Chapter 20
Money Growth, Money Demand, and
Modern Monetary Policy
Conceptual and Analytical Problems
1. Why is inflation higher than money growth in high-inflation countries and lower than
money growth in low-inflation countries? (LO1)
Answer: At very high levels of inflation, the velocity of money rises dramatically as
countries because part of the growth of money is offset by economic growth.
2. * Explain why giving an independent central bank control over the quantity of money
especially in developing economies. (LO1)
Answer: Inflation is a monetary phenomenon and independent central banks are more
likely than governments (who may be looking for a way to finance spending for
central bank may face pressure to monetize government debt and risk high and rising
inflation.
3. If velocity were constant at 2 while M2 rose from $5 trillion to $6 trillion in a single
year, what would happen to nominal GDP? If real GDP rose 3 percent, what would be
the level of inflation? (LO2)
percent.
4. According to Irving Fisher, when velocity and output are fixed, the quantity theory of
velocity? (LO2)
%∆Y.
5. If velocity were predictable but not constant, would a monetary policy that fixed the
growth rate of money work? (LO2)
Answer: We know that money growth + velocity growth = inflation + real growth. If
inflation.
6. Describe the impact of financial innovations on the demand for money and velocity.
(LO3)
Answer: Financial innovations reduce the demand for money and increase velocity.
By making alternatives to money more liquid, individuals need less money as a
difficult to predict the path of velocity over short-run periods of a year or two.
7. Suppose that expected inflation rises by 3 percent at the same time that the yields on
yield on nonmoney assets rose by 4 percent? (LO3)
Answer: Money demand depends in part on its opportunity cost, the difference
between the real yield on nonmoney assets and the real yield on money. If expected
unchanged and the demand for money will not be affected.
If expected inflation rises by 2 percent, the expected real yields on money and on
money.
8. *Explain how money growth reduces the purchasing power of money. (LO2)
Answer: By increasing the supply of money, holding demand for money constant, the
of money in terms of goods and services has fallen.
9. Provide arguments both for and against the Federal Reserve’s adoption of a target
growth rate for M2. What assumptions would be necessary to compute such a target
rate? (LO1)
Answer: In the long run, inflation is tied to money growth. However, in the short run,
the velocity of money is volatile, and controlling the growth rate of money does not
the link—the money multiplier—between the monetary base and the quantity of M2.
10. Explain why we observed a fall in the velocity of M2 during the financial
crisis of 2007–2009. (LO3)
Answer: The increase in uncertainty during the financial crisis drove investors to hold
lowering velocity.
11. Comment on the role given to money in the monetary policy strategy of the
ECB. (LO1)
Answer: Although the ECB has downgraded the role initially given to money in its
monetary policy strategy, it still pays more attention to money than its U.S.
12. Countries A and B both have the same money growth rate and in both countries, real
output is constant. In Country A velocity is constant while in Country B velocity has
fallen. In which country will inflation be higher? Explain why. (LO2)
Answer: Using the equation of exchange: Money growth + Velocity growth =
the inflationary pressures from the rise in the stock of money.
13. Consider a country where the level of excess reserves fluctuates widely and
unpredictably. Would such a country be a good candidate for a money growth rule to
guide monetary policy? Explain your answer. (LO4)
Answer: This country would not be a good candidate. One requirement for a money
fluctuations in the money multiplier.
14. Draw a graph of money demand and money supply with the nominal interest rate on
zero. Use the graph to illustrate how fluctuations in velocity imply that targeting
money growth results in greater volatility of interest rates. (LO4)
Answer: Changes in velocity are reflected in shifts in the money demand curve. For
example, if financial innovation causes money demand to be lower (and so velocity to
demand, so the interest rate must adjust to maintain money market equilibrium.
Money Supply
Interest rate
Money
Money Demand
15. Using the same graph as that described in Problem 14, show how the central bank
could use its control over the quantity of money to target a particular interest rate in
the face of changes in velocity. (LO4)
interest rate at its target.
16. Why might targeting the money supply lead to lower output growth than targeting the
rate of interest? Consider your responses to Problems 14 and 15 before you answer.
(LO4)
Answer: In your answer to Problem14, you found that targeting the money supply
resulted in interest rate volatility (see Figure 20.8 for an example of increased interest
estate. As a result, it tends to reduce investment and slow economic growth.
17. Which of the following factors would increase the transactions demand for money?
Explain your choices. (LO3)
a. Lower nominal interest rates.
b. Rumors that a computer virus had invaded the ATM network.
c. A fall in nominal income.
Answer: Both (a) and (b) would increase the transactions demand for money.
Lower nominal interest rates lower the opportunity cost of holding money and so
money demand will be higher. A computer virus in the ATM network would lead to
Money Supply
Interest rate
Money
Money Demand
i*
fall in nominal income, would lead to a fall in the transactions demand for money as
people spend less on goods and services.