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Additional Issues For Classroom Discussion
1. How Has Technology Changed Money?
Ask your students how they think improved technology has changed the role of
money in the economy. They might mention such things as ATMs, which allow
better access to money in bank accounts; telephone banking and computer
2. How Will Money’s Role Change in the Future?
Imagine an age in which the balance in your checking account is invested immediately and automatically
in the stock or bond market, earning substantially more interest than is typical today. Suppose all payments
become electronic, so we never need to touch a dollar bill. What role would money play in such a
3. Stored Value Cards and Internet Money
The latest developments in money are the stored value card and Internet money.
Do any of your students have a stored value card? They are getting popular, especially for students and
others who may not have enough income to qualify for credit cards. With these cards, you simply pay in
4. Should You Buy Indexed Bonds?
Given a choice between buying nominal bonds and indexed bonds, what would you choose? Ask your
students to list the pros and cons of buying indexed bonds.
You may need to give them a bit of historical background. Though introduced for the first time in the
United States in 1997, bonds whose nominal payments adjust for inflation have been available in other
countries for some time, beginning with Finland in 1945. Typically, countries have started issuing indexed
bonds after a bout with inflation.
As you discuss the bonds with your students, you may want to note a few special features that prevent the
bonds from being as desirable as an economist might like them to be. First, the principal of the bond is
adjusted regularly, so that it maintains its real value, but you must pay taxes immediately on the principal
adjustment. That is, before receiving the money, you get taxed on it. Also, because the U.S. government
didn’t want to allow a tax advantage to the indexed bonds, taxes on principal and interest are both based
1. Money is the economist’s term for assets that can be used in making payments, such as cash and
checking accounts. In everyday speech, people often use the term “money” to refer to their income or
2. The three functions of money are (1) the medium of exchange function, which contributes to a better-
functioning economy by allowing people to make trades at a lower cost in time and effort than in a
3. The size of the nation’s money supply is determined by its central bank; in the United States, the
central bank is the Federal Reserve System. If all money is in the form of currency, the money supply
4. The four characteristics of assets that are most important to wealth holders are (1) expected return,
(2) risk, (3) liquidity; and (4) time to maturity. Money has a low expected return compared to other
5. The expectations theory of the term structure of interest rates is the idea that investors compare bonds
with different times to maturity and choose the ones that yield the highest return. In equilibrium, the
6. The macroeconomic variables that have the greatest impact on money demand are the price level, real
income, and the nominal interest rate on other assets. The higher the price level, the higher the
7. Velocity is a measure of how often money “turns over” in a period. It is equal to nominal GDP
divided by the nominal money supply. The quantity theory of money assumes that velocity is
8. Equilibrium in the asset market is described by the condition that real money supply equals real
money demand because when supply equals demand for money, demand must also equal supply for
9. In equilibrium, the price level is proportional to the nominal money supply; in particular it equals the
nominal money supply divided by real money demand. Similarly, the inflation rate is equal to the
10. Factors that could increase the public’s expected rate of inflation include a rise in money growth or a
decline in income growth. With no effect on the real interest rate, the increase in the expected
1. For a two-year bond, according to the expectations theory, the interest rate would be the average of
the two one-year bonds, which is (6% 4%)/2 5%. Adding the risk premium of 0.5% gives an
interest rate on the two-year bond of 5.5%.
For the three-year bond, according to the expectations theory, the interest rate would be the average
2. (a) Real money demand is
Md/P 500 0.2Y 1000i
500 (0.2 1000) (1000 0.10)
600.
Nominal money demand is
3. (a) Md $100,000 $50,000 [$5000 (i im) 100]. (Multiplying by 100 is necessary since i and
im are in decimals, not percent.) Simplifying this expression, we get
Md $50,000 $500,000(i im).
(b) Bd $50,000 $500,000(i im).
Adding these together we get Md Bd $100,000, which is Mr. Midas’s initial wealth.
4. (a) From the equation MV PY, we get M/P Y/V. At equilibrium, Md M, so Md/P Y/V
10,000/5 2000. Md P (Md/P) 2 2000 4000.
(b) From the equation MV PY, P MV/Y.
5. (a) P/P
Y Y/Y 0.5 6% 3%. The price level will be 3% lower.
6. (a)
e M/M 10%. i r
e 15%. M/P L 0.01 150/0.15 10. P 300/10 30.
e /M 5%. i r
e 10%. M/P L 0.01 150/0.10 15. P 300/15 20. The
7. (a) With a constant real interest rate and zero expected inflation, inflation is given by the equation
M/M
Y Y/Y. To get inflation equal to zero, the central bank should set money growth so
1. (a) People would probably take money out of checking accounts and put it into money market
mutual funds and money market deposit accounts. Money market mutual funds and money
M1, but no change in M2. M2 does not increase because M1 is part of M2, so the decrease in M1
offsets the increase in the rest of M2.
(b) This would reduce both M1 and M2, as people would have reduced need for money in checking
accounts, and home equity lines of credit are not included in either M1 or M2.
2. The general rise in velocity from 1959 to 1980 is most likely due to changes in income, in interest
rates, and in financial institutions. Higher income led to a less than proportional rise in real money
3. (a) New cigarettes mean an increase in the money supply. With higher nominal money supply and
no change in real money demand, the equilibrium price level must rise.
4. (a) A temporary increase in government purchases reduces national saving, causing the real interest
rate to rise for a fixed level of income. If the real interest rate is higher, then real money demand
will be lower. So prices must rise to make money supply equal money demand. The result is that
output is unchanged, the real interest rate increases, and the price level increases.
(b) When expected inflation falls, real money demand increases. With no effect on employment or
1. Money is the economist’s term for assets that can be used in making payments, such as cash and
checking accounts. In everyday speech, people often use the term “money” to refer to their income or
2. The three functions of money are (1) the medium of exchange function, which contributes to a better-
functioning economy by allowing people to make trades at a lower cost in time and effort than in a
3. The size of the nation’s money supply is determined by its central bank; in the United States, the
central bank is the Federal Reserve System. If all money is in the form of currency, the money supply
4. The four characteristics of assets that are most important to wealth holders are (1) expected return,
(2) risk, (3) liquidity; and (4) time to maturity. Money has a low expected return compared to other
5. The expectations theory of the term structure of interest rates is the idea that investors compare bonds
with different times to maturity and choose the ones that yield the highest return. In equilibrium, the
6. The macroeconomic variables that have the greatest impact on money demand are the price level, real
income, and the nominal interest rate on other assets. The higher the price level, the higher the
7. Velocity is a measure of how often money “turns over” in a period. It is equal to nominal GDP
divided by the nominal money supply. The quantity theory of money assumes that velocity is
8. Equilibrium in the asset market is described by the condition that real money supply equals real
money demand because when supply equals demand for money, demand must also equal supply for
9. In equilibrium, the price level is proportional to the nominal money supply; in particular it equals the
nominal money supply divided by real money demand. Similarly, the inflation rate is equal to the
10. Factors that could increase the public’s expected rate of inflation include a rise in money growth or a
decline in income growth. With no effect on the real interest rate, the increase in the expected
1. For a two-year bond, according to the expectations theory, the interest rate would be the average of
the two one-year bonds, which is (6% 4%)/2 5%. Adding the risk premium of 0.5% gives an
interest rate on the two-year bond of 5.5%.
For the three-year bond, according to the expectations theory, the interest rate would be the average
2. (a) Real money demand is
Md/P 500 0.2Y 1000i
500 (0.2 1000) (1000 0.10)
600.
Nominal money demand is
3. (a) Md $100,000 $50,000 [$5000 (i im) 100]. (Multiplying by 100 is necessary since i and
im are in decimals, not percent.) Simplifying this expression, we get
Md $50,000 $500,000(i im).
(b) Bd $50,000 $500,000(i im).
Adding these together we get Md Bd $100,000, which is Mr. Midas’s initial wealth.
4. (a) From the equation MV PY, we get M/P Y/V. At equilibrium, Md M, so Md/P Y/V
10,000/5 2000. Md P (Md/P) 2 2000 4000.
(b) From the equation MV PY, P MV/Y.
5. (a) P/P
Y Y/Y 0.5 6% 3%. The price level will be 3% lower.
6. (a)
e M/M 10%. i r
e 15%. M/P L 0.01 150/0.15 10. P 300/10 30.
e /M 5%. i r
e 10%. M/P L 0.01 150/0.10 15. P 300/15 20. The
7. (a) With a constant real interest rate and zero expected inflation, inflation is given by the equation
M/M
Y Y/Y. To get inflation equal to zero, the central bank should set money growth so
1. (a) People would probably take money out of checking accounts and put it into money market
mutual funds and money market deposit accounts. Money market mutual funds and money
M1, but no change in M2. M2 does not increase because M1 is part of M2, so the decrease in M1
offsets the increase in the rest of M2.
(b) This would reduce both M1 and M2, as people would have reduced need for money in checking
accounts, and home equity lines of credit are not included in either M1 or M2.
2. The general rise in velocity from 1959 to 1980 is most likely due to changes in income, in interest
rates, and in financial institutions. Higher income led to a less than proportional rise in real money
3. (a) New cigarettes mean an increase in the money supply. With higher nominal money supply and
no change in real money demand, the equilibrium price level must rise.
4. (a) A temporary increase in government purchases reduces national saving, causing the real interest
rate to rise for a fixed level of income. If the real interest rate is higher, then real money demand
will be lower. So prices must rise to make money supply equal money demand. The result is that
output is unchanged, the real interest rate increases, and the price level increases.
(b) When expected inflation falls, real money demand increases. With no effect on employment or
