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econ test 2
Undergraduate 3

Additional Economics Flashcards




money demand
Holding money in hand and checking account for liquidity needs of immediate access to its economic purpose.”
• Hold Money for Three Reasons:
1) Precautionary motive: Hold money for unforeseen situations such as sickness, job loss, etc.
2) Speculative motive: Keep money on side to keep advantage and temporary profitable opportunities in stock and commodities market.
3) Transaction motive: For day-to-day transactions people hold money.
Super Neutrality of Money
• If both money supply (M) and price level (P) rise by the same percent or if both double, triple, or quadruple there will be no change in Real GDP with constant velocity of money.
o Remain constant if both change same rate
• In this case, the Fed is helpless to influence Real GDP by changing money supply.
o In, fact money is not super neutral.
o Money has the power to change Real GDP by changing M
Original Quantity Theory of Money (QTM)
• Objective: To find counsel relationship between changes in money supply and price level.
• Assumptions:
1. Economy is at full employment
• Real GDP (y) is constant. (%▲y=0)
• Change= 0
2. Velocity of money (v) is constant.
• %▲v=0

• Fisher’s Equation of Exchange
o MV=Py
• Taking %▲ of the above on both sides
o %▲M + %▲v= %▲P+ %▲y

• x% increase in the quantity of money cause x% inflation.
• In other words, only increase in money supply causes inflation by the same %
• It means that inflation is entirely a monetary phenomenon
• Every theory has some shortcomings.

1. This theory considers only transaction demand for money.
2. It ignores the role of interest rate (relevant to precautionary) and speculative demands for money.
3. In the real world, velocity of money and real GDP are not CONSTANT.
4. Increase in money supply is not the sole cause of inflation.
• It is caused by many other factors.

• Despite the above limitations, this is a ground breaking theory in monetary economics inspiring numerous studies on this issue of great importance.
• Thousands have been published later based on this theory. Two theories published by Dr. Rahman.
• To be practical v and y are allowed to be changed. No longer constant.
o Mv= Py
Cambridge Version of QTM
• M= KPy
o M= Total money in circulation
o P= Price level in absolute term
o y= Real GDP
o K= Holding off money as a % of nominal GDP for transactions
• UK (Cambridge) version, secretly the same.
o Mv=Py → v =
Velocity of Money (v)
• A number of times a unit of money circulates in the economy during a period (number of times it changes hands.
o Example: $1 bill from one holder to another
Quantitative Easing (QE)
• Monetary expansion by the Fed through purchases of Treasury securities.
• In June 2009, the unemployment rate was stubbornly high.
• To bring it down, the Fed unprecedently engaged in massive monetary expansion through 3 rounds of QE (QE1, QE2, and QE3)
since 2008 through 2014.
• The goal was to reduce unemployment rate by reducing short-term interest rate to 0%, if necessary.
Total increase in money supply over 2008-2014 was more than $2 Trillion
*10% (Over 6 years) →4.9%
Long-Term Interest Rate Determined in the Bond Market
A bond is a debt instrument issued by large corporations and governments to raise capital directly from investors for investment and other expenditures.
Major Types of Bonds
1. Treasury Bond: Issued by the federal government.
➢ No default risk
2. Corporate Bond: Issued by large corporations.
➢ Default risk is > 0
3. Municipal Bond: Issued by city governments.
➢ Interest income is not taxable.
➢ Most liked bond choice.
Other Types of Bonds
4. Zero-coupon Bond: Sold at deep discount and redeemed at $1,000 when it matters.
➢ 10-year maturity = Buy at $200
i. And get $1,000 at the end of 10th year
➢ People use it for retirement and education plans.
➢ It grows like fungus in the closet.
5. Callable Bond: Issuer can redeem it earlier when they have excess cash with one period excess coupon as compensation.
6. Convertible Bond: Same corporation’s bond can be converted into certain number of its common stocks.
➢ Microsoft Example
Common Features of Bonds
1. A bond has a FIXED face value (F) at $1,000.
a. Redeemed at $1,000
2. Market price of bond (P) changes.
3. A bond has definite maturity structure.
4. A bond makes annual coupon payment in equal amount over its lifetime.
5. Market price of bond (P) and bond-yield [long-term interest rate (
Reasons for Shifts in Bond-Demand
1. Wealth↑→D↑
2. Relative return on bond ↑→D↑
a. Compared to other assets
3. Relative safety of bond ↑→D↑
a. Compared to common stocks
4. Relative liquidity of bond↑→D↑
a. Compared to real estate
Reasons for Shifts in Bond-Supply
1. Government budget deficit↑→S↑
2. Business profit outlook ↑→S↑
3. Inflation rate ↑→S↑
Demand for Bond
• When $ ↓, I ↑ in bonds
o As P↓, IL up
-more bonds at low price
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