Deck 16: The Demand for Money

Question 1

The next two questions are related to the material in the appendix.
a. Determine the optimal strategy for cash management for a person who earns $1,600 per month, can earn.5 percent interest per month in a savings account, and has a transaction cost of $1. ( Hint: Integer constraints matter here.)
b. What is the individual's average cash balance
c. Suppose income rises to $1,800. By what percentage does the individual's demand for money change

Answer 1

The Baumol-Tobin transaction demand model analyses the relationship between the opportunity cost i.e. nominal interest lost by holding the money in hand, while the money saved by avoiding the transaction cost by having cash not deposited in bank.
The optimal number of transactions cost of cash management can be obtained as shown below:
where
Y is income,
i is interest rate and
is transaction cost.
The given information is as follows:
Income is $1,600 per month.
The interest rate is 5% per month.
The transaction cost is $1.
a.
Substitute the above values in the equation 1 and obtain the optimal cash demand as shown below:
b.
Calculate the average cash balance as shown below:
Therefore, the average cash balance is $400.
c.
The income changes from 1600 to 1800. Calculate the optimal number of transactions cost of cash management as shown below:
.
Calculate the average cash balance as shown below:
.
The percentage change in the individual demand for money changes is as follows:
Therefore, the increase in income leads to a rise in the demand for money by 12.5%.

Question 2

Explain the concept of the opportunity cost of holding money.

Answer 2

Money is an asset to the public.
Public has two choices either to keep money as cash or keep the money in bank which banks can invest.
The money held as cash does not earn any interest whereas the money kept in bank erans interest.
The opportunity cost of money is the interest forgone on the money held as cash.
When people keep money as cash they forgo the interest on that money. That interest is known as opportunity cost of money.

Question 3

The demand for nominal balances rises with the price level. At the same time, inflation causes the real demand to fall. Explain how these two assertions can both be correct.

Answer 3

Nominal money is the money without adjusting price level.
Real money is the purchasing power.
When money increases by 10% and price also increases by 10% then nominal money increases by 10% and real money is constant.
When price increases, purchasing power of consumer decreases. People need more money to buy same quantity of goods.
Therefore, nominal balance rises with the price level.
The real value of money is calculated as follows:
As the price increases, real value falls.
With the fall in real value, demand falls.
Therefore, with increase in price, demand for nominal money increases while demand for real money decreases.

Question 4

"Muggers favor deflation." Comment.

Question 5

What is money, and why does anyone want it

Question 6

The chapter reviewed the different measures of money stock ( M 1 and M 2). You can use any of these money stock measures in order to determine the velocity of money. What is the relationship between M 1 velocity and M 2 velocity Which is the largest and which is the smallest Go to http://research.stlouisfed.org/fred2. Download data for M 1 and M 2 stock by clicking on "Categories," under "Money, Banking, Finance" select "Monetary Data." Then, download GDP data (under "National Accounts," select "National Income Product Accounts," "Gross Domestic Product (GDP) and Components"). Divide the GDP series by the M 1 (or M 2) series, since velocity of M 1 (or M 2) is simply GDP divided by M 1 (or M 2) stock. Then, take a look at these two alternative velocity measures in order to confirm the answer you got for the previous question.

Question 7

Evaluate the effects of the following changes on the demand for M 1 and M 2. Which of the functions of money do they relate to
a. "Instant-cash" machines that allow 24-hour withdrawals from savings accounts at banks.
b. The employment of more tellers at your bank.
c. An increase in inflationary expectations.
d. Widespread acceptance of credit cards.
e. Fear of an imminent collapse of the government.
f. A rise in the interest rate on time deposits.
g. The rise of e-commerce.

Question 8

To what extent would it be possible to design a society in which there was no money What would the problems be Could currency at least be eliminated How (Lest all this seem too unworldly, you should know that some people are beginning to talk of a "cashless economy" in this century.)

Question 9

Is there today in real terms more U.S. currency outstanding per capita than 30 years ago To answer this question, go to http://research.stlouisfed.org/fred2 and get the data in order to fill in the first three columns of the table. To get the currency data, click on "Categories," under "Money, Banking, Finance" select "Monetary Data," then on "M1 and Components," and on "CURRNS." Population can be found under "Population, Employment, Labor Markets" and CPI data can be found under "Prices" then "Consumer Price Indexes (CPI and PCE)."

Question 10

Is velocity high or low relative to trend during recessions Why
b. How can the Fed influence velocity

Question 11

Do you think credit card credit limits should be counted in the money stock Why or why not

Question 12

The next two questions are related to the material in the appendix.
The transactions demand-for-money model can also be applied to firms. Suppose a firm sells steadily during the month and has to pay its workers at the end of the month. Explain how the firm would determine its money holdings.

Question 13

Discuss the various factors that go into an individual's decision regarding how many traveler's checks to take on a vacation.