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1) 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?
Answer: 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.
2) 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.
Answer: 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.

3) 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
Answer: 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.
 Essay Questions
1) Keynes believed that unstable investment caused the Great Depression. Using the simple Keynesian
model, demonstrate graphically and explain how a fall in investment reduces equilibrium output.
What is the impact on equilibrium output?
Answer: A fall in investment shifts the C  I line down in the graph below, from C  I to C  I.
Due to the multiplier effect, the fall in output is greater than the fall in investment, as
equilibrium output falls from Y to Y.

2) Equal increases in government spending and taxes increase equilibrium output. Explain and
demonstrate this graphically.
Answer: An increase in government spending shifts C  I  G up to C  I  G. Equilibrium output
increases from Y to Y. A tax increase shifts the aggregate demand line down by the mpc
times the change in taxes, reducing Y to Y. Since the shift due to taxes is smaller than
the shift due to the increase in government spending, the net effect is to increase
equilibrium output.

3) The Federal Reserve increases interest rates when they want to reduce aggregate demand to fight
inflation. How do increases in the interest rate reduce aggregate demand?
Answer: Increases in interest rates reduce planned investment. The decrease in investment reduces
equilibrium output by a multiple amount due to the multiplier effect. Also, increases in
interest rates increase the value of the dollar, reducing net exports, which reduce
aggregate demand and equilibrium output by a multiple amount.
4) Using the ISLM model, show graphically and explain the effects of a monetary expansion
combined with a fiscal contraction. How do the equilibrium level of output and interest rate
Answer: The monetary expansion shifts the LM curve to the right, from LM to LM, and the fiscal
contraction shifts the IS curve to the left, from IS to IS. The equilibrium interest rate
unambiguously falls, while the effect on output is indeterminate. The graph below shows
Y increasing, but that result depends on the way the graph is drawn. Students should
know the outcome cannot be determined unambiguously.

5) Using the ISLM model, show graphically and explain the effects of a monetary contraction. What is
the effect on the equilibrium interest rate and level of output?
Answer: The monetary contraction shifts the LM curve from LM to LM. The result is that the
equilibrium level of output falls from Y to Y, and the equilibrium interest rate increases
from i to i.

6) Using the ISLM model, explain and show graphically the effect of a fiscal expansion when the
demand for money is completely insensitive to changes in the interest rate. What is this effect
Answer: This is the total crowding out effect. The LM curve is vertical, so any shift of the IS curve
affects only interest rates. The level of output is constant at Y. The fiscal expansion shifts
the IS curve rightward, increasing the interest rate from i to i.

7) Show graphically and explain why targeting an interest rate is preferable when money demand is
unstable and the IS curve is stable.
Answer: Unstable money demand causes the LM curve to shift between LM and LM. If the
money supply is targeted, output fluctuates between Y and Y. With an interest rate
target, output remains stable at Y. Since the objective is to minimize output fluctuations,
targeting the interest rate is preferable.

8) Using the long-run ISLM model, explain and demonstrate graphically the neutrality of money, for
the case of an increase in the money supply.
Answer: The increase in the money supply shifts LM to the right, increasing output to Y, above
the natural rate Y
. The interest rate falls from i to i. Excess demand increases the price
level, reducing the real value of the money supply. The LM curve shifts back until the all
pressure on prices is eliminated by the return to the natural rate of output. The initial and
final levels of output and interest rate are the same. No real variables have changed.

9) Explain the traditional interest rate channel for expansionary monetary policy. Explain how a tight
monetary policy affects the economy through this channel.
Answer: In the traditional channel, a monetary expansion reduces real interest rates, lowering the
cost of capital and increasing investment spending. The increase in investment increases
aggregate demand. A monetary contraction has the opposite effect, raising real interest
rates, lowering investment and aggregate spending.
10) Explain how expansionary and contractionary monetary policies affect aggregate demand through
the exchange rate channel.
Answer: An expansionary monetary policy reduces real interest rates, causing appreciation of the
domestic currency. This depreciation increases net exports and aggregate spending. A
monetary contraction increases real interest rates, reducing net exports and aggregate
11) Explain and show graphically why continuous monetary growth is needed to generate inflation.
Describe how the inflation process is generated.
Answer: Only continuous monetary growth can cause continuous increases in aggregate demand of
the sort needed to generate inflation. Other factors can increase demand and the price
level, but none can increase demand continuously. In the graph, the monetary expansion
shifts AD to the right. The increase in output above the natural rate increases wages, shift
AS to the left. Monetary expansion shifts AD repeatedly, and wages continue to adjust.

12) Explain and show graphically how a tax increase reduces demand and increases unemployment.
Why is the speed of the adjustment of wages and/or the role of expectations important in this
Answer: The tax increase shifts AD down from AD
to AD
. Output falls below the natural rate to
, increasing unemployment. If wages are slow to adjust, the economy remains below
the natural rate for a long time, but adjustment back to the natural rate is rapid if wages
adjust quickly or if expectations lead to rapid adjustment of wages.