What does the quantity theory of money explain?
It explains how the nominal value of aggregate income is determined by the money supply.
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| Term | Definition |
|---|---|
| What does the quantity theory of money explain? | It explains how the nominal value of aggregate income is determined by the money supply. |
| Who developed the quantity theory of money? | Classical economists, notably Irving Fisher. |
| What is the equation of exchange? | M × V = P × Y. |
| In the equation of exchange, what does M represent? | The money supply. |
| In the equation of exchange, what does V represent? | The velocity of money. |
| In the equation of exchange, what does P represent? | The price level. |
| In the equation of exchange, what does Y represent? | Aggregate output or income. |
| What does the quantity theory assume about velocity? | That it is constant in the short run. |
| According to the quantity theory, what causes inflation in the long run? | Growth in the money supply that exceeds growth in output. |
| What is the relationship between money growth and inflation? | Inflation equals money growth minus output growth. |
| What is the government budget constraint? | DEF = G - T = ΔMB + ΔB. |
| What does ΔMB represent in the budget constraint? | The change in the monetary base. |
| What does ΔB represent in the budget constraint? | The change in government bonds. |
| How can a government finance a deficit? | By issuing bonds or creating money. |
| What happens when a deficit is financed by money creation? | It can lead to sustained inflation or hyperinflation. |
| What was a real-world example of hyperinflation? | Zimbabwe in the 2000s. |
| What are Keynes’s three motives for holding money? | Transactions, precautionary, and speculative motives. |
| What is the transactions motive? | Money is held for everyday purchases. |
| What is the precautionary motive? | Money is held for unexpected expenses. |
| What is the speculative motive? | Money is held to take advantage of future investment opportunities. |
| What does liquidity preference theory state? | Money demand depends negatively on interest rates. |
| What happens to money demand when interest rates rise? | It decreases. |
| What happens to money demand when income rises? | It increases. |
| What does the portfolio theory of money demand emphasize? | That money demand depends on risk, return, and wealth. |
| What other factors affect money demand? | Payment technologies, financial innovations, and expectations. |
| How does financial innovation affect money demand? | It makes money demand less stable. |
| What does an unstable money demand imply for policy? | It makes monetary targeting less effective. |
| When is the quantity theory most accurate? | In the long run. |
| When is the Keynesian theory more relevant? | In the short run. |
| What happens to velocity under Keynesian theory? | It becomes unstable. |
| What is the link between budget deficits and inflation? | Persistent deficits financed by money creation cause inflation. |
| What does the equation p = %ΔM - %ΔY represent? | It shows that inflation equals money growth minus output growth. |
| What did empirical evidence show about money demand stability? | It was stable until the 1970s, then became unstable. |
| Why did money demand become unstable after 1973? | Due to financial innovation and new financial instruments. |
| What is seigniorage? | Revenue raised by printing money. |
| What does hyperinflation indicate about fiscal policy? | That it’s often driven by large government deficits. |
| How do interest rates affect speculative money demand? | Higher rates reduce speculative money demand. |
| How is inflation related to money supply growth? | They move proportionally in the long run. |
| What is meant by the velocity of money? | The rate at which money circulates in the economy. |
| If velocity is constant, what determines nominal GDP? | The money supply. |
| What happens if money supply grows faster than output? | Prices rise, causing inflation. |
| What is the key difference between classical and Keynesian theories? | Classical assumes stable velocity |
| What policy implication arises from the quantity theory? | Controlling money supply can control inflation. |
| What is the effect of unstable velocity on monetary targeting? | It makes targeting money supply ineffective. |
| What role does expectations play in money demand? | Expectations of future rates and prices influence money holding. |