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Chapter 19 Homework Solutions

1. Suppose the money supply M has been growing at 10% per year and nominal GDP PY
has been growing at 20% per year. The data are as follows:
M
PY

2004
100
1000

2005
110
1200

2006
121
1440

Calculate the velocity in each year. At what rate is the velocity growing?
Use the quantity theory of money identity: M*V = P*Y V = PY/M
2004: V = 1000/100 = 10
2005: V = 1200/110 = 10.91
2006: V = 1440/121 = 11.9
Growth rate in V is approximately 9.1% per year.
2. Calculate what happens to nominal GDP if velocity remains constant at 5 and the
money supply increases from $200 billion to $300 billion.
PY = M*V
Before:
After:

PY = $200 billion * 5 = $1 trillion


PY = $300 billion * 5 = $1.5 trillion

3. Calculate what happens to nominal GDP if the money supply grows by 20%, but
velocity declines by 30%?
M*V = P*Y %PY = %M + %V = 20% - 30% = -10%
A 20% increase in the money supply plus a 30% decrease in velocity
will decrease nominal GDP by 10%.
4. If credit cards were made illegal by congressional legislation, what would happen to
velocity?
Without credit cards, there would be increased demand for money
since people would have to hold more money to carry out the same
amount of transactions.
V = PY/M When M increases, V must fall.
Banning credit cards would reduce the velocity of money.

5. If velocity and aggregate output are reasonably constant (as the classical economists
believed), what happens to the price level when the money supply increases from $1
trillion to $4 trillion?
Again using the quantity equation, we have M*V=P*Y. Assuming
constancy in both V and in Y, then any increase in M will be met by a
proportionate increase in price. In this example, the money supply
increases by 300%. If both V and Y are constants, then P must also
increase by 300% to restore full employment output.
9. In Keynes analysis of the speculative demand for money, what will happen to money
demand if people suddenly decide that the normal level of the interest rate has declined?
If people believe that the normal level of the interest rate has fallen,
then they believe that current interest rates are above normal.
Therefore, they expect that interest rates will fall in the future,
prompting them to buy more bonds today. The demand for money falls
as people shift their wealth into bonds.
11. If interest rates on bonds go to zero, what does the Baumol-Tobin analysis suggest
Grant Smiths average holdings of money should be?
Since bonds pay no interest, but do incur transactions costs (e.g.
brokerage fees), Grant should not hold any bonds. Thus, Grant will
hold his entire income as money, which according to the analysis
presented suggests that his average cash balance will be equal to half
his income.
12. If brokerage fees go to zero, what does the Baumol-Tobin analysis suggest Grant
Smiths average holdings of money should be?
Since bonds are now costless to hold and pay a higher return than
money, Grant should hold just enough money to make his purchases
and no more. In other words, Grant should always hold bonds and only
convert bonds into money to make his purchases. Grant never holds
any cash balances (bonds are instantly converted to consumption), so
average cash balances equal zero.
13. In Tobins analysis of the speculative demand for money, people will hold both
money and bonds, even if bonds are expected to earn a positive return. Is this statement
true, false, or uncertain?
Tobin argued that people care about both the return and the risk of the
assets they hold. Since bonds are generally considered to be riskier
than money, people will still choose to hold money for diversification
purposes.

14. Both Keynes and Freidmans theories of the demand for money suggest that as the
relative expected return on money falls, demand for it will fall. Why does Friedman
think that money demand is unaffected by changes in interest rates? Why did Keynes
think that money demand is affected by changes in interest rates?
Keynes proposed that people held money to make transactions, in case
a sudden need for liquidity arose, and for speculation. In each of these
cases, the demand for money is inversely related to interest rates. As
interest rates rise, the opportunity cost of holding money increases as
well.
Friedman does not disagree with Keynes analysis behind the
motivation to hold money, but argues that what we need to consider
are excess returns. The opportunity cost of holding money only
increases if the return on bonds (or equities or goods) goes up relative
to the return on money. Friedman argued that excess returns were
constant since all interest rates tend to move in the same direction.
Thus, an increase in the return on bonds would be met by an increase
in the return on money and there would be no additional incentive to
hold bonds over money.