Economics Chapter 20: Quantity Theory & Money Demand
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Questions and Answers

Which of the following are methods the government can use to finance its spending?

  • Issuing stocks
  • Levying taxes (correct)
  • Increasing interest rates
  • Creating money (correct)

What is the implication of financing a budget deficit through increased bond holdings by the public?

  • It causes a decrease in government spending.
  • It leads to an increase in the monetary base.
  • There is no effect on the monetary base. (correct)
  • It results in higher inflation rates.

Which of the following scenarios is most likely to lead to hyperinflation?

  • Stable government spending balanced with tax revenues.
  • Significant tax increases by the government.
  • Excessive government money creation without corresponding economic growth. (correct)
  • Sustained high bond purchases by the public.

According to Keynesian theories, what primarily influences money demand?

<p>The interest rate and level of income. (A)</p> Signup and view all the answers

How does the government budget constraint relate budget deficits to changes in the monetary base?

<p>It suggests that deficits can be covered without altering the monetary base if bonds are sold. (C)</p> Signup and view all the answers

In the context of money growth and inflation, which of the following holds true?

<p>Inflation rates can remain low despite high money growth years. (A)</p> Signup and view all the answers

What does 'monetizing the debt' refer to?

<p>The central bank buying government bonds to increase the money supply. (A)</p> Signup and view all the answers

Which situation demonstrates a weakening link between inflation and money growth?

<p>Years with significant money growth but minimal inflation response. (D)</p> Signup and view all the answers

What is the primary determinant of nominal income in the quantity theory of money?

<p>Quantity of money M (D)</p> Signup and view all the answers

In the long run, what assumption is made about wages and prices in the context of the quantity theory of money?

<p>Wages and prices are completely flexible (D)</p> Signup and view all the answers

How does the quantity theory of inflation express the relationship between inflation rate and economic factors?

<p>Inflation rate equals the growth rate of the money supply minus the growth rate of aggregate output (B)</p> Signup and view all the answers

Why is the quantity theory of money considered a better explanation for long-term inflation rather than short-term inflation?

<p>Short-term factors dominate in the short run (A)</p> Signup and view all the answers

What characteristic of the quantity theory of money helps explain cross-country inflation differences?

<p>Consistency in growth rates of aggregate output over longer periods (B)</p> Signup and view all the answers

What leads to an inflationary monetary policy according to the quantity theory of money?

<p>Budget deficits financed by creating more money (B)</p> Signup and view all the answers

Which of the following is a determinant of the velocity of money as proposed by Irving Fischer?

<p>Frequent utilization of digital transaction tools like credit cards (C)</p> Signup and view all the answers

In the context of liquidity preference theory, which factor is NOT one of the three motives for holding money?

<p>Regulatory motive (C)</p> Signup and view all the answers

If the money supply (M) increases while velocity (V) remains constant, what happens to the price level (P) according to the equation of exchange?

<p>Price level increases proportionally to the money supply (C)</p> Signup and view all the answers

Which statement accurately reflects a misconception about the relationship between interest rates and money demand according to Fischer's theory?

<p>Interest rates influence demand for money. (C)</p> Signup and view all the answers

What impact does using credit cards more frequently have on the demand for real money according to Fischer's quantity theory?

<p>It decreases the demand for real money. (A)</p> Signup and view all the answers

Which of the following scenarios illustrates a situation where inflation may become hyperinflation?

<p>A central bank excessively prints money to cover growing budget deficits. (A)</p> Signup and view all the answers

Which element is considered part of the monetary base rather than the money supply?

<p>Currency in circulation among the public (D)</p> Signup and view all the answers

What is the primary reason why velocity is considered reasonably constant in the short run?

<p>Limited changes in payment methods (C)</p> Signup and view all the answers

How can an increase in the aggregate output (Y) affect the demand for money according to Fischer's theory?

<p>It increases money demand as people require more for transactions. (A)</p> Signup and view all the answers

What is the defining characteristic of hyperinflation?

<p>Inflation rate exceeds 50% per month (D)</p> Signup and view all the answers

Which of the following best describes the speculative motive for holding money?

<p>Holding money as a store of value (A)</p> Signup and view all the answers

How does Keynes's Liquidity Preference Theory classify the reasons for holding money?

<p>Transactional, precautionary, and speculative (C)</p> Signup and view all the answers

What effect does an increase in interest rates have on the demand for real money balances according to Keynesian theory?

<p>Decreases the demand for real money balances (D)</p> Signup and view all the answers

Which statement accurately reflects the relationship between velocity and interest rates?

<p>Velocity rises with increasing interest rates (A)</p> Signup and view all the answers

Which of the following is NOT one of the three main motives for demand for money as outlined by Keynes?

<p>Liquidity motive (C)</p> Signup and view all the answers

In terms of Keynes's theories, which of the following factors can influence money demand?

<p>Interest rates and payment technology (C)</p> Signup and view all the answers

What was one extreme example of hyperinflation mentioned?

<p>Zimbabwe in the 2000s (B)</p> Signup and view all the answers

What does the function L(i,Y) represent in the context of demand for real money?

<p>The liquidity preference function (C)</p> Signup and view all the answers

According to Keynesian theory, how is the demand for money related to income levels?

<p>It increases with increasing income (A)</p> Signup and view all the answers

How does the theory of portfolio choice relate the demand for real money balances to interest rates?

<p>It shows that higher interest rates lead to lower money demand. (C)</p> Signup and view all the answers

Which factor decreases the demand for money according to the given factors affecting money demand?

<p>Enhanced payment technology (D)</p> Signup and view all the answers

What is the relationship between income and the demand for money as per Keynesian theories?

<p>Higher income results in increased money demand. (C)</p> Signup and view all the answers

How does wealth affect the demand for money?

<p>An increase in wealth typically increases money demand. (B)</p> Signup and view all the answers

If inflation risk rises, what is expected to happen to the demand for money?

<p>It decreases as money becomes relatively more risky. (D)</p> Signup and view all the answers

According to the evidence, what happens to the relationship between the money supply and aggregate spending when demand for money is sensitive to interest rates?

<p>The connection becomes more unpredictable. (B)</p> Signup and view all the answers

Which of the following correctly describes a consequence of the demand for money being inelastic?

<p>Velocity will be predictable. (C)</p> Signup and view all the answers

What happens to money demand if there is increased risk associated with other assets?

<p>Demand for money increases. (D)</p> Signup and view all the answers

Which statement regarding the classical quantity theory view on nominal income is true?

<p>Nominal income is directly linked to the quantity of money. (A)</p> Signup and view all the answers

How does the demand for money change with rising interest rates according to classical economics?

<p>Demand decreases, as opportunity costs are higher. (B)</p> Signup and view all the answers

Flashcards

Government Budget Constraint

The relationship between a government's spending, taxation, and the changes in its money supply and government bonds.

Financing Budget Deficit

Ways a government can cover the difference between spending and tax revenue. It can increase taxes, borrow money by issuing bonds, or create money.

Monetizing the Debt

When a central bank buys government bonds to finance a budget deficit.

Budget Deficit

When government spending exceeds government tax revenue.

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Public Bond Holdings

When the public (individuals or institutions) buys government bonds to finance a portion of government spending.

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Money Supply

The total amount of money circulating in an economy.

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Inflation and Money Growth Relationship

A relationship where high money growth can lead to higher inflation if the central bank purchase government bonds.

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Short-run link between inflation and money growth

Data suggests that there isn't a direct, consistent short-run relationship between money growth and inflation.

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Hyperinflation

A period of extremely high inflation, exceeding 50% per month. It can occur in both developing and developed economies.

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Keynesian Liquidity Preference Theory

Explains why individuals decide to hold onto their money, rather than invest it. It's based on three motives: transactions, precautionary, and speculative.

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Transactions Motive

The reason people hold money to make daily purchases and transactions. Initially, it was thought to directly relate to income.

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Precautionary Motive

This is the reason people hold money to cover unexpected expenses or emergencies.

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Speculative Motive

People hold money in anticipation of future price changes, believing that its value will increase.

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Real vs. Nominal Money Balances

Real money balances adjust for inflation, showing the real value of your money. Nominal money balances are the raw numbers, not adjusted.

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Velocity of Money

The rate at which money changes hands in an economy. It's calculated by dividing total spending by the money supply.

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Velocity and Interest Rates

Velocity is influenced by interest rates: higher interest rates generally lead to faster money circulation.

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Payment Technology and Money Demand

Technological advancements in payments (like online banking) can actually reduce the need for physical cash, impacting money demand.

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Is Velocity Constant?

No. Velocity fluctuates due to changes in interest rates and how people choose to hold their money (liquidity preference).

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Keynesian Liquidity Preference

The theory that the demand for money is influenced by the interest rate, with higher interest rates leading to a lower demand for money.

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Portfolio Choice Theory

This theory explains how individuals allocate their wealth among different assets like money, bonds, and stocks, based on factors like risk and return.

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How does income affect money demand?

As income increases, the demand for money also increases because people need more money for transactions.

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How do interest rates affect money demand?

Higher interest rates reduce the demand for money because holding money becomes less attractive compared to earning interest on other assets.

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How does payment technology affect money demand?

Improvements in payment technology, like online banking, reduce the need for physical cash, lowering the demand for money.

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How does wealth affect money demand?

Individuals with higher wealth tend to hold more money due to a larger opportunity to invest in other assets.

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How does risk affect money demand?

When risk in other assets is high, money is seen as a safer asset, increasing its demand.

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How does liquidity of other assets affect money demand?

When other assets are more liquid, the demand for money decreases because it becomes easier to convert those assets into cash.

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How does inflation affect money demand?

Inflation reduces the demand for money because its purchasing power falls over time.

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What is Velocity of Money?

The rate at which money changes hands in an economy. It is calculated as the ratio of nominal GDP to the money supply.

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Equation of Exchange

A formula that connects the money supply (M), price level (P), real GDP (Y), and velocity of money (V): MV = PY.

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What determines velocity?

Factors that influence how often money is used, such as technology (credit cards, online banking), consumer habits, and institutional factors.

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Demand for Money

The amount of money individuals and businesses want to hold at a given time.

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How does the quantity theory relate to money demand?

The quantity theory suggests that if velocity is constant, the demand for money (Md) is directly proportional to nominal GDP (PY): Md = kPY, where k is the reciprocal of velocity.

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Liquidity Preference Theory

A theory that suggests the demand for money is influenced by interest rates, emphasizing three motives: transactions, precautionary, and speculative.

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Portfolio Theory of Money Demand

A theory that expands on the liquidity preference theory, suggesting that the demand for money is influenced by the entire portfolio of assets, not just money.

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Quantity Theory of Money

This theory posits that the level of nominal income (spending) is primarily determined by the quantity of money in circulation.

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How does the Quantity Theory link to inflation?

Inflation is directly tied to the growth of the money supply, assuming velocity is constant and output (Y) is at full employment. Inflation rate is calculated as % change in money supply minus % change in real GDP.

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Why is the Quantity Theory better in the long run?

The quantity theory is more accurate in the long run because it assumes flexibility in wages and prices. Short-run inflation can be influenced by factors like changes in velocity.

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What makes the Quantity Theory not perfect in the short run?

There are situations where money growth is high but inflation is low. This suggests the theory is less reliable in the short run due to factors like changes in velocity or output.

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Study Notes

Chapter 20: Quantity Theory, Inflation, and the Demand for Money

  • The chapter discusses quantity theory, inflation, and the demand for money
  • Learning objectives include assessing the relationship between money growth and inflation, identifying circumstances where budget deficits lead to inflationary policy, summarizing the motives behind liquidity preference theory, and assessing empirical evidence of liquidity preference and portfolio theories.

Velocity of Money and Equation of Exchange

  • The equation of exchange is MV = PY
    • M = money supply
    • V = velocity of money (average times per year a dollar is spent)
    • P = price level
    • Y = aggregate output (real GDP)
    • PY = aggregate nominal income (nominal GDP)
  • Velocity is determined by institutional and technological features of the economy, such as charge accounts and credit cards. Using credit cards more often leads to a higher velocity.

Demand for Money

  • Fisher's quantity theory can be interpreted as the demand for money, or the quantity people want to hold
  • If money supply equals money demand, then Md = M
  • If velocity of money is constant, then k = 1/V
  • Md = kPY
    • Demand is purely a function of income (PY)
    • Interest rates have no effect

From the Equation of Exchange to the Quantity Theory of Money

  • Fisher's view that velocity is fairly constant in the short run transforms the equation of exchange into the quantity theory of money.
  • Nominal income is determined solely by movements in the quantity of money (M)

Quantity Theory and the Price Level

  • Classical economists believed wages and prices are completely flexible
  • Aggregate output (Y) remains at the full-employment level during normal times
  • Price level (P) is calculated by dividing both sides of the equation MV = PY by Y
    • P = (MV)/Y

Quantity Theory and Inflation

  • The quantity theory of money can be transformed into a theory of inflation
  • Price level is proportional to money supply, velocity, and real GDP
  • Assuming constant velocity, inflation rate (π) = %ΔM - %ΔY

Testing the Quantity Theory of Money

  • The quantity theory is a good theory of inflation in the long run, but not in the short run
    • Long run: based on assumption that wages and prices are flexible, growth rate of aggregate output over 10-year periods does not vary dramatically. Explains cross-country inflation differences.
    • Short run: Many periods where money growth is high but inflation is low.

Budget Deficits and Inflation

  • The government budget constraint: Deficit = Spending – Taxes = Change in monetary base + change in government bonds
    • Ways a government pays for spending: raise taxes, issue government bonds, or create money to spend
  • If the government deficit is financed by an increase in bond holdings by the public, there's no effect on the monetary base and the money supply.
  • If the deficit is not financed by increased bond holdings, the monetary base and the money supply increase.
  • Monetizing the debt/printing money: When the central bank purchases government bonds, this action monetizes the debt.

Hyperinflation

  • Hyperinflation is extremely high inflation (over 50% per month).
  • Many economies, both poor and developed, have experienced hyperinflation.
  • Zimbabwe in the 2000s provides a historical example.

Keynesian Theories of Money Demand

  • Keynes' Liquidity Preference Theory includes 3 Motives for holding money: transactions, precautionary, and speculative.
  • Distinguishes between real and nominal quantities of money

Three Motives of Money Demand

  • Transactions motive: Initially accepted the quantity theory view that the transactions component is proportional to income. Later economists recognized that payment technology can affect the demand for money.
  • Precautionary motive: Keynes recognized that people hold money as a cushion against unexpected wants and that the precautionary money balances are proportional to income.
  • Speculative motive: People hold money as a store of wealth.

Putting the Three Motives Together

  • Be careful to distinguish between nominal and real quantities
  • Suppose people hold a certain amount of real money balances (Md/P)
    • Demand for real money balances falls with interest rate and rises with real income. Demand for real money and real income and velocity are related, with velocity rising with the interest rate.
  • Velocity is not constant. Demand for money is negatively related to interest rates; if interest rates rise, velocity rises.

Portfolio Theories of Money Demand

  • Theory of Portfolio Choice: The demand for real money balances is positively related to income and negatively related to the nominal interest rate
  • Other factors affecting demand for money: Wealth, risk, and liquidity of other assets

Factors That Determine the Demand for Money (Summary Table)

  • Summary table showing variables affecting money demand, direction of change in the variable, the response in money demand, and the reason for the response. Includes interest rates, income, payment technology, wealth, risk of other assets, inflation risk, and liquidity of other assets

Evidence: Interest Rates and Money Demand

  • Velocity is more likely to be constant (or predictable) if interest rates do not affect the demand for money.
  • The quantity theory is more likely to be true.
  • The more sensitive the demand for money is to interest rates, the less clear link there is between the money supply and aggregate spending.

Evidence: Stability of Money Demand

  • Unstable, unpredictable shifts in the money demand function make velocity unpredictable, and the relationship between money and aggregate spending less direct.
  • Post-1973 financial innovations call into question the adequacy of theories, and raise concerns for implementing effective money policies involving money demand functions.

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Description

Dive into Chapter 20, which explores the quantity theory of money and its relationship with inflation. Understand key concepts like the equation of exchange and the demand for money. This quiz covers learning objectives related to liquidity preference theory and its empirical evidence.

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