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Chapter 10
The Demand for Money
 Multiple Choice Questions
1.
In developing early theories about money demand, economists limited their view of money to
(a) its function as a medium of exchange.
(b) its function as a store of value.
(c) its function as a means of deferred payment.
(d) gold and silver coins.
2.
People use money primarily
(a) to carry out transactions.
(b) as a measure of their income.
(c) as a measure of their wealth.
(d) as an asset in their portfolios.
3.
The premise of the quantity theory of money demand is
(a) only gold and silver coins have value.
(b) it is only the quantity of money, and not its quality, that counts.
(c) the most obvious reason that households and businesses demand money is for use in making
transactions.
(d) the store of value function of money is more important than the medium of exchange function of
money.
4.
A key problem with the basic quantity theory of money is that it
(a) did not apply to money in its role as a medium of exchange.
(b) failed to explain completely actual changes in real money balances.
(c) assumed that prices did not change.
(d) assumed that the stock of money did not change.
The demand for money for transactions is
(a) independent of the price level.
(b) likely to fall during periods of inflation.
(c) proportional to the price level.
(d) constant over long periods of time.
5.
6.
Since 1965, the price level in the United States has
(a) remained roughly the same.
(b) declined by about 50%.
(c) roughly doubled.
(d) more than quadrupled.
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Hubbard • Money, the Financial System, and the Economy, Fifth Edition
7.
In order to buy in 2003 a bundle of goods that cost $100 in 1965, you would need roughly
(a) $104.
(b) $200.
(c) $400.
(d) $2400.
8.
If nothing else changes, a higher price level
(a) increases the value of real money balances.
(b) leads to a proportionately higher nominal demand for money.
(c) leads to a proportionately lower nominal demand for money.
(d) decreases the value of nominal money balances.
9.
If nominal money balances increase from $2 billion to $3 billion, while the price level increases
from 100 to 150, real money balances will
(a) have increased by 50%.
(b) have decreased by 50%.
(c) have increased by 100%.
(d) be unchanged.
If nominal money balances increase from $2 billion to $3 billion, while the price level increases
from 100 to 200, real money balances will
(a) have increased by 25%.
(b) have decreased by 25%.
(c) have increased by 100%.
(d) have decreased by 100%.
10.
11.
Real money balances equal
(a) MP.
(b) M/P.
(c) P/M.
(d) nominal money balances.
12.
When did Irving Fisher first develop the quantity theory of money demand?
(a) Late 1700s
(b) Early 1800s
(c) Early 1900s
(d) Late 1990s
13.
The American economist who developed the quantity theory of money demand in the early 1900s
was
(a) Milton Friedman.
(b) John Maynard Keynes.
(c) Glenn Hubbard.
(d) Irving Fisher.
14.
The velocity of money represents
(a) the total number of times a dollar is spent on a purchase of final goods and services.
(b) the average number of times a dollar is spent on a purchase of final goods and services.
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15.
The Demand for Money
355
(c) the speed with which one country’s currency may be converted into another country’s currency.
(d) how quickly paper currency wears out and must be replaced.
Transactions velocity
(a) was rejected by Irving Fisher as the correct definition of velocity in the quantity theory of
money demand.
(b) is much smaller than the value of velocity obtained from dividing GDP by the money stock.
(c) is much smaller than the value of velocity obtained from dividing the money stock by GDP.
(d) is much larger than the value of velocity obtained from dividing GDP by the money stock.
16.
The volume of transactions is
(a) greater than GDP, because GDP does not include purchases of assets.
(b) greater than GDP, because GDP does not include spending by the government.
(c) smaller than GDP, because GDP includes purchases of assets which are not included in the
volume of transactions.
(d) smaller than GDP, because data on the volume of transactions are published monthly, whereas
data on GDP are published annually.
17.
Velocity equals
(a) PY/M.
(b) M/PY.
(c) MP/Y.
(d) MY/P.
18.
If the quantity of money is $4 trillion and nominal GDP is $8 trillion, velocity is
(a) 0.5.
(b) 2.
(c) $32 trillion.
(d) not computable unless the value of the price level is given.
19.
If the quantity of money is $1 trillion and real GDP is $4 trillion, velocity is
(a) 0.25.
(b) 4.
(c) $4 trillion.
(d) not computable unless the value of the price level is given.
If on average a dollar is spent five times each year to purchase goods and services in the economy,
then
(a) the value of velocity must be 0.2.
(b) the value of velocity must be 5.
(c) the value of nominal GDP divided by the money supply must be 0.2.
(d) the value of the money supply divided by nominal GDP must be 5.
20.
21.
The correct expression for the equation of exchange is
(a) PV  MY.
(b) VY  MP.
(c) MV  PY.
(d) M/P  VY.
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Hubbard • Money, the Financial System, and the Economy, Fifth Edition
22.
The equation of exchange
(a) holds better for some periods of time in the United States than for other periods of time.
(b) holds better for certain countries than for other countries.
(c) is an identity and therefore always holds.
(d) has been disproved by modern economic analysis.
23.
The equation of exchange is an identity because
(a) it has been shown empirically to hold in many different times and places.
(b) it defines the money supply to be equal to currency plus checkable deposits.
(c) of the way velocity is defined.
(d) the price level is assumed to be constant.
24.
In order to convert the equation of exchange into a theory of money demand, we need to rewrite it as
(a) V  PY/M.
(b) M/P  (1/V)Y.
(c) M  PY/V.
(d) P/M  V/Y.
Irving Fisher converted the equation of exchange into a theory of money demand by assuming that
(a) nominal balances always equal real balances.
(b) velocity is a constant.
(c) inflation is always zero.
(d) short-term interest rates always equal long-term interest rates.
25.
26.
According to Irving Fisher, the demand for real money balances should
(a) be constant.
(b) equal the reciprocal of velocity.
(c) be proportional to the level of real transactions.
(d) equal the price level multiplied by the volume of real transactions.
27.
In the quantity theory of money demand,
(a) velocity is assumed to be constant.
(b) the demand for real balances is determined by the price level.
(c) the price level is assumed to be constant.
(d) velocity is assumed to vary with the price level.
28.
Which of the following is a key assumption of Irving Fisher’s quantity theory of money demand?
(a) Increases in the price level reduce the level of real money balances.
(b) The price level is always constant.
(c) The money supply is always constant.
(d) Velocity is always constant.
29.
During the 1980s, the velocity of M1
(a) was constant.
(b) fluctuated, but within a narrow band.
(c) experienced significant instability.
(d) fell to zero.
After 1987, the Fed
30.
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(a)
(b)
(c)
(d)
The Demand for Money
stopped targeting M1 growth, but continued to target M2 growth.
stopped targeting M2 growth, but continued to target M1 growth.
stopped targeting either M1 or M2 growth.
continued to target both M1 and M2 growth.
31.
From 1959 to 1989, M2 velocity
(a) declined sharply.
(b) increased sharply.
(c) declined during the 1960s and then increased during the 1970s and 1980s.
(d) was stable.
32.
Most of the collapse in M2 growth during the early 1990s can be explained by
(a) high inflation rates.
(b) the drop in the amount of small time deposits.
(c) a movement out of currency and into checking account deposits.
(d) a movement out of checking account deposits and into currency.
33.
In the period since 1914,
(a) M1 velocity has been roughly constant.
(b) M2 velocity has been roughly constant.
(c) neither M1 nor M2 velocity has been constant.
(d) both M1 and M2 velocity have been roughly constant.
34.
Which of the following statements is true concerning the velocity of M1?
(a) It declined during most of the period from the late 1940s to 1980 but rose during the 1980s.
(b) It has increased during most of the period since the late 1940s.
(c) It has been roughly constant since the late 1940s.
(d) It declined during the 1980s.
Which of the following is a likely causative factor in the movement of M1 velocity during the
1980s?
(a) Movements in interest rates
(b) Exchange rate fluctuations
(c) Changes in marginal tax rates
(d) Political instability in Eastern Europe
35.
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36.
The inclusion in M1 of interest-bearing substitutes for conventional checkable deposits in the early
1980s,
(a) increased the demand for M1 at each level of nominal GDP, thereby decreasing velocity.
(b) decreased the demand for M1 at each level of nominal GDP, thereby increasing velocity.
(c) increased the demand for M1 at each level of nominal GDP, thereby increasing velocity.
(d) decreased the demand for M1 at each level of nominal GDP, thereby decreasing velocity.
37.
Fluctuations in velocity indicate that
(a) changes in money holdings cannot be completely explained by changes in the price level.
(b) changes in money holdings cannot be completely explained by changes in the volume of
transactions.
(c) the Fed will have an easier time in hitting monetary aggregate targets than in hitting interest rate
targets.
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Hubbard • Money, the Financial System, and the Economy, Fifth Edition
(d) inflation must be accelerating.
38.
What are substitutes for money in transactions called?
(a) Transactions factors
(b) Substitution factors
(c) Payment system factors
(d) Credit clearing factors
39.
If people use automated teller machines more frequently, what will happen to M1 velocity?
(a) It will rise.
(b) It will fall.
(c) It will be unaffected.
(d) It will rise, fall, or be unaffected depending upon the size of the money multiplier.
Holding everything else constant, the increased use of credit cards in recent years probably
(a) increased M1 velocity.
(b) decreased M1 velocity.
(c) did not affect M1 velocity.
(d) caused nominal balances to rise more slowly than real balances.
40.
41.
If credit card companies imposed a per purchase charge for using their cards,
(a) money balances would fall, and the velocity of money would rise.
(b) money balances would rise, and the velocity of money would fall.
(c) both money balances and the velocity of money would fall.
(d) both money balances and the velocity of money would rise.
42.
The quantity theory of money
(a) included the interest rate, but did not include income as a factor in the demand for money.
(b) included income, but did not include the interest rate as a factor in the demand for money.
(c) did not include either income or the interest rate as factors in the demand for money.
(d) included both income and the interest rate as factors in the demand for money.
43.
The effects of interest rates on the transactions demand for money
(a) were explored by Irving Fisher.
(b) are usually considered to be negligible by modern economists.
(c) are of importance only during recessions.
(d) were explored by William Baumol and James Tobin.
44.
The economist who has expanded the Baumol-Tobin approach to address effects of shifts between
money and nonmoney assets on the economy is
(a) Milton Friedman.
(b) David Romer.
(c) Stephen Goldfeld.
(d) Ray Fair.
In the Baumol-Tobin view of the transactions demand for money,
(a) economic agents do not adjust their money holdings in the face of interest rate fluctuations.
(b) economic agents trade off the benefits of holding money against the cost of interest foregone
from holding bonds.
45.
Chapter 10
The Demand for Money
(c) the quantity of money demanded will rise only if the interest rate rises.
(d) the quantity of money demanded will rise only if the interest rate falls.
46.
In the Baumol-Tobin view, a decrease in interest rates will cause individuals to hold
(a) larger money balances, and velocity will increase.
(b) larger money balances, and velocity will decrease.
(c) smaller money balances, and velocity will increase.
(d) smaller money balances, and velocity will decrease.
47.
In the Baumol-Tobin view, an increase in interest rates will cause individuals to hold
(a) larger money balances, and velocity will increase.
(b) larger money balances, and velocity will decrease.
(c) smaller money balances, and velocity will increase.
(d) smaller money balances, and velocity will decrease.
48.
According to Baumol and Tobin, the transactions demand for money is
(a) negatively related to market interest rates, but the velocity of money is positively related to
market interest rates.
(b) positively related to market interest rates, but the velocity of money is negatively related to
market interest rates.
(c) negatively related to market interest rates, as is the velocity of money.
(d) positively related to market interest rates, as is the velocity of money.
49.
The interest rate is a measure of
(a) the opportunity cost of holding real money balances.
(b) the inflation rate.
(c) the opportunity cost of holding bonds.
(d) the growth rate of output in the long run.
The fact that in addition to being a medium of exchange, money serves as a store of value means
that
(a) movements in the interest rate should not affect the demand for money.
(b) movements in the price level should not affect the demand for money.
(c) money competes with other assets in the portfolios of businesses and households.
(d) the demand for real balances should increase more than proportionately with increases in real
income.
50.
51.
An individual with a high income will probably
(a) hold a smaller fraction of her wealth in the form of money than will an individual with a low
income.
(b) hold a larger fraction of her wealth in the form of money than will an individual with a low
income.
(c) hold the same fraction of her wealth in the form of money as will an individual with a low
income.
(d) hold a smaller fraction of her wealth in the form of money than will a large corporation.
52.
Which of the following is true?
(a) The demand for real balances increases more than proportionately with real income.
(b) The demand for real balances increases less than proportionately with real income.
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Hubbard • Money, the Financial System, and the Economy, Fifth Edition
(c) The demand for real balances decreases as real income increases.
(d) The demand for real balances is unaffected by changes in real income.
53.
Money’s convenience yield is
(a) the nominal interest rate paid on money balances minus the expected inflation rate.
(b) the nominal interest rate paid on money balances plus the expected inflation rate.
(c) the amount of interest sacrificed in exchange for money's safety, liquidity, and low information
costs.
(d) the interest rate on T-bills minus the interest rate on money.
54.
Which of the following would cause demand for M1 to increase?
(a) Banks make taking out home equity loans easier.
(b) The market for closed-end stock mutual funds becomes more liquid.
(c) Early withdrawal penalties for certificates of deposit are eliminated.
(d) Several major corporations default on their commercial paper.
In which of the following books did J. M. Keynes first present the liquidity preference theory of the
demand for money?
(a) Money through the Ages
(b) The Theory of Interest
(c) The General Theory of Employment, Interest, and Money
(d) Money, Banking, and the Economy
55.
56.
The liquidity preference theory was developed by
(a) James Tobin.
(b) Milton Friedman.
(c) John Maynard Keynes.
(d) William Baumol.
57.
The liquidity preference theory emphasizes
(a) the transactions motive for holding money.
(b) the sensitivity of money demand to changes in interest rates.
(c) the precautionary motive for holding money.
(d) the effect of price level changes on the demand for real balances.
58.
Keynes referred to the effect of portfolio allocation decisions on the demand for money as the
(a) interest motive.
(b) transactions motive.
(c) precautionary motive.
(d) speculative motive.
59.
Keynes assumed that the expected return on bonds is determined by
(a) the interest rate on the bond.
(b) the interest rate on the bond adjusted for expectations of capital gains or losses on the bond.
(c) the interest rate on the bond adjusted for the expected inflation rate.
(d) the expected inflation rate adjusted for expectations of capital gains or losses on the bond.
Keynes assumed that the return on money was
(a) zero.
60.
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(b) the same as the return on bonds.
(c) the same as the return on bonds, adjusted for capital gains.
(d) the nominal interest rate minus the expected inflation rate.
61.
Keynes believed that people would hold less of their wealth in money when interest rates were high
because
(a) the opportunity cost of holding money would be low.
(b) they would expect a capital gain from holding bonds.
(c) they would expect a capital loss from holding bonds.
(d) when interest rates are high they tend to rise even higher.
62.
Keynes called the willingness of individuals to hold money to pay for unexpected transactions,
(a) the transactions motive.
(b) the impulse motive.
(c) the speculative motive.
(d) the precautionary motive.
63.
According to Keynes’s liquidity preference theory of the demand for money, the demand for money
will
(a) increase when output increases but decrease when the interest rate increases.
(b) decrease when output increases but increase when the interest rate increases.
(c) increase when output or the interest rate increases.
(d) decrease when output or the interest rate increases.
64.
According to Keynes, the demand for real balances is best expressed by which of the following
equations?
(a) M/P  (1/V)Y
(b) M/P  L(Y, i)
(c) M/P  L(Y *, i – iM,  e - iM)
(d) M/V  PY
The expression for velocity derived from Keynes’s liquidity preference theory is
(a) V  P/L(Y, i).
(b) V  L(Y, i)/P.
(c) V  Y/L(Y, i).
(d) V  L(Y, i)/Y.
65.
66.
According to Keynes, if the interest rate on bond falls, but aggregate income doesn’t change,
(a) the demand for money will decrease.
(b) velocity will decrease.
(c) velocity will increase.
(d) the price level will decrease.
67.
Milton Friedman first proposed his explanation of money demand in
(a) the 1800s.
(b) the early 1900s.
(c) 1956.
(d) 1995.
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Hubbard • Money, the Financial System, and the Economy, Fifth Edition
68.
Milton Friedman’s approach to money demand focuses on
(a) currency.
(b) checkable deposits.
(c) M1.
(d) M2.
69.
According to Milton Friedman, permanent income is
(a) income received for a specific period of time under a contract.
(b) nominal income divided by the price level.
(c) expected average income over a lifetime.
(d) income received as interest payments on financial assets.
Friedman’s expression for the demand for real balances is
(a) M/P  L(Y *, i – iM,  e – iM).
(b) M/P  L(Y *, i).
(c) M/P  L(Y *, iM – i,  e – iM).
(d) M/P  L(Y *, i – iM, iM –  e).
70.
71.
An important difference between Keynes’s approach to the demand for money and Friedman’s
approach is that
(a) there is no role for the opportunity cost of holding money in Friedman’s theory.
(b) in Keynes’s theory changes in output have no effect on the demand for money.
(c) in Friedman’s theory money demand responds only slightly to short-run fluctuations in income.
(d) in Keynes’s theory money demand is a function of the real interest rate, rather than the nominal
interest rate.
72.
In Friedman’s theory of money demand, when households expect a high rate of inflation, they will
(a) buy bonds.
(b) buy houses and consumer durable goods.
(c) increase their nominal balances.
(d) increase their real balances.
73.
Which of the following is NOT considered an important determinant of money demand?
(a) The average personal income tax rate
(b) Real income
(c) Payments system developments
(d) The difference between the nominal interest rate and the yield on money
74.
An increase in expected inflation leads to a decline in money demand if
(a) interest payments are taxed at the same rate as wage income.
(b) nominal output increases as least as much as the price level.
(c) market interest rates fall.
(d) market interest rates rise more than the interest paid on money balances.
The most important difference between M1, on the one hand, and M2 and M3, on the other hand, is
that
(a) M1 includes currency, but M2 and M3 do not.
(b) M1 includes checkable deposits, but M2 and M3 do not.
(c) M2 and M3 include assets with less liquidity than those included in M1.
75.
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(d) M2 and M3 include assets with greater liquidity than those included in M1.
76.
Weighted monetary aggregates differ from traditional monetary aggregates in that they
(a) weight included assets by their liquidity.
(b) weight all included assets equally.
(c) include a much broader range of assets.
(d) include a much narrower range of assets.
77.
Divisa aggregates
(a) are another name for weighted aggregates.
(b) differ from weighted aggregates in that they do not include components of M1.
(c) weight the inflation rate, as well as monetary aggregates.
(d) provide a poor fit when estimating money demand equations.
78.
Stephen Goldfeld’s estimate of the demand for money failed to predict the actual level of M1
demanded in the years after 1973 because
(a) nominal interest rates fell to very low levels during those years.
(b) financial innovation produced substitutes for checkable deposits.
(c) the economy suffered through several recessions.
(d) the Fed unexpectedly decided to decrease the rate of growth of M1.
79.
During the early 1980s as interest-bearing checkable deposits were incorporated into the definition
of M1,
(a) the demand for M1 balances increased substantially.
(b) the demand for M1 balances decreased substantially.
(c) the dollar value of M1 became greater than the dollar value of M2.
(d) the nominal return on M1 balances declined.
Changes in the payments system
(a) are rare and their effect on money demand can usually be ignored.
(b) usually result in an increase in money demand.
(c) are hard to incorporate into empirical money demand functions.
(d) cause interest rates to rise, if everything else is held constant.
80.

Essay Questions
1.
George has total wealth of $50,000. He allocates $40,000 to Treasury bills yielding 6% and $10,000
to a NOW account yielding 3%. What value does George place on his checkable deposits? What if
the yield on T-bills rises to 12%?
2.
Irving Fisher originally described velocity using transactions, rather than income or output. Would
velocity calculated using transactions be a larger or a smaller number than velocity calculated using
national income or GDP? Why do economists use income or output, rather than transactions, when
calculating velocity? Under what circumstances might it matter how velocity is defined?
3.
Why do economists and policy-makers view fluctuations in velocity as a problem? What action did
the Fed take in the late 1990s that was related to uncertainty about the behavior of velocity?
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Hubbard • Money, the Financial System, and the Economy, Fifth Edition
Which model of the demand for real balances discussed in this chapter relies solely on the
transactions motive? Is this model able completely to explain observed movements in real balances?
Briefly explain why or why not.