Answers to Review Questions

1. Answers to Review Questions • 1.What is a real money balance? If the nominal money supply increases 20 percent while prices increase 20 percent, what happens to the demand for real money balances? What happens to the supply of real money balances? • A real money balance is the quantity of money expressed in real terms (M/P). If the nominal money supply and prices increase by the same percentage, then the demand for and supply of real money balances stays the same.

2. 2.If real income increases 20 percent, what happens to the demand for real money balances? Is the change in demand proportional to the change in real income?

3. If real income increases by 20 percent, then the demand for real money balances increases but by less than 20 percent. The change in demand is less than proportional to the change in real income. As income increases, spending units are able to economize on real money balances and hence the increase in demand for real money balances is proportionally less than the increase in income.

4. 3.What is the difference between a onetime increase in prices and inflation? How does a onetime increase in prices affect the demand for real money balances? How does expected inflation affect the demand for real balances? How does a onetime increase in prices affect the real money supply?

5. A one‑time increase in prices is not inflation. Inflation is a sustained overall price increase as measured by a price index. A one‑time increase in prices does not affect the demand for real money balances. Expected inflation reduces the demand for real balances.

6. 4.Why do firms want to hold real money balances? Why do households? What factors determine the quantity of real balances that each wants to hold? • Firms want to hold real money balances to consummate transactions because inflows and outflows are not perfectly synchronized. In deciding the optimum amount of money balances to hold, a firm will want to minimize money holdings, subject to the constraint of having enough money on hand or access to it when it is needed. Households demand to hold real money balances to fulfill the transactions and precautionary motives. The quantity of real balances that each wants to hold is inversely related to the interest rate.

7. Firms want to hold real money balances to consummate transactions because inflows and outflows are not perfectly synchronized. In deciding the optimum amount of money balances to hold, a firm will want to minimize money holdings, subject to the constraint of having enough money on hand or access to it when it is needed. Households demand to hold real money balances to fulfill the transactions and precautionary motives. The quantity of real balances that each wants to hold is inversely related to the interest rate.

8. 5.What happens to the demand for real balances if interest rates on time deposits rise relative to interest rates on checkable deposits? • If interest rates on time deposits rise relative to interest rates on checkable deposits, the quantity demanded of real balances will fall.

9. 6.Correct the following statement: “When the interest rate increases, the demand for real money balances decreases.” • When the interest rate increases, the quantity demanded of real money balances decreases, ceteris paribus.

10. 7.In Chapter 3, our initial peek at the data showed that changes in money were more highly correlated with changes in nominal GDP than with changes in either real GDP or inflation. Does this finding support or refute monetarism? Explain. • The conclusions of Chapter 3 support monetarism. Monetarism is the school of thought that emphasizes the importance of changes in the nominal money supply as a cause of fluctuations in prices, employment, and output.

11. 8.Using the liquidity preference theory, explain why the quantity demanded of money is inversely related to the interest rate. What is a liquidity trap? • .

12. According to Keynes, spending units can hold their financial wealth in either money or bonds. • The caveat of the Keynesian liquidity preference theory is that if interest rates are high, more and more individuals will come to believe that interest rates will be going down in the future and will therefore prefer to buy bonds today in hopes of a capital gain when interest rates do fall. Consequently, because individuals hold either bonds or money, when interest rates are high, the quantity demanded of money will be low. Likewise, when interest rates are low, more and more individuals will believe that interest rates will rise in the future. If they buy bonds today, they will make a capital loss in the future when interest rates do rise. Therefore, when interest rates are low, the quantity demanded of money will be high and vice versa

13. The liquidity trap is when interest rates are very low (bond prices are high), and virtually everyone comes to believe that interest rates will rise in the future. If they buy bonds at this point, they will make a capital loss when rates do rise. When all market participants hold this belief, the demand for money becomes perfectly horizontal, and the economy is in a liquidity trap. The Fed is unable to lower interest rates by increasing the supply of money. Monetary policy is ineffective in a liquidity trap because it does not lead to a fall in the interest rate.

14. 9.When is the market for real money balances in equilibrium? If the Fed engages in open market sales, what happens to the supply of real balances? • The market for real money balances is in equilibrium at the interest rate where the quantity supplied of and the quantity demanded of real money balances are equal. If the Fed engages in open market sales, the supply of real balances decreases.

15. 10.Explain the transactions and precautionary motives for demanding real money balances. • The transactions motive is a motive for holding money based on the need to make payments. The precautionary motive is a motive for holding money as a precaution against unforeseen developments.

16. 11.What are the benefits of holding real money balances? What are the costs? What is the optimum amount of real money balances that households and firms will demand?

17. The benefits of holding real money balances are the interest payments that are earned on checkable deposits plus the stream of services that money balances provide. • The cost of holding real money balances are the foregone interest payments that holding nonmonetary financial assets would have yielded. • Households and firms should adjust their holdings of real balances to the point where the marginal benefits of doing so are equal to the marginal costs.

18. Answers to Analytical Questions • 12.Graph the supply and demand curves for real money balances. Explain what happens to the interest rate in each of the following situations: • a. Credit cards become more widely used and accepted to make transactions. • b. The economy is growing faster than the Fed thinks is desirable, and therefore the Fed sells bonds to the public. • c. Many new near money substitutes are created. • d. The overall price level falls while the nominal money supply remains constant. • e. ATM machines become more accessible and more widely used. • f. The secondary markets for negotiable CDs and junk bonds collapse. • g. Inflation is expected to pick up in the coming year.

20. a. Since the demand for real balances decreases, the demand curve (D curve) shifts to the left, causing a lower interest rate. • b. Since the money supply decreases, the money supply curve (MS curve) shifts to the left, causing a higher interest rate. • c. Since demand for real balances decreases, the demand curve (D curve) shifts to the left, causing a lower interest rate. • d. Since the real money supply increases, the money supply curve (MS curve) shifts to the right, causing a lower interest rate. • e. Since demand for real balances decreases, the demand curve (D curve) shifts to the left, causing a lower interest rate. • f. Since demand for real balances increases, the demand curve (D curve) shifts to the right, causing a higher interest rate. • g. Since demand for real balances decreases, the demand curve (D curve) shifts to the left, causing the interest rate to decrease.

21. 13.The graph in Exhibit 14-1 shows a typical household’s real money holdings, assuming that real money balances are gradually depleted over the course of the month. Jacques gets paid on the first of each month, but parties extensively over the next week and is broke for the remainder of the month. Graph Jacques’s real money holdings over the course of a month.

23. 14.Graphically show what happens to the interest rate if the Fed takes action that leads to a decrease in the supply of real money balances while the economy is in a liquidity trap.

25. If the Fed takes action that leads to a decrease in the supply of money, the money supply curve (MS) shifts to MS1. Since the economy is in a liquidity trap, the interest rate stays the same.

26. 15.What is the equation of exchange? If nominal GDP is $12 trillion and the money supply is $1.5 trillion, what is velocity? If the Fed increases the nominal money supply, what happens to nominal GDP? (Hint: First assume that velocity is constant and then relax this assumption.) Can we be sure of the direction of change in prices and real GDP?

27. The equation of exchange is M  V = P  Y = GDP. If nominal GDP is $12 trillion and the money supply is $1.5 trillion, then velocity must be 8. If the Fed increases the nominal money supply and velocity remains constant, then GDP will increases proportionally to the increase in the money supply. If velocity is not constant when the Fed increases the money supply, then the Fed cannot be sure of the direction or magnitude of the change in GDP.

28. 16.Graphically show what happens to the real money supply if the price level rises while the nominal money supply remains constant. What happens to the real money supply if both the nominal money supply and the price level rise by the same percent?

30. If the price level rises while the nominal money supply remains constant, then the money supply curve shifts from MS to MS1 and the supply of money decreases. If both the nominal money supply and the price level rise by the same percent, then the supply of real money balances remains constant.

31. 17.If Sara earns $4,000 per month, the interest rate is 4 percent, and the cost of a call to the broker is $.75, what should her transactions demand for real balances per month be? (Appendix ) • Sara should make additional calls to the broker as long as the additional benefits are greater than the additional costs. In this case, Sara should make 3 trips to the broker. The benefit of the first trip is $6.66. The benefit of the second trip is $2.22. The benefit of the third trip is $1.10. The benefit of the fourth trip is $.66. Since the cost of each trip is $.75, Sara should stop at three trips. If Sara makes 3 calls to the broker, then her demand for real money balances is $666.67.

32. 18.Referring to question 17, if Sara’s income increases to $6,000 per month, what happens to his demand for real money balances? (Appendix 21-A) • If Sara's real income goes up to $6,000, Sara should make 4 calls to the broker and his demand for real balances will also go up to $750.