Chapter 20 Problems and Solutions

1. Why is inflation higher than money growth in high-inflation countries and lower than money growth in low-inflation countries? Answer: At very high levels of inflation, the velocity of money rises dramatically as people rush to spend their currency before it loses value; this causes inflation to be higher than money growth. Inflation is lower than money growth in low-inflation countries because part of the growth of money is offset by economic growth. 2. Explain how the central bank can control the growth rate of money.

Answer: The central bank controls the size of its balance sheet. It can sell or purchase securities to change the size of the monetary base. Through the banking system, growth of the monetary base results in growth of the monetary aggregates. 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? Answer: Money growth + velocity growth = growth of nominal GDP, so nominal GDP would rise by (6-5)/5*100 percent + 0 percent = 20 percent. Nominal GDP growth = inflation rate + real growth, so inflation = 20 percent 3 percent = 17 percent. 4. If velocity were predictable but not constant, would a monetary policy that fixed the growth rate of money work? Answer: We know that money growth + velocity growth = inflation + real growth. If velocity is not constant, then fixing the growth rate of money will result in unstable inflation. However, since velocity is predictable, policymakers could increase money growth at the same rate that velocity is decreasing (or decrease money growth at the same rate that velocity is increasing) in order to stabilize inflation. 5. Nobel-prize winning economist Milton Friedman suggested that the Federal Reserve could control the quantity of money more accurately by changing certain financial regulations. Describe the changes he suggested and explain the effects they might have. Do you think such changes would have an impact on velocity? Why or why not? Answer: Friedman suggested increasing the reserve requirement or restricting the number and types of loans that banks could make in order to limit banks control over the rate at which money is created. Friedman thought this would reduce the volatility of the money multiplier and allow the central bank to be more successful at controlling the quantity of money. However, technology has enabled banks to work around the reserve requirements, so increasing the requirements is not likely to have a large effect. Also, the money multiplier

is determined both by the level of excess reserves held by banks and by the amount of currency that consumers desire to hold; even if the central bank tightens certain financial regulations, changes in the behavior of consumers would still impact the velocity of money, making it difficult for central bankers to accurately control the growth rate of money. 6. Using data from website of the Federal Reserve Bank of St. Louis, compute the velocity of M2 over the past five years. To do so, convert the monthly, seasonally adjusted M2 data to quarterly data by averaging the three months in each quarter together. Plot the points you have computed and discuss the likely causes of recent fluctuations. Answer:
M2 Velocity
2.1 2 Velocity 1.9 1.8 1.7 1999

2000

2001

2002

2003

2004

The velocity of M2 has fallen over most of the past 5 years but has risen slightly over the past 3 quarters. The decrease in the velocity of money from 2000 to 2003 can probably be attributed to an increase in the demand for money due to lower interest rates, higher perceived riskiness of alternative investments, and lower returns to alternative investments. Recently, the velocity has risen as returns to alternatives have increased and riskiness of alternatives has decreased. 7. Using the numbers in the example on page 533, compute the monthly interest rate above which a twice-monthly shift in funds from your interest-bearing bond fund to your checking account would become worthwhile. Answer: You would start with $1000 in your checking account and $2000 in the bond fund. After 10 days, you would transfer $1000 into the checking account, leaving $1000 in the bond fund. After 20 days, you would transfer the remaining $1000 in the bond fund into the checking account. This strategy would be worthwhile if the net interest income you earn is greater than the net interest income you would earn if you shifted your funds between the bond fund and your checking account once a month. The net interest income you would earn from shifting funds once a month is $750i$2 (see page 534). If you shift your funds twice a month, you would have an average balance of $1000 in the bond fund over the course of the month ($2000 for the first 10

days, $1000 for the second 10 days, and $0 for the final 10 days). It would cost you $4 to transfer your funds twice. Your net interest income would equal $1000i-$4. At any rate above the interest rate i that equates 750i 2 with 1000i 4, you will want to shift your funds twice a month. Here, i = 0.8 percent. 8. If the interest rate on bonds dropped to zero, what would happen to the transactions demand for money? Answer: The opportunity cost of holding money would fall and the transactions demand for money would rise. 9. Suppose that expected inflation rises by 3 percent at the same time that the yields on money and on nonmoney assets both rise by 3 percent. What will happen to the demand for money? What if expected inflation rose by only 2 percent? What if the yield on nonmoney assets rose by 4 percent? Answer: If expected inflation rises by 3 percent as the yields on money and on non-money assets rise by 3 percent, the expected real yields on money and on non-money assets are 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 non-money assets both rise by 1 percent and the demand for money will once again be unaffected. If the yield on non-money assets rises by 4 percent while the yield on money rises by only 3 percent, then the return to alternative investments relative to the return on money rises, regardless of the level of inflation. This reduces the portfolio demand for money. 10. Do you think money demand should be higher in cities or in rural areas? Explain your answer. Answer: In a big city, there is generally at least one ATM every few blocks; however, in rural areas, ATMs are less ubiquitous. Because withdrawing cash from their accounts is not as convenient for people in rural areas, they would have a higher transactions demand for money. 11. If people suddenly lost faith in the banking system, what would happen to the demand for money? What impact would their loss of confidence have on inflation? Answer: If people lost their faith in the banking system, they would not want to use checking accounts or own money market mutual funds or CDs. This would decrease the demand for money, which in turn would increase the velocity of money. Growth in the velocity of money would cause inflation to rise. 12. Provide arguments both for and against the Federal Reserves adoption of a target growth rate for M2. What assumptions would be necessary to compute such a target rate?

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 necessarily translate to control over inflation. If the Fed were to compute a target rate, it would need to make assumptions about the velocity of money; it would need to predict the behavior of both banks and consumers in order to make assumptions about the link between the monetary base and the quantity of M2. 13. Using data from FRED II at the Federal Reserve Bank of St. Louis, compute M1 and M2 velocity over the past year. (You will need to convert the monthly M1 and M2 data to quarterly data. Do this by taking the middle month of each quarter.) Answer: Nominal GDP (in billions) 10024.8 10088.2 10096.2 10193.9 10329.3 10428.3 10542.0 10623.7 10735.8 10846.7 11107.0 11262.0 11459.6 M1 (in billions) 1099.433 1115.618 1147.374 1166.567 1186.182 1184.103 1182.926 1204.503 1235.090 1258.015 1281.526 1283.163 1305.956 M2 (in billions) 5027.159 5151.943 5252.737 5397.139 5504.600 5550.854 5650.148 5765.869 5866.211 5984.322 6105.575 6062.237 6110.904 M1 Velocity 9.118155 9.042701 8.799398 8.738375 8.708023 8.80692 8.9118 8.819986 8.692322 8.622075 8.667011 8.776749 8.774874 M2 Velocity 1.994128 1.958135 1.922084 1.88876 1.876485 1.878684 1.865792 1.842515 1.830108 1.812519 1.819157 1.85773 1.875271

2001 Q1 2001 Q2 2001 Q3 2001 Q4 2002 Q1 2002 Q2 2002 Q3 2002 Q4 2003 Q1 2003 Q2 2003 Q3 2003 Q4 2004 Q1

During this period the U.S. economy was recovering from a brief recession, which helps explain the fall in velocity. 14. Describe the impact of financial innovations on the demand for money and velocity. Answer: Financial innovations reduce the demand for money and increase velocity. By making alternatives to money more liquid, individuals need less money as a means of payment. My providing a broader array of financial instruments that can be used as stores of wealth; innovations have reduced the use of traditional money as a store of wealth. Since we never know exactly when the innovations will occur, it is difficult to predict the path of velocity over short-run period of a year or two. 15. Comment on the ECBs use of the reference value for money growth.

Answer: Observers claimed that the relationship between money growth and inflation was too unpredictable to be useful in the short run. They argued that the velocity of money in the newly created euro-area would be difficult to forecast. For a new central bank with no proven record of controlling inflation, they charged, this was a potentially dangerous move that could damage policymakers credibility. Even from the data provided in Figure 20.10, it appears that there are significant short-run fluctuations in the velocity, making it of limited usefulness for day-to-day policymaking.