Economics 374-01A Dr. John F. Olson
Monetary Theory and Policy Spring 2005
Study Guide for First Test
The bulleted points below are from the end of the chapter “Summary of Critical Conclusions” in the text by Handa. See/study the appropriate chapter sections of the text for details. I have also inserted annotations in italics.
Chapter 1 – Introduction
You should know the component definitions of M1 and M2. (See the hand-out on current measures of the
money stock and the Federal Reserve web-documents on the measurement of the
money stock and components.)
Other financial intermediaries do have (and create) liabilities, but
they are not very liquid and, thus, are not used as monies; this is one feature
that makes banks “different”.
The differentiated financial assets arise because of the different
needs (return vs. risk, liquidity, term to maturity) of financial market
participants (savers-lenders, intermediaries, and borrowers-spenders).
The evolution of the classical paradigm includes the traditional
classical ideas, the neo-classical model, monetarism, the modern classical
model (incorporating rational expectations), and the new classical model (with Ricardian equivalence).
Other key elements of this chapter/unit: the functions of money, why does money exist
– how does it arise as a social invention from economic decisions, definitional
distinctions between the money supply and money stock, nominal vs. real values,
and notions of the “money market” in macroeconomic models. See also the Introductory Class Notes.
Chapter 4 – The Transactions Demand for Money
In addition to the
basic inventory analysis (aka the Baumol-Tobin)
model used to derive the transaction demand for money, you should also
understand the “shopping-time” model developed and presented in class (see the
handout from the McCallum text).
More correctly, it will be between one and one-half; recall that visits
to the bank must be measured in integers and when this is taken into account,
the real-income-elasticity will be an average of the mix of households (some
having unit-elastic demands, others having elasticity values of one-half).
This is just re-asserting that it is the demand for “real” money that
matters (what money can purchase in “real” terms). People do not suffer “money illusion” – they
are not fooled by nominal prices increases; as the price level increases, they
accordingly increase the amount of nominal money they want to hold in order to
maintain the level of their real money holdings.
As above, more correctly, it will be between zero and one-half; for the
same reason (integer bank visits), the elasticity will be an average of the mix
of households (some having zero interest-elasticity, others having one-half).
Think, for example, how increased availability and use of credit cards
might affect cash management and the transactions demand for money by
households. And what about recent and
historical changes in financial and cash management practices in business and
financial firms?
Notes on Portfolio Selection & the Speculative Demand
for Money
The transactions
demand for money may include the interest rate as a variable affecting the
demand for money, usually reflecting an opportunity cost of holding value in
money (as opposed to in an interest-earning asset). Portfolio analysis (or speculative demand)
approaches provide an alternative explanation for inclusion of the interest
rate in the money demand function.
For example, Keynes
relied upon the inverse relationship between interest rates and bond
prices. He argued that as interest rates
deviated from their long-run trend (or expected) levels, individuals would
adjust their holdings of money and bonds.
In order to avoid subsequent capital losses on bonds when interest rates
were currently low and would be expected to rise in the future, individuals’
money holdings would be high. And to
seek capital gains on bonds when interest rates were currently high and would
be expected to fall in the future, individuals’ money holdings would be
low. Thus, in the speculative demand for
money, the quantity of money demanded changes inversely as interest rates vary.
Money is, relative to other assets, risk-less.
First, from a portfolio selection analysis with the proper assumptions,
the optimally-composed portfolio (in terms of risk and return) will include
more money (the risk-less asset) as the relative expected return(s) on the
risky assets decreases – that is, people (who are typically risk averse) will
try to lower risk by holding more money if the returns on risky assets go down.
Second, portfolio selection analysis suggests that the money demand function might be very unstable (fluctuate a lot) because of the volatile expectations of returns and risks of non-money assets. That is just another way of saying it moves around so much and so quickly that would be hard to usefully predict even if you had all the necessary data to do so in a timely manner.
Chapter 7 – The Estimating Function for the Demand for
Money
This chapter begins addressing
some practical problems in estimating the money demand function.
RE is more suitable from a theoretical perspective, but the modeling
and informational requirements may not be worth the effort in estimation.
AE is more appropriate statistically than RE – see above.
If there are costs to adjusting into or out of money balances in
response changes in equilibrium holdings, then a partial adjustment model needs
to be incorporated.
Beside stationarity, other problems include
single-equation (partial equilibrium) vs. general equilibrium estimation,
imposing coefficient restrictions, the identification problem, multi-collinearity, and serial or auto-correlation of the error
terms. Another issue is the selection of
the functional form for estimation – usually a log-linear form is employed
because the coefficients can be directly interpreted as elasticities
– the choice is often determined by the relative empirical performance of
different forms.
Chapter 9 – Money Demand and Empirical Findings
While empirical
estimation of the money demand function yields some meaningful results, the
endeavor also demonstrates the difficulties and problems described in previous
chapters.
Money has changed and, accordingly, so has the demand function.