Econ 330

Week 2 Answers

Fall 2002

1. Burton and Lombra ch.2 questions 5 and 6

How does the Fed calculate M1, M2, M3, and DNFD? I will leave it to you to read your notes and page 28 in your text. Remember that your class notes add a couple of items to M3 that your textbook does not include.

Are all these aggregates money? The answer to this question is not straightforward, but most texts seem to think M1 is the closest to thing to money, since “M1 contains the “monetary” assets we currently use in transactions” (Burton and Lombra, p. 29). The assets we use in transactions are changing over time, though, so our idea of what money is might also change (we may still call it M1, however).

Which contains the most liquid assets? M1 contains the most liquid assets.

Which aggregate is smallest? Largest? M1 is smallest, M3 is largest. This is obvious, since M2 contains everything in M1 plus some items and M3 contains everything in M2 plus some items.

Why does the Fed have so many monetary measures? Which monetary aggregate is most closely associated with transactions balances?

First, M1 should be most closely associated with transactions balances since this aggregate contains those assets actually used in transactions.

Why does the Fed have so many monetary measures? Some ideas:

- There is disagreement among economists about what actually constitutes a means of payment, since many financial claims are “borderline.”

- The measurement of monetary aggregates is subject to error, so keeping track of more than one aggregate can provide some insurance. For e.g., if policymakers find that a monetary aggregate is behaving erratically due to measurement error, they can look at another aggregate for guidance.

- The items included in any one measure are changing all the time, so an aggregate that is useful for some purpose at one point in time might be less useful at a later point.

- The Fed needs to target a monetary aggregate when setting monetary policy. Even if aggregates are not changing over time, one aggregate may be more useful than another over a time period. In fact, we have seen the Fed change choose to target different monetary aggregates at different times.

- From your class notes, different emphasis on the theoretical approach to defining what money is (money is what is used as a means of payment) vs. the empirical approach (a useful monetary aggregate moves in expected ways with other aggregate macroeconomic variables) might lead to different ideas about what the proper definition of money is, or which aggregate is most useful for a certain purpose.

2. a) With Y=3 given exogenously, we can solve for equilibrium values by setting M^D = M^S:

18 + 0.85(3) – 0.40i = 15 => i = 13.88%

If the nominal interest rate is below this equilibrium rate, then money demand is greater than money supply. Without going through the details, we know that in cases of excess demand, price (the nominal interest rate in this case) rises until equilibrium is reached. More formally, if we consider a simplified world with only two ways to hold your wealth, money and bonds, excess demand for money means excess supply of bonds. Excess supply of bonds means bond prices are falling and the nominal interest rate is therefore rising (using the inverse relationship between bond prices and interest rates). Nominal interest rates continue to rise (as bond prices fall) until the bond market (and therefore the money market) is back in equilibrium.

b) If M^S rises to 20, we just redo part (a) with this new (exogenously given) money supply subbed in:

18 + 0.85(3) – 0.40i = 20 => i = 1.38%

Similarly, if Y rises from 3 to 5 (using the old level of money supply):

18 + 0.85(5) – 0.40i = 15 => i = 18.13%

Graphically, the first change would be illustrated by a rightward shift in the M^S curve. The second change would be illustrated by a rightward shift in the money demand curve.

c) A money supply contraction is a leftward shift in the M^S curve; a contraction in money demand is a leftward shift in the money demand curve. In this case, we can say for sure that the level of money balances held will be lower but we cannot say whether the interest rate went up or down without more information about the relative magnitudes of the shifts in money supply and money demand.