

Answer 11

the amount of additional returns that is necessary for company to make any investment, if a reduction of interest rates decrease may increase the hurdle rate.

Question 12

The exchange-rate transmission mechanism

Answer 12

stage 1 - money supply changes → interest rates change
stage 2 - interest rate changes → exchange rate changes
stage 3 - exchange rate changes → imports and exports change

Question 13

Portfolio balance theory

Answer 13

more strongly believed by monetarists,
The key idea in the portfolio-balance theory is that the interest rate adjusts to achieve the market equilibrium. A change in the interest rate sets the demand for money and bonds into balance with the supply of money and bonds.
- Money supply goes up, leading to the supply of money being greater than the demand of money, leads to a surplus liquidity, this gets used to buy goods, which eventually increases aggregate demand.

Question 14

The stability of the velocity of the circulation of money

Answer 14

The stability of the velocity of circulation of money refers to how consistently money is used in an economy over a period of time.

Question 15

what monetary is affected by changes in aggregate demand

Answer 15

effects interest rates
effects national income

Question 16

expansionary fiscal policy

Answer 16

Expansionary fiscal policy refers to a set of government actions aimed at increasing overall economic activity, especially during periods of economic downturn or recession. The goal is to stimulate demand in the economy, boost employment, and increase output.

Question 17

Crowding out

Answer 17

when public sector investment goes up, leads to private sector investment goes down.
depends on:
- responsiveness of demand for money to an interest rate change
- responsiveness of investment to an interest rate change

Question 18

What does the Liquidity preference curve look like according to Keynesians or monetarists

Answer 18

Keynesian = elastic, flat curve
Monetarists = inelastic, steep curve

Question 19

What does the Investment curve look like according to Keynesians or monetarists

Answer 19

Keynesian = Inelastic, steep curve
Monetarist = Elastic, flat curve

Question 20

what does the exogenous money supply curve look like

Answer 20

vertical, monetarists believe this

Question 21

what does the endogenous money supply curve look like

Answer 21

slanted to the right slightly,
Keynesians believe this.

Question 22

IS/MP analysis

Answer 22

IS = investment savings
MP = monetary policy
IS = goods market
MP = interest rates
the reaction of these curves and markets

The equilibrium: when the real national income = real rate of interest

Question 23

the IS curve

Answer 23

IS, (J=W)
every iteration and possibility of withdrawals = injections, for every possible given real interest rate.

a downward sloping curve, (demand curve)

Elasticity:
- if you have a more responsive IS curve it is more elastic.
- the higher the multiplier, the more elastic
- Keynesians believe in an inelastic curve, leads to interest rates not impacting the goods market.
- monetarists believe in an elastic curve, interest rates significantly impact the goods market, crowding out is a big problem.

Question 24

shifts + movements with the IS curve

Answer 24

• Change in interest rates will cause movements along the IS curve.
• Change in another determinant of investment/saving moves the whole curve. e.g fiscal policy, investments etc…

Question 25

the MP curve

Answer 25

Chosen by the central banks target inflation. a function of the target inflation. A rise in national income leads to a higher rate of inflation and hence to the central bank raising interest rates to bring inflation back towards the target.

Question 26

price expectation inertia

Answer 26

Price expectation inertia refers to the tendency of individuals, businesses, and policymakers to expect future prices to behave in a similar way to past price trends, leading to slower or limited changes in price expectations. In other words, if prices have been rising or stable for a long period, people may expect them to continue in the same direction, even if underlying economic conditions change. The central bank want to intervene as soon as to make sure the right price expectation is anchored.

Question 27

real interest rates calculation

Answer 27

nominal interest rates - inflation

Question 28

Elasticity of the MP curve

Answer 28

- if we are below potential output, under PPF, very little impact on interest rate the central bank chooses to set, elastic MP curve - if we are above, in a boom, inelastic MP curve

Question 29

Shifts in the MP curve

Answer 29

* reduce in target rate of inflation: MP shifts downwards * Inflationary shock: MP shifts upwards * Changes in C.B. policy: change of shape → ↑target Y (steep curve) * Increase in national income Y: shift to the right.

Question 30

effects of shifts of curves in IS/MP analysis

Answer 30

IS shifts outwards - a rise in injections MP shifts outwards - rise in potential national income

Question 31

Financial accelerators

Answer 31

a means by which developments in financial markets amplify the effects of small changes in the economy - Interest-rate differentials - saving & borrowing rate differentials - Availability of credit (pro-cyclical flows) - Interaction of multiplier and financial accelerator- Accelerator increases mpc.

Question 32

what does the financial accelerator do to the expenditure line.

Answer 32

Expenditure curve gets less steep with the pivotal point at the equilibrium with income. People are more likely to spend more when they don't have enough income larger debts.

Question 33

Financial accelerator impacts on the IS/MP framework

Answer 33

flatter IS curve, whenever the real interest rate changes, with these affects the reduction in real interest rates with reduce real income if you have accelerator effects. Larger movement along the MP curve

Question 34

Financial instability hypothesis

Answer 34

 stages of credit accumulation - financial tranquillity, financial fragility and financial bust  irrational exuberance (euphoria→confidence→↑exp.returns on assets)  Minsky moment - economic shock after irrational exuberance→ pessimism  balance-sheet recession: agents ↑saving & ↓debt →AD shock

Question 35

IS/LM Analysis

Answer 35

national income x-axis, interest rates y-axis The goods and the money markets. IS - focuses on the facts many central banks forcuses directly on the money supply, no set target inflation, goods market, movements along - when interest rates go up and down shifts - changes in money supply that has nothing to do with interest rates LM - curve derrived from the equilibrium points from the demand of money curve (L) and money supply curve. Every equilibrium point from every L curve when demand for money has changed. upwards sloping curve.

Question 36

Elasticity of LM curve fiscal policy

Answer 36

the elasticity of the lm curve effects how effective expansionary fiscal policy is.

Question 37

Shifts outward in LM curve

Answer 37

A rise in money supply, expansionary fiscal policy.