Economics 374-01A Dr. John F. Olson
Monetary Theory and Policy Spring 2008
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 assigned
hand-out on current measures of the money stock and the assigned Federal Reserve web-documents
on the measurement of the money stock and components.)
The increased use of U.S. currency in foreign countries, either as
day-to-day currency or as a store of value against domestic currency
depreciation, creates a measurement problem (especially since 1985) – while the
estimates vary, about 50% of U.S. currency outstanding is abroad.
Other financial intermediaries do have (and create) liabilities, but
these instruments are not very liquid and, thus, are not used as monies; this
is one feature that makes banks “different” from other financial institutions.
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).
What are the key features or assumptions which distinguish or
differentiate the classical and Keynesian paradigms?
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,
Fisher’s equation relating nominal and real interest rates, and notions of the
“money market” in macroeconomic models. See also the assigned Introductory Class Notes.
Chapter 2 – Money and Prices
These assertions are the neutrality of money. You should be able to discuss the
perspectives of Fisher, the
The QTM disequilibrium changes are, of course, short-run adjustment
processes in moving to the new long-run equilibrium.
Wicksell noted the connection between the banking system’s creation of money
and credit (and its price – the market rate of interest) and the real economy’s
saving=investment equilibrium (at the normal rate of interest). Explain the different concepts or views of
the transmission mechanism (see the final two bulleted conclusions below).
Present and explain the economic reasoning underlying each of the three
Keynesian motives for holding money.
Recall that the classical view assumes there is no money illusion and,
thus, there is the classical dichotomy between the real (commodity markets) and
nominal (money) economies. Money is
primarily a transactions asset with few or no good substitutes.
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). These models provide
a more rigorous economic theoretical foundation for the demand for money –
rather than relying on simple ad hoc or “black box” reasoning. While each model has its unique aspects, the
analytical results posit a functional relationship between the quantity of real
money balances demanded and real income or expenditures (positive effect) and
interest rates (negative effect). These
functional relationships are derived from the first-order economic optimization
conditions; that is, within the context of the model, economic agents are maximizing
their well-being or minimizing the cost from holding money – the mathematical
expressions have economic content and meaning which you should be able to
describe and explain.
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.
This conclusion is derived from the two previous conclusions.
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 and
debit cards, ATMs, and internet or electronic banking 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. In
these approaches, money still serves as a transactions asset, but is considered
within the context of determining the optimal composition of a portfolio of
assets.
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.