Economics 3200, fall 2003, alston study guide for midterm # 3 (also see the questions/problems at the end of each chapter) Essay Questions and Answers for Chap 19

Essay Questions and Answers for Chapter 22

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Essay Questions and Answers for Chapter 22

1. Explain the Keynesian theory of money demand. What motives did Keynes think determined money demand? What are the two reasons why Keynes felt velocity could not be treated as a constant?

Keynes felt the demand for money depended on income and interest rates. Money was held to facilitate normal transactions and as a precaution for unexpected transactions. For both of these motives, money demand depended on income. People also held money as an asset, for speculative purposes. The speculative motive depends on income and interest rate. People hold more money for speculative purposes when they expect bond prices to fall, generating a negative return on bonds. Since money demand varies with interest rates, velocity changes when interest rates change. Also, since money demand depends upon expectations about future interest rates, unstable expectations can make money demand, and thus velocity, unstable.

2. What factors determine the demand for money in the Baumol-Tobin analysis of transactions demand for money? How does a change in each factor affect the quantity of money demanded?

The factors are real income, the price level, interest rates, and the brokerage cost of shifting between money and bonds. Increases in real income increase money demand less than proportionately, since the model predicts scale economies in transactions demand. Increases in prices increase money demand proportionately, since the demand is for real balances. The quantity of money demanded varies inversely with interest rates, since interest is the opportunity cost of holding money. The brokerage fee is the cost of converting other assets (bonds) into money. An increase in this cost increases money demand.

3. What factors determine money demand in Friedman’s modern quantity theory? How does each affect money demand? What determines velocity in Friedman’s theory? What effect do interest rates have on velocity?

In Friedman’s theory, increases in permanent income increase money demand. Increases
in the returns on bonds relative to money and the returns on equities relative to money decrease money demand. Increases in the returns on goods relative to the return on money, which is the expected rate of inflation relative to the return on money, decrease money demand. Velocity is determined by the ratio of actual to permanent income. As actual income increases in an expansion, permanent income increases less rapidly, so money demand increases less rapidly than income, and velocity rises (and vice versa for contractions). Interest rates do not affect velocity in Friedman’s theory, since the relative returns on money and other assets are predicted to remain relatively constant.

4. In the liquidity trap the demand for money becomes horizontal. Depict this graphically. Demonstrate and explain why increases in the money supply do not affect interest rates, and thus aggregate spending, in the liquidity trap.

The graph should at least have a horizontal line for money demand. There should be an increase in the money supply, which does not change rates when money demand is horizontal. Since monetary policy affects aggregate spending by changing interest rates, aggregate spending is unaffected.

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