Mini-Review
- Which of the following is a main principle held by monetarists?
A. Aggregate demand depends on government involvement.
B. The Fed should use GDP as a guide to policymaking.
C. The Fed should act independently of GDP.
D. The government should be more involved in the economy.
E. None of the above. - Which one of the following is true regarding Keynesians?
A. Keynesians believe in no government involvement.
B. The Fed must act in accordance to inflation rates.
C. The government should be involved in the economy at all times.
D. The Fed can treat economic problems through interest rates and aggregate demand.
E. The government must control all interest rates. - Which one of the following is true regarding the classical theory?
A. The economy is healthy only when the government contributes spending.
B. The economy is self-correcting and all inequalities will find equalities in the long run.
C. Aggregate supply is influenced by aggregate demand.
D. It is the government’s duty to control inflation.
E. None of the above.
Mini-Review Answers
- B.Monetarists believe that the Fed should use GDP as a gauge for policy decisions. Essentially, the Fed should
mimic its actions after the progress of GDP. - D. The Fed can treat economic problems through interest rates and aggregate demand. When the Fed changes the
money supply, this affects interest rates, which then influence aggregate demand. According to Keynesians, this is
an affective way to affect aggregate demand. - B.Classicalists believe that the economy is self-correcting. The main premise behind this theory is that supply
affects demand. When firms choose to produce more, consumers will buy more.
The Money Demand Function
If you understand why people hold money, then you can understand what changes the amount of money they hold.
People hold money for two reasons: (1) to carry out transactions (transactions demand), (2) to be prepared for emer-
gencies (precautionary demand), and (3) to speculate on purchases of various assets (speculative demand). The inter-
est rate and income measured in current dollars (adjusted for inflation) influence how much money people hold in order
to carry out these three activities.
The Interest Rate
An inverse relationship exists between interest rates and the quantity of money demanded. The interest rate becomes the
opportunity costof holding money. If you recall, opportunity cost is the next best alternative given up. If you have a
thousand dollars hidden under your mattress, you are earning no interest on that money. You are relinquishing, or trad-
ing off, the interest for some other reason. The higher the interest rate, the higher your opportunity cost because you are
Monetary Policy