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Classical monetary theory assumes that the velocity of money is constant. The only reason that people want to hold money is for spending. The relationship between the quantity of money that people want to hold and the quantity that they want to spend will be constant. Thus, if nominal GDP increases by 5%, M will also increase by 5% and V will remain constant. Q (Real GDP) is also assumed to be constant in the short run. Since (according to classical theory) the economy is self-regulating and automatically adjusts towards Natural Real GDP, it will tend to be close to Natural Real GDP at all times. Real GDP will not change significantly in a short period of time. If V is constant and Q is constant, then there must be a directly proportional relationship between M (money supply) and P (price level). This is illustrated in Example 2A. Example 2A: Assume that the equation of exchange numbers are originally; M = $2,000 billion, V = 8, P = 1.00, Q = $16,000 billion. Then the money supply increases by 10%. The price level also increases by 10%, as illustrated below: M x V = P x Q $2,000B x 8 = 1.00 x $16,000B +10% +0% +10% +0% $2,200B x 8 = 1.10 x $16,000B $17,600B = $17,600B Classical monetary theory sees a directly proportional relationship between the money supply and the price level. In the actual economy, velocity has not been constant. Velocity rose during the 1970s, was fairly stable through the 1980s to the mid-1990s, rose in the late 1990s, rose again from 2005 to 2007, and then decreased by about 40% from 2008 to mid-2014. If velocity is not constant, there will not be a directly proportional relationship between the money supply and the price level. Example 2B: Assume the same original equation of exchange numbers as in example 2A. Then the money supply increases by 10% and velocity decreases by 5%. What happens to the price level? The price level increases by 4.5%, as illustrated below: M x V = P x Q $2,000B x 8 = 1.00 x $16,000B +10% -5% +4.5% +0% $2,200B x 7.6 = 1.045 x $16,000B $16,720B = $16,720B In the long run, increases in the money supply do tend to cause increases (but not directly proportional increases) in the price level. The inaccuracy of classical monetary theory (especially in the short run) led to the development of the theory called monetarism. Monetarism Monetarism is an economic theory based on classical theory, but with some differences from classical monetary theory. Monetarism holds that: 1. Velocity is not constant, but changes in predictable ways. Changes in certain variables will cause velocity to change. The variables include the interest rate and the expected rate of inflation. Monetarists see velocity as relatively stable in the long run. (Classical monetary theory holds that velocity is constant.) FOR REVIEW ONLY - NOT FOR DISTRIBUTION Monetary Policy 12 - 2
2. A change in aggregate demand (AD) can be caused by a change in the money supply and/or by a change in the velocity of money. AD depends on the money supply (how much money is available to spend) and on velocity (how rapidly the money is spent). An increase in the money supply and/or an increase in velocity would increase AD. A decrease in the money supply and/or a decrease in velocity would decrease AD. (Classical monetary theory holds that only changes in the money supply affect AD, since the velocity of money is constant.) 3. Changes in AD will change both the price level and Real GDP in the short run. Monetarists see the SRAS curve as upward sloping. An increase in AD will cause an increase in both the price level and Real GDP. A decrease in AD will cause a decrease in both the price level and Real GDP. (Classical monetary theory sees the aggregate supply curve as vertical in both the short run and the long run. Thus, classical monetary theory holds that changes in AD affect only the price level, both in the short run and in the long run.) Example 3A: The graph below illustrates the effect of an increase or a decrease in AD, assuming that the SRAS curve is upward sloping. Both the price level and Real GDP are changed by a change in AD. This represents the monetarist view. Price Level Real GDP SRAS AD3 AD1 AD2 Example 3B: The graph below illustrates the effect of an increase or a decrease in AD, assuming that the SRAS curve is vertical. A change in AD affects only the price level. This represents the classical view. Price Level Q N SRAS AD3 AD1 AD2 FOR REVIEW ONLY - NOT FOR DISTRIBUTION Real GDP 12 - 3 Monetary Policy
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PRINCIPLES OF ECONOMICS JEFF HOLT S
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Principles of Economics, 6th Editio
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16. Study Guide for Chapter 7 17. C
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11. Appendix: Book Review - “The
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20. Appendix: The NCAA Cartel 21. S
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Introduction: A Brief History of U.
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In the twentieth century, per capit
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Appendix: The 35 Largest National E
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Multiple Choice: ___ 1. The Jamesto
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2. Describe the economic cost of th
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Chapter 1 Scarcity and Choices The
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Example 5B: At the end of 1982, the
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Example 11: When Cindy quits her jo
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consequences may result in failure
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An upward sloping curve (as in Exam
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In making decisions, humans tend to
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5. ______________________ _________
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___ 13. If the value of one variabl
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Y Point X Y A 0 1 B 3 3 C 6 5 D 9 7
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Chapter 2 Trade and Economic System
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Example 4B: The following quantitie
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1. An increase in the quantity of r
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3. For whom to produce? This is det
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The graph below illustrates the shi
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The two primary economic systems ar
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___ 12. The capitalist vision sees
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___ 25. According to the book “Ca
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Chapter 3 Demand, Supply, and Equil
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. For inferior goods, income and de
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The same information can be placed
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Not only does a free market elimina
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$7 - 6 - 5 - S 3 S1 S 2 Price 4 - 3
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Example 17: The graph below illustr
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Questions for Chapter 3 Fill-in-the
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___ 12. Assuming a market originall
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$8 - 7 - 6 - 5 - Price 4 - 3 - 2 -
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Chapter 4 Inflation and Unemploymen
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Computing the Rate of Inflation The
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Full Employment Though unemployment
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3. Cyclical unemployment - due to d
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During the Great Depression, the ec
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Appendix: Think Like an Economist -
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Answer questions 8. and 9. based on
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___ 25. The extension of unemployme
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Chapter 5 Measuring Total Output: G
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5. Leisure. Leisure time is by defi
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The U.S. is a high per capita GDP c
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Example 17: In “An International
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The simple circular flow diagram be
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___ 3. Which of the following would
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2. Explain what nonproduction trans
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Chapter 6 The Aggregate Market The
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Example 2C: Assume the same facts a
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Example 5B: The price of crude oil
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Price Level Real GDP SRAS AD 2 AD 1
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Appendix: Why the Aggregate Demand
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___ 3. DEF Company can invest in ne
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2. List and explain the two factors
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Chapter 7 Classical Economic Theory
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Notice that the investment demand c
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Long-Run Equilibrium If Real GDP is
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Example 6B: When the economy is in
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Laissez-faire If the economy is sel
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___ 5. According to Say’s Law: a.
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3. On the graph below, draw an aggr
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Chapter 8 Keynesian Economic Theory
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Example 2B: The graph below illustr
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Example 5: Assume that the table be
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Notice on the graph on the previous
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According to Keynesian theory, a ch
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“The General Theory” also inclu
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___ 8. If the consumption function
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3. If the MPC is .667, and investme
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Page 167 and 168: Demand-side One-shot Inflation Exam
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Page 185 and 186: Relaxed Standards for Mortgage Loan
Page 187 and 188: The Bursting of the Housing Bubble
Page 189 and 190: On February 17, 2009, the federal g
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Page 239 and 240: will increase both Real GDP and per
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Obstacles to Economic Development f
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c. Restrictions on international tr
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Appendix: Book Review - “The Powe
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Example 25: In Brazil, about half t
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Study Guide for Chapter 15 Chapter
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___ 13. Among the counterproductive
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4. List four ways that governments
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Chapter 16 International Trade The
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Other Benefits of Free Internationa
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Example 6: The graph below illustra
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competitive disadvantage. But dumpi
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is only 25% as productive as before
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Smith was skeptical of government a
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___ 4. For Country X, what is the o
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___ 18. Frédéric Bastiat’s “P
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4. On the graph below: (1) What is
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Chapter 17 Elasticity We are often
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Example 4A: What is price elasticit
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Example 5A: Gertie’s Gas and Go i
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Example 10A: When the price of Good
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Example 13B: On the graph below, su
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$7 - 6 - 5 - Price 4 - 3 - 2 - 1 -
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In the long run, would the deadweig
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___ 7. The factors that determine w
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3. a. Which price (or prices) from
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Chapter 18 Utility The basic econom
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Nonetheless, society generally assu
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Example 9: Capital City operates a
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Marginal rate of substitution - the
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The diamond-water paradox is the ob
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Complete the table below to answer
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4. The graph below shows indifferen
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Chapter 19 The Firm The basic econo
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than contributing to team productio
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1. Difficulty in raising large amou
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Corporations also use self-financin
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Example 24: A blacksmith who produc
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For financing needs, proprietorship
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___ 13. Corporations: a. are comple
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5. List two things that the absence
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Chapter 20 Production and Costs The
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In Example 5B, Birdwell finds that
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variable cost initially decreases,
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Quantity TC MC AFC AVC ATC 0 240 X
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If the scale of operation is increa
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average total cost. Average fixed c
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___ 11. Concerning the cost curves:
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5. Complete the following cost tabl
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Chapter 21 Perfect Competition The
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Even though a perfect competitor ca
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Example 6C: This example builds on
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At what price will there be neither
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Appendix: Perfect Competition in th
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Multiple Choice: ___ 1. A perfect c
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___ 17. Perfect competition: a. req
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Answers for Chapter 21 Fill-in-the-
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Chapter 22 Monopoly Of the four mar
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3. Exclusive ownership of an essent
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maximizing quantity (4 units) creat
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$22 - 20 - 18 - 16 - 14 - Deadweigh
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2. Negotiating, beginning at a high
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Legal barriers are created by gover
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___ 8. The slope of the demand curv
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Price Quantity 3. List some of the
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Chapter 23 Monopolistic Competition
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For Percomp (the perfect competitor
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Example 7A: The graph below represe
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Example 9: The Organization of the
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Example 12 illustrates the dilemma
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its current price and quantity. The
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___ 14. Game theory: a. is a method
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Answers for Chapter 23 Fill-in-the-
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Chapter 24 Factor Markets The basic
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$ $240 - 200 - 160 - 120 - 80 - 40
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Since producers will attempt to equ
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2. Differences in nonmoney aspects
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were his strikeouts, walks, and hom
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___ 3. To maximize profits, a produ
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___ 19. According to the book, “M
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Multiple Choice: 1. a. 8. c. 15. d.
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Chapter 25 Labor Unions The primary
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The elasticity of demand for union
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Example 4A: Assume that the graph b
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Notice from the graph in Example 6
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Wage Factory A Quantity of Labor S
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As a cartel, a labor union faces a
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___ 10. For a monopsony: a. there i
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3. The graph below represents a lab
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Chapter 26 Interest, Present Value,
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An increase in expected rates of re
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An asset is valuable because we exp
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Example 13B: General Ordnance prove
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Appendix: Present Value Table One f
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___ 4. An increase in expected rate
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Problems: 1. List and explain the t
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Chapter 27 Market Failure The basic
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External Benefit If a market genera
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Example 2: To encourage the consump
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$100 - 90 - 80 - MSC 70 - $ 60 - 50
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A common good is nonexcludable. Non
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___ 5. What government policy would
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4. Based on the information on the
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Chapter 28 Public Choice and Govern
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Candidates and the Median Voter Mod
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Example 8: According to State and F
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Example 10: When Elvis Presley was
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4. Pessimistic bias. This is the te
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___ 5. An elected official will: a.
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2. If a certain policy will yield s
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Chapter 29 Government Regulation of
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underproduction is the amount that
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micromanagement results in business
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market. They may agree with their c
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Questions for Chapter 29 Fill-in-th
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___ 10. The public interest theory
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4. List the four types of costs imp
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Chapter 30 Agriculture and Health C
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weather may cause bumper crops. Bad
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Security and Rural Investment Act o
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Example 12: From 1960 to 2013, the
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1. NHI would provide universal heal
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d. Insurance providers are not allo
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Answer questions 7. through 10. by
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___ 21. If there were no individual
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Chapter 31 Income Distribution and
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Income is more equally distributed
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over a typical career is the accumu
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Ideal Income Redistribution The ide
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Poverty - a family whose income fal
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Appendix: Income Inequality around
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How is this story an analogy for th
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___ 2. In 2013, the Lowest Income 6
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Problems: 1. Explain the two primar
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Absolute advantage - when one natio
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Fiat money - money by government de
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Nonrivalrous good - a good for whic
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Absolute advantage, 16-9 Absolute e
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“Company town”, 25-6 Comparativ
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Eli Lilly and Company, 22-1 Emergen
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Houston, Texas, 15-10 Human capital
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Market, 3-1, 3-8-9 Market basket, 4
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Political bias, 9-4, 12-7 Political
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Short run production, 20-2-3 Short-
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Upturns, 9-4 USDA, 27-9, 30-1-2, 30
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