1
Quiz-2 MECO 121 11:00
Section 4
Each question carries 10 points
Q.1 According to Keynesian theory of speculative demand for money an individual either
hold all money or all bonds/securities True/false? Explain the answer.
Ans:- The above statement is true. According to Keynesian theory an individual will
hold bond if and only if
*
t
ii
where
*
i
is that rate of interest (critical rate of interest) at which net return from holding
bonds is equal to zero (
*0ig+=
) where
1
e
t
t t
pp
gp
+−
=
(
p
is price of bond) is capital gain
and loss which occur due to variation in bonds/security prices. On the other hand, an
individual will hold money if
*
t
ii
Since individual is certain about the sign of
*
ig+
as per her expectation, she will hold
either money or bond. In other words, she will not hold a portfolio which comprises of
both money and bonds.
Q.2 If we move along the LM curve from left to right (
) the transaction demand for
money will increase, speculative demand for money may increase or decrease, and
precautionary demand for money will decrease. True/false? Explain your answer.
Ans:- The statement is False
For a given money supply (M), prices (P), and the degree of uncertainty (
) the LM
curve is a locus of all those combinations of
r
and
y
at which money market is in
equilibrium. The equation of LM curve is given as follows:
( ) ( ) ( )
d d d
T S P
MM y M r M
P
+ − +
= + +
If we move from left to right along the curve then both
r
and
y
will increase.
Consequently, money demand for transaction reason (
d
T
M
) will increase, money demand
for speculative (
d
S
M
) reason will decrease whereas money demand for precautionary
reason (
d
P
M
) will remain the same (since there is no change in the degree of uncertainty as
we move along the same LM curve). Since both money supply and price levels are
constant, the increase in money demand (in absolute term) has to be equal to the decrease
in the speculative demand for money for LM equation to be satisfied.
Q.3 Explain how IRR determine the interest sensitivity of investment demand whereas critical
rate of interest determine the interest sensitivity of money demand.
Ans:- IRR is that rate of discount at which the NPV of income stream generated by a piece
of capital is equal to zero:
1 2 1 2
0
22
….. ….. 0
1 (1 ) (1 ) 1 (1 ) (1 )
NN
NN
RC
R R C C
NPV C
IRR IRR IRR IRR IRR IRR

= + − + + =

+ + + + + +
