Chapter 5 Macro

If the nominal interest rate is 1% and the inflation rate is 5%, the real interest rate is:

-4 percent

According to economic theory, which of the following expressions can possibly represent the (general) demand for money (real)

100 - .05* i + 0.2* Y answer explanation: since demand for money depends negatively (inversely) on nominal interest rate, and positively on real income

If the average price of goods and services in the economy equals $10 and the quantity of money in the economy equals $200,000, then real balances in the economy equal:

20,000

According to the quantity theory of money equation, if the money supply increases 12%, velocity decreases 4%, and the price level increases 5%, then the change in real GDP must be _________ percent.

3 answer explanation: since the quantity theory of equation is: M*V = P*Y, each side is a product of two variables. Now use the % change result in chapter 2 to deduce: % change in M + % change in V = % change in P + % change in Y. Plugging all the given values from the question into the last equation, we have: 12 + (-4) = 5 + % change in Y, which implies, % change in Y = 3.

If nominal GDP is $1000,then if there is $200 of money in the economy, velocity is _________ times per year:

5 answer explanation: use the equation M*V = P*Y = nominal GDP

In the classical model, and according to the quantity theory of money, a 5% increase in money through increases inflation by _______ percent. According to the Fisher equation a 5% increase in the rate of inflation increases the nominal interest rate by _______.

5; 5 answer explanation: since in the classical model, Y is already determined/fixed at Y-bar and r is determined (already) in the goods market equilibrium equation. Given the above, M is proportional to P (given velocity is a constant also). And since the real rate, r is already determined or fixed, any increase in inflation rate translates to the same increase in nominal rate

If the real return (real interest rate) on government bonds is 3% in the expected rate of inflation is 4%, then the cost of holding money is ________ percent

7 answer explanation: use answer in question 17

The classical economist wears a T-shirt printed with the slogan "fast money raises my interest!" use the results of the classical model, quantity theory of money and the fish are equation to explain the slogan

According to the classical model and quantity theory of money, since velocity and real output (Y) are constant/fixed, an increase in quantity of money, M, would, by the quantity theory of money equation, increase the price level by the same percentage. This means an increase in the inflation rate. By the Fisher equation/effect, an increase in inflation rate would increase the nominal interest rate by the same percentage (as real interest rate is determined already in the goods market equilibrium).

If the demand for money depends positively on real income and depends inversely on the nominal interest rate, what will happen to the price level today, if the central bank announces that it will decrease the money growth rate in the future, but it does not change the money supply today

People will expect lower inflation rate in the future. A lower inflation means a lower nominal interest rate. This means the demand for (real) money will increase. Since the Fed does not immediately decrease the money supply, price (P) must fall so the real balances ( M/P ) would increase to match the increase demand for money [the money market equilibrium equation]. Thus, current price will fall as a result of expected future decrease in money growth

In classical macroeconomic theory, the concept of monetary neutrality means that changes in the money supply do not influence real variables. Explain why changes in money growth affect the nominal interest rate, but not the real interest rate

Recall that in the model in chapter 3 (the so-called classical model), the real interest rate, r, is already determined in the goods market equilibrium, and the real output, Y, is determined from the production function with fixed amounts of L (L-bar) and K (K-bar). Hence all these real variables are determined without reference to money. In the quantity theory of money (equation), the money supply, M, (with fixed Y and velocity, V) has a one-to-one positive relationship with price, P (since velocity is constant and Y is fixed at Y-bar). An increase in money supply would result in the same percentage increase in P. Hence an increase in money supply would result in the same percentage increase in inflation. By the Fisher equation/effect, this would result in the same percentage increase in nominal interest rate. Hence money supply only affects nominal variables such as P, nominal GDP ( which is P*Y), inflation rate, and nominal interest rate. Note that by the relationship: nominal variable = P * the corresponding real variable, and since money supply affects P, which in turn would affect other nominal variables such as nominal consumption, nominal investment, and so on.

According to the quantity theory of money, ultimate control over the rate of inflation in the United States is exercised by:

The Fed answer explanation: because we can see for any fixed Y and V, M is proportional to P. It means any change in M (controlled by the Fed) would lead to changes in P (inflation)

Assume that the demand for real money balance (M/P) is M/P=0.6Y-100i, where why is national income and i is the nominal interest rate (in percent). The real interest rate car is fixed at 3% by the goods market equilibrium equation. The expected inflation rate equals the right of the nominal money growth.

a. If Y is 1000, M is 100, and the growth rate of nominal money is 1%, what must i and P be? - Since the expected inflation rate = rate of growth of M = 1% (given), the nominal interest rate = i = real interest rate + inflation rate = 3 + 1 = 4%. Now the (demand for) real balance is M/P = 0.6*1000 - 100*4 = 200. Since M = 100, it means 100 / P = 200 or P = ½. Note that the equation, M/P = 0.6Y - 100i, can be interpreted as the money market equilibrium equation. And the above exercise shows that the value of price, P, can be determined from the money market equilibrium equation (when the values of Y, r and expected inflation rate are given) b. If Y is 1000, M is 100, and the growth rate of nominal money is 2%, what must i and P be? - Repeat the same exercise as part a), we have P = 1 and i = 5%

Real money balances equal the:

amount of money expressed in terms of the quantity of goods and services it can purchase answer explanation: real money balances or real money supply = M / P, where P = price per unit of goods

If the Fed announces that it will raise the money supply in the future that does not change the money supply today,

both the nominal interest rate and the current price level will increase answer explanation: nominal rate will increase because of increase in expected inflation rate. If nominal rate goes up, the demand for real balances will go down, hence for the money market to be in equilibrium, the supply of real balances, M/ P, has to decrease, which means prices have to go up assuming that there is no change in M

The demand for real money balances is generally assumed to:

increase as real income (real GDP) increases

The characteristic of the classical model that the money supply it does not affect real variables is called:

monetary neutrality

If velocity is assumed to be constant, but no other assumptions are made, the level of ______ is determined by M.

nominal GDP answer explanation: see the equation in question 3 above

If the velocity of money remains constant while the quantity of money (M) doubles, then:

nominal GDP must double answer explanation: use the same equation as in question 3 above

The opportunity cost of holding money is the:

nominal interest rate answer explanation: because by holding money, not only one miss out on the real return (r ), but there is loss due to inflation (lowering of purchasing power), and the nominal interest rate is the sum of real rate/return and inflation rate

The concept of monetary neutrality in the classical model means that an increase in the money supply will increase:

nominal interest rates

With the quantity theory of money equation, if the quantity of real money balances is k*Y, where K is a constant, then velocity is:

none of the above answer explanation: because rearranging the quantity theory of money equation, we have real balances = M / P = (1/V) * Y. We can identify 1/V as k. So k = 1 / V

The one to one relation between the inflation rate and the nominal interest rate, the fisher affect, assumes that the:

none of the above answer explanation: since nominal rate = real rate + inflation rate, inflation rate has a one-to-one effect on nominal rate if the real rate is constant

The rate of inflation is the:

percentage change in the level of prices

The definition of the velocity of money, V, is:

price (index) multiplied by real GDP divided by money supply

The general demand function for real (money) balances depends on the nominal interest rate and:

real income answer explanation: it depends on nominal rate because of the opportunity cost argument, see question 17

In the classical model, together with the quantity theory of money equation and the Fisher equation/effect, an increase in nominal money supply increases:

the nominal interest rate answer explanation: see answer in question 15 above

The real interest rate is equal to the:

the nominal interest rate minus the inflation rate

The quantity theory of money assumes that:

velocity is constant