Questions and Answers
What is payment technology?
Technology improvements to the ways payments are made.
What did Keynes believe about technology advancements' relationship to the demand for money?
Technology advancements in payments cause the demand for money to decrease relative to income.
What is the precautionary motive?
The idea that people hold onto cash to deal with unexpected events.
What does the speculative motive refer to?
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What is created when combining the three motives for holding money together?
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What two things does Keynes clearly differentiate in his demand for money model?
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Why does Keynes believe there is a difference between real and nominal quantities?
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What is Keynes' liquidity preference function?
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What does Keynesian theory believe about velocity?
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Why do Keynesian economists disagree with classical economists?
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What does the theory of portfolio choice explain?
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How do interest rates affect expected returns on money and bonds?
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What is a dominated asset?
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Is money considered a less risky asset than other assets?
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What are inflation hedges?
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What are the 7 factors that affect the demand for money?
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What is Monetary Theory?
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Why do you need to understand the supply of money to understand how monetary theory will affect the economy?
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What is a major question of monetary theory?
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What is the Quantity Theory of Money?
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Which economist best explains the classical theory approach, and how did they do this?
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What does P*Y represent?
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What is the velocity of money?
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What is the equation for the velocity of money?
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What is an example of the velocity of money?
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What is the equation of exchange?
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What does the equation of exchange not tell economists?
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How can economists change the equation of exchange from an identity to a theory?
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How does Fisher believe velocity is determined?
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What does Fisher believe happens to velocity when most transactions are done with credit cards?
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What does Fisher believe happens to velocity when most transactions are done with cash and checks?
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What does Fisher believe about velocity in the short run?
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What is the demand for money?
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What is an easier way to understand Fisher's theory on quantity theory?
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How are the quantity theory of money and demand for money similar?
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What is Fisher's demand for money equation?
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What does Fisher's demand for money equation show?
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How does Fisher change the equation of exchange into the quantity theory of money?
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What does nominal income in the quantity theory of money depend on?
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What is the quantity theory of money equation?
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What do classical economists believe about prices and wages?
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What does the equation P = (M*V)/Y mean?
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Why do classical economists rely on the quantity theory of money?
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What do percent changes resemble in variables?
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What is the theory of inflation equations?
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How does the quantity theory of money prove that higher money growth rates cause higher inflation rates in the U.S?
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How does the quantity theory of money prove that higher money growth rates cause higher inflation rates worldwide?
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Does quantity theory of money work in the short-run?
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What is a major source of inflationary monetary policy?
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What are the five ways governments can pay for their spending/budget deficits?
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What is the government budget deficit?
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How can a government finance its deficit for a supercomputer?
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What two important things does the government budget constraint show economists?
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What is one way a government budget deficit can lead to an increase in the monetary base?
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Why does printing money not work in the U.S and other countries to eliminate a government deficit?
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What happens when government bonds do not end up in public hands?
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How does the government finance its deficits?
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What is monetizing the debt?
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What is printing money?
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When does a budget deficit cause inflation?
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What does the quantity theory of money imply for inflation in the long run?
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What is hyperinflation?
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What caused the hyperinflation in Zimbabwe?
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How did John Maynard Keynes view the quantity theory of money?
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What is liquidity preference theory?
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What assumption about payment technology is made under the quantity theory of money?
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What was Keynes' view on payment technology compared to classical economists?
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Study Notes
Monetary Theory and Economic Impact
- Monetary Theory: Studies the effects of monetary policy and money supply on the economy.
- Understanding money supply is crucial as it influences the overall quantity of money in the economy.
Key Questions and Concepts
- Major question in monetary theory: Do interest rates significantly affect money demand?
- Quantity Theory of Money: Developed by classical economists; explains the relationship between money supply and nominal income, asserting that interest rates have no impact on money demand.
Irving Fisher's Contributions
- Irving Fisher: Key figure in classical economics; established the connection between money supply (M) and total spending on goods/services (P*Y).
- P*Y signifies aggregate nominal income, equating to nominal GDP.
Velocity of Money
- Velocity of Money: Indicates how frequently money is used in transactions within an economy.
- Equation for velocity: ( v = \frac{P \times Y}{M} ).
Equation of Exchange
- Equation of Exchange: ( M \times V = P \times Y ) illustrates the relationship between money supply, velocity, and nominal income.
- Highlights that changes in money supply do not directly equate to changes in nominal income.
Demand for Money
- Demand for Money: Refers to the amount of money individuals wish to hold.
- Fisher's demand for money equation: ( M^d = k \times P \times Y ) where ( k ) is constant, suggesting demand is driven by income, not interest rates.
Long-Run vs. Short-Run
- Classical economists advocate that price flexibility maintains full employment, stabilizing aggregate output.
- The quantity theory implies that inflation rates correlate positively with increases in money supply in the long run.
Inflation and Money Supply Dynamics
- The inflation rate is influenced by changes in money supply and aggregate output: ( \pi = % \Delta M - % \Delta Y ).
- Historical data reveals a strong connection between money growth rates and inflation rates across various periods and nations.
Government Budget Deficits
- Government Budget Deficit: Occurs when spending exceeds revenue.
- Governments can finance deficits through taxes, borrowing, or printing money, influencing monetary base and money supply.
Challenges with Monetary Policy
- Printing money may not effectively reduce deficits due to governmental restrictions and public trust.
- If the public does not hold bonds, the central bank may purchase them, thus increasing the monetary base.
Keynes vs. Classical Theories
- John Maynard Keynes: Criticized the quantity theory for assuming constant velocity and minimizing the importance of interest rates on money demand.
- Liquidity Preference Theory: Introduced by Keynes, focusing on precautionary, speculative, and transactional motives for holding money.
Payment Technology Advancements
- Technological improvements in payment methods impact money demand, shifting from cash to electronic transactions.
- Keynes argued that technology decreases the need for holding money relative to income.
Precautionary and Speculative Motives
- Precautionary Motive: Individuals retain cash for unforeseen emergencies, impacting their overall money holdings.
- Speculative Motive: People hold liquid assets as a store of wealth, anticipating changes in interest rates affecting other assets.### Bonds and Money Demand
- Increased nominal rates on bonds raise the opportunity cost of holding money, leading to decreased money demand.
- Higher interest rates result in a decreased money supply due to reduced spending and increased saving, as the cost of borrowing rises.
- Inflation and spending tend to decline, while higher borrowing costs make lending more profitable.
- Bond prices drop when interest rates rise, as older bonds with lower rates are less attractive compared to new issues.
Keynes Demand for Money Model
- Differentiates between real and nominal qualities, emphasizing that the value of money is based on purchasing power.
- An increase in price level reduces the quantity of goods one can buy with the same nominal amount of money.
Real Money Balances
- Defined as the quantity of money adjusted for price changes, indicating real purchasing power.
Liquidity Preference Function
- Represents demand for real money balances: Md/P = L(i, Y).
- The function shows that money demand is inversely related to nominal interest rates and directly related to real income.
- A rise in nominal interest rates decreases the demand for real money balances.
Velocity of Money
- Velocity is not constant; it fluctuates with changes in interest rates.
- The liquidity preference function demonstrates that as nominal interest rates increase, liquidity decreases and velocity increases.
Keynesian vs. Classical Economists
- Keynesians reject the notion that nominal income is solely determined by the money supply.
- They argue against the classical assumption that velocity remains constant over time.
Portfolio Theory of Money Demand
- Explains how individuals choose asset composition in their portfolios, factoring in risk and return.
- Demand for a specific asset is influenced by wealth, comparative expected returns, liquidity, and relative risk.
Wealth and Money Demand
- An increase in an investor's wealth generally raises the demand for money assets but has a limited effect if income remains constant.
Dominated Assets
- Defined as assets that are less desirable compared to others that offer higher returns with similar risk.
Risk of Money as an Asset
- While money appears less risky due to universal acceptance, its real returns are affected by inflation, making it volatile.
- Investors may seek alternative assets if the real return on money declines.
Inflation Hedges
- Investments aimed at preserving purchasing power when inflation occurs, leading to a shift away from cash to less affected assets.
Financial Innovation Impact
- New liquid assets (e.g., home equity lines and money market funds) reduce the relative liquidity of traditional money, decreasing its demand.
Factors Influencing Demand for Money
- Key determinants of money demand include interest rates, income, payment technology, wealth, risk of alternative assets, inflation risk, and liquidity of other assets.
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Description
Explore the principles of monetary theory and its impact on the economy. This quiz delves into key concepts such as the Quantity Theory of Money, interest rates, and the contributions of Irving Fisher. Test your understanding of how money supply and velocity affect economic dynamics.