Money and Macroeconomic Activity, Part 2
Question 1: Discuss the equation of exchange and its relationship to the quantity theory of money.
Answer 1: The foundation of the quantity theory of money is the equation of exchange: MV = PY, in which M is the money supply, V is the velocity of money, P is the price level, and Y is the income/output level. Quantity theorists assume that velocity and income/output level are constant in the short term. As such, changes in the price level will mirror fluctuations in the money supply. Since the velocity of money only changes in response to long-term technological and political advances, and since wage and price adjustments keep output at roughly the same level, the only way to control inflation is to manage the money supply.
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Question 2: Describe the adaptive expectations theory.
Answer 2: The adaptive expectations theory asserts that individuals base their economic decisions on recent trends in financial indicators like interest rates. Individual investors assess the recent financial data and then make suppositions regarding future events. With this in mind, proponents of the adaptive expectations theory assert that only historical information should bear upon current concerns regarding monetary policy. One of the problems with adaptive expectations theory is its overemphasis on recent trends at the expense of a more long-term perspective. Adaptive expectations theory economists often are caught short when the recent past fails to explain current economic activity.
Question 3: Discuss the asset demand theory of money demand.
Answer 3: The asset demand theory of money demand, promoted by Milton Friedman, asserts that the demand for any assets, including money, depends upon the return on investment. This theory assumes that cash can earn interest such as in checking accounts. Proponents of this theory believe that individuals invest or save money based on not only their current income, but also based on their permanent income. If people perceive that bonds have a higher return on investment, then the demand for money will fall. Like many theories of money demand, the asset demand theory supposes excellent and accurate economic knowledge. For this reason, it is useful more as a benchmark against which to measure actual behavior.
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