6B: Classical and Neoclassical Theories of Money

Business cycles tend to be relatively minor and are quickly and automatically cured so that the economy will return to its original full employment equilibrium according to: (a) the population dynamics theory. (b) psychological theories of the business cycle. (c) Joseph Schumpeters theory of creative destruction. (d) classical macroeconomic theory. (e) external shock theory. A graph showing a positive relationship between the interest rate and the expected inflation rate would illustrate the: (a) Cambridge equation. (b) Friedmans liquidity effect. (c) Fisher effect. (d) Laffer curve. (e) quantity theory of money. Interest rates on given financial instruments tend to be higher the: (a) shorter the period to maturity. (b) lower the risk of default. (c) more liquid the asset is. (d) greater is the level of uncertainty about the real rate of interest that will be received. (e) lower is the face value at maturity relative to the current market price. The effect on nominal interest rates of an increase in the rate of monetary growth that is least consistent with the other effects is the: (a) expected inflation [Fisher] effect. (b) nominal income effect. (c) liquidity [Keynes] effect. (d) price level effect. 1. The idea that growth of the money supply at a low fixed percentage rate annually is likely to yield greater macroeconomic stability than when monetary policy is at the discretion of government officials is the foundation for: (a) neoclassical macroeconomic theory. (b) John Maynard Keyness liquidity preference theory. (c) Irving Fishers natural rate of interest. (d) Abba Lerners wage-price reaction functions. (e) Milton Friedmans monetary growth rule. According to classical economists, Aggregate Demand primarily determines: (a) levels of national output and income. (b) total production in the economy. (c) Aggregate Supply at full employment. (d) the price level. The income velocity of money in Irving Fishers equation of exchange is calculated as: (a) nominal money stock/nominal GDP. (b) nominal GDP/nominal money stock. (c) real money stock/real GDP. (d) mc2. The demand for money would be negatively affected by increases in: (a) income (b) expected hikes in interest rates. (c) wealth. (d) uncertainty about future income. (e) expected inflation. Classical macroeconomics views the cost of holding money as: (a) current interest rates. (b) profits from economic investment. (c) goods that could be purchased with the money. (d) hard to determine because of sticky pricing. (e) the percentage rate of inflation.

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According to modern monetarists, short-run shocks to Aggregate Demand or Aggregate Supply: (a) are ignored. (b) are assumed away. (c) have no lasting effect on inflation or unemployment. (d) require active discretionary monetary policy. According to the classical macroeconomic model, the: (a) demand for nominal money can be written as Md = kPQ, or Md = kPy. (b) price level depends primarily on velocity. (c) income velocity of money determines real output. (d) money supply determines real output. (e) government should run deficits to reduce unemployment. According to the classical macroeconomic model: (a) output grows when the price level rises. (b) real output is unaffected by the money supply. (c) employment depends on the velocity of money. (d) growth of permanent income is impossible. According to the Equation of Exchange: (a) MP=VQ. (b) MV=PQ. (c) price changes require velocity changes. (d) in the long run, we're all dead. If the theory that money is neutral in the long run is correct, then: (a) exchange rates are unaffected by the relative growths of the money supplies of different countries. (b) interest rates are the only real economic variable affected by fiscal policy. (c) money illusion may be more significant in the long run than in the short run. (d) changes in the money supply result in proportional increases in the price level, but ultimately do not affect real economic variables. If the velocity of money increases and real GDP and the money supply are constant, the price level will: (a) rise. (b) fall. (c) become more stable. (d) not be affected. (e) None of the above. Between September 11, 2001 and February 2005, the M1 money supply grew 3% to 7% faster than measured GDP, which suggests that during this period: (a) pessimism among consumers and investors reduced the velocity of money. (b) the underground economy grew substantially. (c) the real wage rate increased faster than prices. (d) the exchange rate of the dollar declined about 30% relative to the Euro. Consumers increased reliance on credit cards and the ready availability of currency through ATMs has tended to increase the: (a) marginal propensity to consume. (b) velocity of money. (c) average costs of transactions. (d) pure economic profits of commercial banks. (e) M1 money supply. If aggregate output is constant while the money supply and its velocity both double, the equation of exchange predicts that the price level will: (a) double. (b) remain constant. (c) fall by 1/2. (d) quadruple (rise by a factor of 4.)

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If technological advances, growth of the labor force, and capital accumulation generate increases in potential Aggregate Supply of three percent annually, then modern monetarists would predict that a four percent annual growth rate of the money supply would cause (a) the price level to rise by 1% annually. (b) average nominal wages to rise by seven percent annually. (c) the price level to fall by 1% annually. (d) annual increases in the exchange rate of the dollar of 1% against most other currencies. (e) accelerating inflation. Classical economists would rebut the underconsumptionist theories of economic downturns (expressed, e.g., by Malthus and Keynes) by stressing that all saving will be invested because of the flexibility of: (a) interest rates. (b) wage rates. (c) relative prices. (d) nominal prices for goods. (e) monetary prices. Classical economists, modern monetarists, and Keynesians would all agree that: (a) declining investment leads to lower rates of return. (b) economic activity is volatile in a market economy. (c) equilibrium investment occurs when rates of return equal interest rates. (d) business cycles occur because of volatility in investors' moods. People with surpluses of money adjust by increasing their: (a) efforts to secure higher incomes. (b) consumption or outlays for financial or capital investments. (c) demands for money. (d) saving rates out of current income. (e) bank balances in checking accounts. Stronger preferences for current consumption over future consumption would be indicated by a: (a) higher interest rate. (b) more rapid rate of investment. (c) larger government budget surplus. (d) surplus in the balance of trade. Most modern monetarists argue that central banks should adopt rules so that each year, the: (a) federal budget would balance. (b) money supply would grow by a fixed low percentage. (c) economy would be fine-tuned countercyclically. (d) interest rate would be low to stimulate investment. Milton Friedman asserts that the demand for money is strongly and positively related to: (a) wealth. (b) interest rates on bonds. (c) returns on physical capital. (d) expected rates of inflation. If the price level falls with a given money supply, real money balances will: (a) fall. (b) rise. (c) not be affected. (d) cause a reduction in national debt. (e) reduce the wealth of most households. The early Quantity Theory of Money concluded that, in equilibrium, the price level is: (a) negatively related to the money supply. (b) independent of movements in the money supply. (c) exactly proportional to the money supply. (d) higher when the economy experiences excess capacity. (e) positively related to the level of national output. The early Quantity Theory of Money was based on assumptions that: (a) prices and real GDP were fixed. (b) real GDP and velocity were constant. (c) prices and real GDP grew as the money supply rose. (d) doubling the money supply would double real GDP.

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Test Bank for Corporate Finance and Financial Markets

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Complete Milton Friedman's famous statement, "Inflation is always and everywhere a _____ phenomenon." (a) recessionary (b) discretionary (c) repressionary (d) monetary The Equation of Exchange is written: (a) MQ = PV. (b) M = QVP. (c) MV = PQ. (d) VP = MQ. Velocity of money is: (a) greater, the more efficient money is in reducing the transactions costs of exchange. (b) greater, the smaller the ratio of nominal GDP to the price level. (c) lower, the greater the ratio of the transaction demand for money to nominal GDP. (d) unaffected by inflationary expectations. The neutrality of money in the long run (a) prevents short run speculative bubbles. (b) is a crucial conclusion of classical economists and monetarists. (c) implies that Phillips curves are smoothly parabolic. (d) helps explain the desirability of backing the money supply with precious metals. (e) is logically necessary for the operation of the equation of exchange MV=PQ. The notion that market adjustments automatically cure swings in business cycles is central to the ideas of: (a) Malthus and his population S-curves. (b) Schumpeter long waves. (c) Marxist cycles of exploitation. (d) modern business psychology. (e) classical and neo-classical macroeconomic theorists. Higher inflationary expectations make borrowers willing to pay the higher nominal interest rates that lenders insist on according to the: (a) Keynes effect. (b) natural real rate of interest theory, as refined by Irving Fisher and, more recently, Milton Friedman from earlier work by Knut Wicksell. (c) conflict theory of interest. (d) liquidity avoidance theory. (e) Phillips curve hypothesis. If persistent, huge federal budget deficits were consistently accommodated by FED purchases of U.S. bonds, Milton Friedman and most other monetarists would predict that, in the long run, there would be: (a) disinflation in relative prices, but higher unemployment. (b) lower interest rates and faster economic growth. (c) better job opportunities and less stagflation. (d) increases in the price level, but not in aggregate output. Say's Law is a cornerstone for: (a) Marxist macroeconomics. (b) Keynesian economics. (c) classical macroeconomics. (d) Schumpeterian business cycles. Many Japanese workers receive about half of their annual income as year-end bonuses. Compared with the U.S. practice of paying workers monthly or weekly, the Japanese bonus system: (a) makes money more efficient in exchange. (b) raises average money balances held as a percentage of annual income. (c) lowers average money balances held as a percentage of annual income. (d) decreases the use of credit.

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n the diagram, region a equals: (a) the demand for money. (b) the supply of money. (c) asset balances. (d) transactions balances. Region b in the diagram is equal to: (a) precautionary balances. (b) asset balances. (c) transactions balances. (d) precautionary plus asset balances.

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The classical macroeconomic model concludes that: (a) production costs determine the price level. (b) absolute (aka nominal or monetary) prices are proportional to the money supply. (c) interest rate changes cause velocity changes. (d) a tradeoff between inflation and unemployment is unavoidable. Classical macroeconomists contended that the only reason we hold money is to: (a) hoard wealth. (b) earn high interest income. (c) make transactions. (d) perpetuate capitalism. Classical economists believed that: (a) workers react to changes in real wages with a lag. (b) involuntary unemployment is a persistent problem. (c) workers quickly react to changes in real wages. (d) unemployment is primarily involuntary. (e) fiscal policy is required to combat unemployment. According to the natural real rate of interest hypothesis: (a) contractionary monetary policies permanently reduce real interest rates. (b) the real rate of interest is the percentage purchasing power paid by a borrower to a lender. (c) monetary growth lowers nominal interest rates in the long run. (d) the natural unemployment rate equals the nominal interest rate. Many modern monetarists (most notably, Milton Friedman) believe that discretionary monetary policies should be replaced with: (a) the equation of exchange. (b) Keynesian discretionary policies. (c) a monetary growth rule. (d) a zero growth rule. (e) presidential discretion. Milton Friedman's views are LEAST consistent with the idea that: (a) unstable Aggregate Demand can cause depression and inflation. (b) velocity is more predictably stable than the money supply. (c) the money supply should grow at a fixed annual rate of about 2 to 5 percent. (d) increases in government spending will quickly cure a recession.

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Milton Friedman believes it likely that an increase in the rate of monetary growth will cause nominal interest rates to: (a) rise because nominal income, the price level, and expected inflation will all rise, swamping the Keynesian liquidity effect. (b) fall because inflation will reduce the willingness of financial investors to borrow. (c) rise because foreign investors will view U.S. financial securities more favorably. (d) fall because it will be easier for the U.S. Treasury to fund any federal deficit. Monetarists would say that the primary cause of inflation is (a) the lack of fiscal responsibility. (b) too fast a rate of increase in the money supply. (c) high interest rates, which increase the cost of borrowing. (d) unstable investment demand. This graph hints that even though peoples incomes typically vary across their lifetimes, most try to smooth their rates of consumption. An economist who could use this graph to illustrate his theory is: (a) Milton Friedman. (b) Adam Smith. (c) Frank Knight. (d) Robert Merton. (e) John Kenneth Galbraith.

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Most classical theorists and modern monetarists believe that the: (a) capitalist system is unstable. (b) money supply ultimately determines Aggregate Demand, but not Aggregate Supply. (c) velocity of money is unstable. (d) money supply should grow faster than money demand to prevent inflation. (e) money supply should be used to "fine tune" the economy. Wages and prices are assumed to adjust almost instantaneously and with equal rapidity to given equal rates of excess demand or excess supply according to: (a) Lerner wage-price reaction functions. (b) such modern variants of neoclassical economic theory as the theory of efficient markets. (c) traditional Keynesian theory of business cycles. (d) modern behavioral economics. (e) the new Keynesian theories of business cycles.

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Natural rate theory suggests that if policy makers continually aim for a target interest rate below the natural rate, maintaining the target rate would require: (a) high real interest rates and low nominal interest rates. (b) constant or declining rates of inflation. (c) actual inflation to exceed expected inflation continuously. (d) tariff barriers to prevent competition from cheap labor. The classical demand for money was summarized in the late 19th century at Englands Cambridge University in an equation written: (a) [G-T] = [S-I] + [M-X]. (b) V = MQ/P. (c) C=I=G=(X-M) = Y. (d) Md = kPQ, or Md =kY. (e) MV=PQ. Suppose P = CPI/100. According to the Cambridge version of classical monetary theory, the cost of holding a dollar is: (a) [$1/P], so that it is negatively related to [the reciprocal of] the price level. (b) the interest forgone by holding $1 instead of investing in capital. (c) the security sacrificed by holding $1 during an inflationary period. (d) the purchasing power lost because of inflation.

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46. The idea that natural rates of unemployment and interest would be unaffected in the long run by the time paths of the economy if different macro policies were pursued is most consistent with: (a) hysterisis. (b) stochastic macroequilibration. (c) neoclassical macroeconomics and Milton Friedmans monetarist theory. (d) a horizontal long run Phillips curve. (e) asymmetric wage and price reaction functions. 47. The notion that, ex ante, the nominal interest rate equals the real interest rate plus the expected rate of inflation [in = r* + E()] is called the: (a) classical paradigm (b) Fisher equation. (c) Hume conjecture. (d) Keynesian equation. (e) monetarist equation. (f) Marshall equation. A rise in the price level is mirrored by an increase in the demand for money, a function known as the: (a) price-level effect. (b) law of one price. (c) inflation effect. (d) inflation risk effect. (e) law of increasing price. Many early business cycle theories focused on: (a) external shocks. (b) changing interest rates. (c) decisions of the Fed. (d) all of the above. A monetary growth rule would dictate that the money supply would grow at: (a) an increasing rate each year. (b) a rate lower than that of years past. (c) a fixed rate compatible with historical GDP growth. (d) a rate equal to the previous years inflation rate. Milton Friedman argued that ______ policy does not strongly affect aggregate demand, but _________ policy does based on an equation of the general form 0 >> 1: PQ = B + oM + 1(G-T/Y).: (a) fiscal \ monetary. (b) discount \ open market. (c) fiscal monetary; 0; 1. (d) tax \ spending.

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Ralph Byrns

Test Bank for Corporate Finance and Financial Markets

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According to Milton Friedman, John Maynard Keynes liquidity preference analysis ignored the possibility that: (a) interest rates respond to changes in the money supply. (b) changes in the money supply may affect other segments of the economy, raising interest rates. (c) changes in the money supply are sometimes intentional, leading to anticipated changes in the interest rates. (d) consumers will attempt to offset any losses of purchasing power from expected inflation. According to the quantity theory of money, in the long run, the dominant determinant of the price level is: (a) expected inflation. (b) average exchange rate. (c) government spending. (d) interest rate. (e) money supply. According to the quantity theory of money, in the long run, the money supply is the sole determinant of: (a) the price level. (b) real exchange rates. (c) government spending. (d) real interest rates. (e) money supply. Ben Bernanke is among many central bankers all over the world who increasingly favor: (a) setting the growth of the money supply at a low fixed percentage rate regardless of short run economic conditions. (b) expanding the money supply at rates that would precisely yield price level stability. (c). pursuing deflationary policies that would reduce nominal interest rates to zero. (d) targeting inflation at a low rate (2% or so) to significantly reduce the risk of deflation. Between September 11, 2001, and March 2004, the: (a) money supply grew faster than GDP. (b) income velocity of money increased sharply. (c) exchange rate of the dollar increased relative to the euro, the pound, and the yen. (e) federal funds rate increased because of increases in the perceived riskiness of financial investments. Effects of an increase in the money supply on interest rates do not include the: (a) pricelevel effect. (b) income effect. (c) liquidity effect. (d) velocity effect. (e) Fisher effect. If transaction motives dominate the demand for money, then after the price level has increased people are most likely to: (a) consume even more than usual so there is no chance the money will devalue even further. (b) hold a greater real quantity of money[M/P]. (c) hold a greater nominal quantity of money [M]. (d) consume more in the short run but then slow to their original level of consumption. The phenomenon that interest rates rise in response to an increase in expected inflation is known as the: (a) liquidity effect (b) the inflation effect (c) the Fisher effect (d) the Keynesian effect Using a statistical analysis of the equation PQ = a + b0M + b1(G-T/Y), Milton Friedman thought he had shown that ______ policy does not work, but that _________ policy does, because subscripts b__ >b__:. (a) fiscal; monetary; 1; 0 (b) monetary; fiscal; 1; 0. (c) fiscal, monetary; 0; 1 (d) monetary; fiscal; 0; 1 The ex ante equation iN = r* + E[Pe] and the ex post equation: r = iN Pe are mathematical characterizations of the: (a) theory of rational expectations. (b) law of interest rates. (c) Fisher effect. (d) law of inflation.

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Which effect is named after the first American economist who identified a positive relationship between expected inflation and interest rates?. (a) Marx effect. (b) Nash effect. (c) Irving effect. (d) Fisher effect. Pre-1930s versions of neoclassical macro theory and Keynesian theory per the General Theory [1936] differ least about the: (a) importance of liquidity in determining optimal asset portfolios. (b) flexibility of wages, prices, and interest rates. (c) possibility that unemployment may be involuntary in the short run. (d) validity of the equation of exchange [MV=PQ] and the quantity theory of money in long run equilibrium. (e) (f) opportunity cost of holding money. Classical macroeconomic theory neither assumes nor concludes that, in a macroeconomic equilibrium: (a) the willingness of firms to operate depends critically on expectations that there is a ready market for their products. (b) a societys production possibilities frontier is determined almost solely by the state of technology and available resources. (c) people can find a job almost immediately if they are willing to accept a wage commensurate with their productivity. (d) the nominal quantity of money demanded will be precisely proportional to the price level.

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Ralph Byrns

Test Bank for Corporate Finance and Financial Markets