Keynesian EconomicsMonetarismTest Item File 3: Principles of Macroeconomics 19(32) Debates in Macroeconomics: Monetarism, New Classical Theory, and Supply-Side Economics Keynesian Economics1. Explain what the velocity of money means.The velocity of money is the number of times a dollar bill changes hands (in an income or final output transaction), on average, during a year; the ratio of nominal GDP to the stock of money.Difficulty: E Type: D2. Write out the equation for the income velocity of money and identify each term.V = GDP M GDP is gross domestic product and M is the money supply.Difficulty: E Type: A3. If $9 trillion worth of final goods and services are produced in a given year and if themoney stock is $3 trillion what is the velocity of money?V = $9 trillion/$3 trillion = 3Difficulty: E Type: A352Test Item File 3: Principles of Macroeconomics4. What is the equation that the quantity theory of money uses and its assumption?The quantity theory of money is based on the identity M x V = P x Y where M is the stock of money, V is the velocity of money (the rate of change over of money) , P is the price level and Y is output. It also assumes that the velocity of money (V) is constant (or virtually constant). Difficulty: E Type: A5. Explain the key concepts of Keynesian economics. Why do Keynesians still support monetary and fiscal policy intervention even though it is clearly not capable of perfectly"fine-tuning" the economy? Define and explain the basic equations of Keynesians and Monetarists. Hint: aggregate expenditures. Keynes was really the first to emphasize aggregate demand and the connection between the money and goods markets. Keynes also emphasized the problem of "sticky" or downwardly inflexible wages. Keynesian economics is often associatedwith active government intervention into the economy. Because most Keynesians recognize that stabilization policies, although not perfect, can help prevent even larger economic problems. For example, without the tax cuts and money supply expansion in 1975 and 1982 the recessions in those years could have been much worse. Keynesians are associated with the equation GDP = C + I + G + X - N, whereas monetarists are associated with the quantity theory of money, MV = PQ. Keynesians focus on the coordination of monetary and fiscal policies to manipulate one or all of the variables in the aggregate expenditure function. Monetarists, basically, argue that monetary policy, or changes in the money supply, is the primary determinant of GDP. Difficulty: M Type: A6. Why is it that the quantity theory of exchange equation is written with a double equal sign instead of the triple equal sign?The reason is that the equation is no longer an identity. The equation is true if velocity is constant, but not otherwise.Difficulty: E Type: A7. What did early economists believe to be true about the velocity of money and why?Early economists believed the velocity of money was determined largely by institutional considerations, such as how often people are paid and how the banking system clears transactions between banks. Because these factors change gradually, they believed velocity was essentially constant.Difficulty: E Type: F353Chapter 19 (32): Debates inMacroeconomics 8. Suppose that the money supply is $800 billion. If the velocity of money were only tochange by .2 percent (without a change in the money supply) how much of a change should that elicit in nominal GDP?The change in nominal GDP would be .002 x $800 billion = $1.6 billion.Difficulty: E Type: A9. Why is it important which monetary aggregate we choose when testing the stability ofvelocity?Suppose that there were large shifts of assets from accounts that are in both M1 and M2 to accounts which are only in M2. All other things being equal this would imply an increase in the velocity of money. However, if we chose M2 to measure velocity (with no change in GDP) then velocity would not change at all.Difficulty: E Type: C10. Suppose that an increase in the money supply today of 5 percent increases GDP one year from now by precisely 5 percent. How would this time lag effect the empirical measurement of velocity?If we measure the ratio of today's GDP to today's money supply, it would seem that the velocity of money has fallen by 5 percent. If we measured today's money supply against GDP one year from now, then velocity would have been constant.Difficulty: E Type: CMonetarism11. Assume the money supply grows by 3 percent. According to the "strict monetarists" view what should be the result? (Hint: M x V = P x Y)The "strict monetarists" would conclude that the 3 percent increase in the money supply will simply increase the price level by 3 percent if output remains constant.Difficulty: E Type: F12. Explain how the following statements relate to the velocity of money. Assume a constant money supply.(a) Businesses around the country decide to pay workers only once a month in order to reduce paperwork and improve efficiency.(b) Banks around the country begin using a new check clearing system that allows checks to clear much faster than they did previously. (a) Velocity would fall. This would cause money to change hands fewer times, on average, in a year. When workers are paid only once a month from, say twice a 354Test Item File 3: Principles of Macroeconomicsmonth, this is one less time a month that workers are out there buying things withtheir paychecks. Thus, money, on average, changes hands fewer times in a year.(b) Velocity would increase. This would cause money to change hands more, on average, in a year. When checks clear more quickly, this allows money to circulatein the economy more rapidly. Thus, velocity would increase. Difficulty: M Type: A13. In 1994 the velocity of money = 3 and the Money Supply = $700 billion. Based on this information answer the following questions. Assume 1994 is the base year.(a) What are the values of nominal and real GDP for 1994?(b) If the money supply increases 10% in 1995, what is the effect on nominal GDP, assuming the velocity is constant?(c) Using the same data from Part (b), if the velocity of money also changes from 3 to 2, now what is the effect on GDP? (a) M V = GDP (nominal), thus $700 3 = $2,100 billion. If 1994 is your base year then both nominal and real GDP are $2,100 billion.(b) $700 .10 = 70, thus a 10% increase in the Ms = $770. Nominal GDP is now $770 3 = $2,310 billion in 1995.(c) Nominal GDP is now $770 2 = $1,540 billion.