1. Compare and contrast the three different theories of money demand (15 points)
ID: 1208797 • Letter: 1
Question
1. Compare and contrast the three different theories of money demand (15 points)
2. Given the quantitative theory of money,
A. What happens to real GDP if the money supply is cut in half, velocity is stable and prices are sticky? (5 points)
B. What happens to prices if the money supply doubles under the classical model assuming that velocity is stable? (5 points)
3. Explain the 4 tools of monetary policy and how they impact interest rates, AD, & GDP (10 points)
4. Give 4 transmission mechanism and explain how each impacts the financial markets and the overall economy (20 points)
5. Given the current state of the economy, what should Fed. Do with monetary policy and why? (15 points)
6. Compare the pros and cons of independent central bank? (5 points)
7. Compare pros and cons of monetary rule and discretionary monetary policy (5 points)
8. Give the money multiplier and explain how the 3 different players impact the money multiplier and the money supply (20 points)
Explanation / Answer
Q1.Transactions theory or Fisher’s quantity theory,cash balances theory and Keynes theory of liquidity preference.Fisher’s Equation: Through his equation of exchange he made an attempt to determine price level and value of money. M’V’+MV=PT,Value of money is meant by purchasing power of money. Fisher transformed the quantity theory equation into a theory of demand for money. According to Fisher, the nominal quantity of money is fixed by the central bank and istherefore, treated as an exogenous variable which is assumed to be a given quantity in a particular period of time.Marshall, Pigou and Robertson focussed their analysis on the factors that determine individual demand for holding cash balances. Although, theyrecognised that current interest rate, wealth owned by the individuals, expectations of future prices and future rate of interest determine the demand for money, they however believed that changes in these factors remain constant or they are proportional to changes in nominal income.Quantity theory of money seeks to explain the value of money in terms of changes in itsquantity.Keynes suggested three motives which led to the demand for money in an economy theyare: the transactions motive, Precautionary motive and Speculative motive.According to Keynes the totaldemand for money means total cash balances which may be of two types: active and Idle balances.
Q2 a. changes in the nominal money supply will lead to changes in the real money supply. With sticky wages and/or prices, the classical dichotomy is broken. The classical dichotomy teaches us that changes in the money supply do not affect the velocity of money or the level of output. It follows that any changes in the growth rate of the money supply will show up one-for-one as changes in the inflation rate. Real variables, such as real GDP and the velocity of money, stay constant. A change in a nominal variable—the money supply—leads to changes in other nominal variables, but real variables do not change. The fact that changes in the money supply have no long-run effect on real variables is called the long-run neutrality of money.
b.The price level and the nominal wages also double. If velocity is stable, an increase in the money supply creates a proportional increase in nominal output.
Q3.1. OMO - Open market operations refer to the Fed's buying and selling of government bonds
2. RR - It is the fraction of reserves required relative to their customer deposits.
3. DR - Definition: the interest rate that the Fed charges to commercial banks that borrow from the Fed.
4. Term Auction Facility - very similar to the discount rate (DR)
1. Open market operations are most important. This decision is flexible because securities can be bought or sold quickly and in great quantities. Reserves change quickly in response.
2. The reserve ratio is rarely changed since this could destabilize bank's lending and profit positions.
3. Changing the discount rate has become a passive tool of monetary policy. The Fed sets their target for the Federal funds rate, and then sets the discount rate at 1 percentage point above that target.
4. The Term Auction Facility was introduced in December 2007 in response to mortgage debt crisis.
Q4.The transmission mechanisms of the monetary policy may be defined as the channels, not mutually exclusive, through which the evolution of monetary aggregates affect, often after variable and not completely predictable intervals, the level of product and prices. The economic literature has identified the existence of at least four different mechanisms through which monetary policy is able to influence the price level and the national income: 1.The interest rate, On the securities market, the increased demand exerts upward pressure on prices and determines a further reduction in nominal interest rates that, inflationexpectations being equal, results in a reduction of the real interest rate. 2.The prices of financial assets,As mentioned above, an expansionary monetary policy is able to exert strong upward pressure on prices of financial assets increasing the market value of firms in relation to the cost of capital and positively influencing the value of securities wealth of households. 3.The domestic credit, this branch of the economic research focuses on the determination of loans granted by banks, which are viewed as non-perfect substitutes of the direct financing to businesses. 4. The exchange rates, Monetary policy exerts a strong impact on the exchange rate. In particular, it was seen how increasing the amount of currency in circulation would result in a reduction in the nominal interest rate.
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