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# assign3-key - Answer key assignment three Version 2.0...

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Answer key, assignment three Version 2.0 (October 11, 2008). Compiled by Corey Garriott 1 Mv = pY Nominal GDP py equals 40; money supply M equals 16. v = 40 16 = 2 . 5 k = 1 v = 0 . 4 2 Quantity theory of money The classical quantity theory took k (and v ) to be a fixed constant. In contrast the modern theory thinks k = c i , which can be affected by the economic environment (in particular by the interest rate). Data on the U.S., England and other low-inflation countries exhibits an imperfect (or absent) correlation between the money supply M and nominal GDP, which can only be explained by a quantity theory of money if it allows k to move. Hence the modern quantity equation fits the data much better than the classical. 3 Demand for money People keep money in the wallet for an important reason: to buy things. And there is an opportunity cost to holding that money in cash. Money held in cash cannot at the same time be invested, such as on the market or even in a savings account. Suppose the expected return of money sitting on the market or in a savings account rises. People then will find it less worthwhile on the margin to forego the interest payments by holding money in cash. That is, the opportunity cost of holding money rises. Hence k , the propensity to hold money, will fall ceteris paribus . 1 1 Never forget, young economists: “Other things being equal.” 1

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4 Demand for money by a firm This question uses a production function that treats money as if it were a factor of production. Prof. Farmer argues for this on the ground that firms require money to do practically anything that they do. Imagine if a firm had no money on hand—would it be able to produce? However, if
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assign3-key - Answer key assignment three Version 2.0...

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