Download ECON 102 Tutorial: Week 23

ECON 102 Tutorial: Week 23
Shane Murphy
www.lancaster.ac.uk/postgrad/murphys4/econ15
[email protected]
Today’s Outline
 Week 23 worksheet – Money and Bonds
 Additional Slides at the end contain material from past
exams – these might be helpful for your revision, so I’ve
included them.
Question 1
Within Keynesian models the demand to hold money is called
‘liquidity preference’ (i.e., a preference to hold ‘money’ as the most
liquid of wealth assets) as the alternative to holding bonds, This is
written (and drawn below) as a demand curve for money: L = L(Y, r);
with L1 > 0; L2 < 0.
a) Explain the respective meanings of L1 > 0; L2 < 0.
liquidity preference increases as (i) income rises: by the need to
undertake more transactions, the demand curve shifts outwards; (ii)
the interest rate falls: there is a movement along the demand curve.
Question 1
Within Keynesian models the demand to hold money is called
‘liquidity preference’ (i.e., a preference to hold ‘money’ as the most
liquid of wealth assets) as the alternative to holding bonds, This is
written (and drawn below) as a demand curve for money: L = L(Y, r);
with L1 > 0; L2 < 0.
b) With an exogenous shift in the money supply (M1 to M2) what is
the reaction by economic agents that causes the interest rate fall from
r1 to r2?
From their initial (asset-portfolio
equilibrium, agents now hold
too much money. Their reaction
is to buy bonds. As bond prices
rise, interest rates fall.
Question 1
Within Keynesian models the demand to hold money is called
‘liquidity preference’ (i.e., a preference to hold ‘money’ as the most
liquid of wealth assets) as the alternative to holding bonds, This is
written (and drawn below) as a demand curve for money: L = L(Y, r);
with L1 > 0; L2 < 0.
c) What is meant by exogenous?
Outside of the model, external to the model.
Question 2
In question 6 of week 18 there is a specific form (MD = 20,000 −
8,000r) of the more general function:
L = L(Y, r)
where L is the demand to hold money (‘MD’)
Y is nominal income
r is the interest rate
The independent variables (Y, r) relate respectively to the transactions
demand to hold money (i.e., the use of money as a means of
exchange) and the speculative demand to hold money (i.e., the use of
money as a store of value).
a) Where money is held for speculative purposes, what is the nature
of the speculation?
That bond prices are likely to fall (leaving a capital
loss to the bondholders).
Question 3
The manner in which the liquidity preference schedule falls
asymptotically (as in the diagram shown above) is described
by Keynes as the ‘liquidity trap.’
a) Give the rationale for the liquidity trap.
There is a fear that bond prices will fall: ‘a long-term rate of
interest of (say) 2 per cent, leaves more to fear than to
hope, and offers, at the same time, a running yield which is
only sufficient to offset a very small measure of fear’ (TGT,
202)
b) Show how the liquidity trap is relevant to a horizontal LM
line.
Question 4
A contemporary of Keynes disparagingly described his
liquidity preference theory of interest rate determination as
a ‘bond price theory’.
a) Explain that description.
Where central bank intervention puts new money into
circulation the result is an increase in the demand for bonds:
as bond prices rise, bond yields fall and, across competitive
money markets generally, interest rates fall.
b) Explain the inverse relationship between bond prices and
interest rates.
The capitalised value of an annuity varies inversely with the
discount rate.
Question 5
Extending the content of question 6 of week 18, UK commercial banks
tend not to operate according to the model found in Economics
textbooks. Therefore,
a) Explain the manner in which a UK commercial bank creates credit
money in 2016
A commercial bank credits the account of a client with £x (the bank’s
liability) and simultaneously writes £x (as the bank’s asset) on the
other side of the balance sheet. When the account holder writes a
cheque, the credit will be transferred to another’s account. Unless
recipients then withdraw banknotes from their accounts, the
commercial bank has created bank credit money. As the liabilities of
commercial banks are transferred between different accounts, those
liabilities are serving as endogenous money; i.e., bank credit money.
Question 5
Extending the content of question 6 of week 18, UK
commercial banks tend not to operate according to the
model found in Economics textbooks. Therefore,
b) Explain how a ‘repo’ allows a commercial bank to obtain
reserves from the central bank
A central bank ‘refinances’ a commercial bank loan by
buying a debt instrument (i.e., a ‘bond’, ‘security’ or ‘iou’) at
price P1, where the commercial bank agrees to repurchase
that security at a later date at price P2 > P1. The interest
paid is determined by the two prices and the duration of the
repo.
Question 6
Explain how a UK building society cannot create credit
money.
UK building societies do not feature within the commercial
bank clearing system wherein bank credit money may
circulate between individuals’ accounts. Instead, building
societies hold accounts with banks to enable them to make
transfers in the same manner as individual holders of
commercial bank deposits make transfers.
Question 7 & 8
7. What is the money base (aka base money, narrow money,
exogenous money, UK - M0)?
Base money is created (new banknotes and reserves) as the
liability of the central bank
8. What is broad money (UK - M4)?
Broad money is the sum of bank credit money and
banknotes in circulation. The exclusion of base money held
as ‘till money’ by commercial banks is necessary to avoid
double-counting.
Next Class
 Week 24 Worksheet
Practice Past Exam Questions
Please Note: Solutions are not given to tutors for these
questions. The solutions I’ve prepared here are my best
guess – I cannot guarantee they are correct.
Note: View in slideshow mode for suggested solutions.
Fiscal monetarists argue that inflation is a
consequence of excessive growth in:
a) revenue from taxation
b) sovereign debt
c) the money supply
d) national output
2013 Exam Q36
As defined in Keynes’s General Theory,
‘involuntary unemployment’ relates to
individuals whose employment
prospects would be raised by
a) a rise in the price of wage goods (i.e., a rise in
the cost of living)
b) a fall in the price of wage goods (i.e., a fall in
the cost of living)
c) greater trade union participation
d) a shift to capital-intensive production methods
2013 Exam Q30
Labour Market:
real wage (W/P)
W/P1
MPL
E1
L1
‘Men are involuntarily unemployed if, in the event of a small rise in the price
of wage-goods (P2 > P1) relative to the money-wage (W), both the aggregate
supply of labour willing to work (L2) for the current money-wage and the
aggregate demand for it at that wage (E2) would be greater than the existing
volume of employment (E1)’ (Keynes, 1936)
2013 Exam Q30
Assuming national income is at the full
employment level, which one of the
following policies would be most likely
to lead to inflation?
a) A fall in taxation with unchanged
Government spending
b) A reduction in investment by firms
c) A fall in exports
d) An increase in labour productivity with no
corresponding increase in wages
2014 Exam Q27
In the IS-LM model, a fall in the money
supply will:
a) Shift the LM curve downwards
b) Cause the interest rate to rise and so raise
investment
c) Cause the interest rate to fall and so raise
investment
d) Cause national income to fall and the interest
rate to rise
2014 Exam Q30
Causation is determined in Keynesian
macroeconomic models by
a) consumers’ behaviour
b) changes in exogenous variables
c) investors’ behaviour
d) changes in endogenous variables
2014 Exam Q40
Keynes’s analysis of the demand to
hold money (i.e., ‘liquidity preference’)
assumes that asset holders speculate
in regard to
a) the exchange rate
b) prices of consumption goods
c) prices of capital goods
d) bond prices
2014 Exam Q34
Money illusion is people failing to
distinguish between
a) Real and money wages
b) Real and nominal interest rate
c) Real and nominal money balances
d) All of the above
2014 Exam Q33
Which aggregate demand curve
indicates a situation of inflationary
The diagram below refers to questions 31 and 32 and
demand?
shows aggregate demand (D) curves and an aggregate
a)D1
b)D2
c) D3
d)D4
supply curve (S) for an economy.
2014 Exam Q33
An increase in aggregate demand
above D3 will lead to:
a) More goods and services
being produced
b) Fewer goods and services
being produced
c) The same amount of
goods and services being
produced
d) It is impossible to tell
The diagram below shows aggregate demand
(D) curves and an aggregate supply curve (S)
for an economy.
2014 Exam Q34