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Monetary Economics 2nd Edition Jagdish Handa - Solutions
Discuss, using diagrams, the following statement: if the money demand function has a high interest inelasticity, the case for a monetary aggregate as against an interest rate as the central bank’s operating target is strengthened, especially in an economy subject to stochastic shocks.
Design a study to judge whether a central bank of a country uses the interest rate or the money supply as its operating target of monetary policy. What relationships and tests can you use for this purpose?
Conduct an empirical study along the lines suggested in the preceding question for a country of your choice, and discuss your findings for the effectiveness of monetary policy pursued through interest rates.
In the context of interest-rate targeting (as against monetary targeting), suppose you wanted to estimate a St Louis equation for (i) nominal income, (ii) real output, but with the interest rate as the monetary policy variable. Specify the appropriate equation.Discuss its estimation by
Specify the Taylor rule. Discuss its estimation by cointegration and error-correction techniques, specifying and justifying your choices of the dependent and explanatory variables.
Are there any conceptual problems with the application of the cointegration techniques to money-demand functions, or can the estimates from such techniques be relied upon? In particular, how can you make certain that the estimated cointegration vector is the money demand and not the money supply
What are the reasons for requiring the use of cointegration techniques in money demand estimation? What would be the disadvantages of using ordinary least squares for such estimation? If you use both and obtain different estimates, which would you rely on, and why?
Discuss: shifts in the estimated coefficients of the money demand function are as likely to be due to shifts in monetary policy (supply side shifts) as about money demand behavior. (This question relates to the identification of demand versus supply functions.)
For a selected country and using quarterly data, specify and estimate the money demand function. Check and correct for shifts in this function during the period of your study.Try the following variations of the independent variables:(i) Expected income and permanent income for the scale
How would you formulate your money demand function for estimation in an empirical study? Comment on the a priori relationships that you expect between your independent variables and money. Compare your demand function with some roughly similar and some different ones estimated in the literature.
Specify the appropriate relationship and discuss whether the cointegration and errorcorrection estimates can shed any light on the question of whether the deviations of output from its full-employment level are transitory and self-correcting, as the modern classical model asserts. If they were not
Specify the appropriate relationship and discuss the use of cointegration and errorcorrection estimates to judge (i) long-run, (ii) short-run neutrality of money.
Specify the relevant relationships and discuss how the error-correction model can be used to assess causality between money and (i) nominal income, (ii) real output?
Empirical studies of the demand for money in the last two or three decades have raised serious doubts about the stability of the money demand function. What were the main causes of this instability?Was the finding of instability related to the particular monetary aggregate used or did it occur
Present and discuss the three major modes of estimating currency substitution for an economy.
Define weak separability. Discuss the role that it plays in specifications of the estimation equations for CS?
Define currency substitution and distinguish it from capital mobility, as well as from substitution between domestic and foreign bonds. How are the returns on foreign monies and foreign bonds determined? What multicollinearity problems arise in the open economy money demand equation and how would
Starting with a cost function leading to a second order partial adjustment model, and a money demand function with permanent income as the scale variable, derive the appropriate form of the estimating equation for the demand for money.
Starting with a cost function leading to a second order partial adjustment model, and a money demand function with expected income as the scale variable, derive the appropriate form of the estimating equation for the demand for money.
Discuss the justification for the use of expected income in a money demand function.Assuming that rational expectations are to be used to derive expected income, derive the estimating money demand equation.Discuss the suitability of adaptive expectations for estimating expected income.
Discuss the justification for the use of permanent income in a money demand function.Assuming that adaptive expectations are to be used to derive permanent income, derive the estimating money demand equation.Discuss the suitability of rational expectations for estimating permanent income.
Are there significant costs in adjusting actual to desired money balances or in changing balances between periods? Or are any such costs relatively insignificant but the delay in the adjustment of actual to desired balances occurs as a consequence of the costs of adjusting commodities and other
Specify the chain-weighted Divisia function for the monetary aggregate for your economy, derive its estimation equations and estimate the Divisia aggregate.What tests would you use to select between your VES and Divisia estimates? Carry out at least two of them and discuss their results.
Specify the variable elasticity of substitution (VES) function for the monetary aggregate for your economy, derive its estimation equations and estimate the VES aggregate.
Conduct the Sims–Granger test for the direction of causality between simple-sum and Divisia monetary aggregates and income in your economy and interpret its results for the direction of causality and the choice among the monetary aggregates.
“Money–demand functions have been shifting in ways that make them unsuitable for selecting the appropriate monetary aggregate for a given economy.” Report on some studies that have used the stability of the money–demand function for judging among monetary aggregates but have arrived at
Given two variables Y and X , specify the Granger test for the direction of causality between them. What did Sims’s study on Granger causality between money and national income for the United States show?How would you also test for the possibility that a third variable Z also Granger-causes one
Can evidence that the future values of the money stock are significant in equations forecasting nominal GDP provide any information on the direction of Granger causality between changes in the money stock and nominal GDP? Discuss.
Can evidence that the lagged values of the money stock are significant in equations forecasting nominal GDP help in establishing the claim that changes in the money stock Granger-cause changes in nominal GDP? Discuss.
Compare the a priori restrictions imposed on the elasticity of substitution by the following aggregation procedures:(i) simple-sum aggregates(ii) Divisia aggregates(iii) VES (variable elasticity of substitution) aggregates.Using your intuition on the likely elasticities of substitution in your
How would you test for the substitutability of different near-monies for M1? Present at least two different procedures that have been used in the literature for this purpose. How would you compare the estimates obtained from the two procedures?
The definition of money is clear enough if we consider only the transactions demand for money, but the introduction of the asset demand for money makes any attempt to distinguish sharply between M1 and other monetary assets unsatisfactory. Discuss.
How would you define the liquidity of an asset, measure this liquidity, and to what uses can your definition have relevance? Compare your definition with one other definition or measure of liquidity and outline its strong and weak points.
Present at least one rule model and one smoothing model of the buffer stock demand for money. What are the major differences in their implied money demand functions?
To what extent is Baumol’s inventory-theoretic approach, with its assumption of certainty, a satisfactory explanation of money demand?How does managing an inventory of money differ from managing inventories of goods? How do such differences affect the speed of adjustment of money demand to
What is the justification for and what are the arguments against the buffer stock approaches to money demand?
If money demand is dependent on changes in the money supply in the short-run, as the buffer stock models show, does the functional form of the money demand function remain the same or change? What are the arguments of the money demand function incorporating a buffer stock component? How would you
“Some recent empirical studies seem to show that the money demand function may not be independent of the money supply function.” Report on the methodology and results of at least one such study.
If the speculative demand for money is zero in a financially developed economy, as some have claimed, is the precautionary demand for money also zero? Evaluate with reference to both M1, M2 and broader monetary aggregates. If both the speculative and precautionary components of money demand are
What is the buffer stock demand for money and how does it differ from the precautionary money demand? Present at least one model of each that shows such a difference.
“Individuals hold money because of uncertainty over the timing of transactions.Therefore, the theory of the transactions demand for money must take account of this uncertainty.” Discuss this statement.How can this uncertainty be incorporated into a model utilizing the inventory analysis of the
“Liquidity preference as behavior towards risk is a demand for short-term securities –not money.” Present Tobin’s analysis of the demand for money.
“The theory of portfolio choice has little to do with the demand for money in the modern economy.” Discuss.
Does the existence of a speculative demand component increase or decrease the income elasticity of the overall demand for money? When would broader monetary aggregates have higher income elasticities than narrower ones, especially M1?
Evaluate the usefulness and defects of CARA and CRRA utility functions for deriving the demand functions for monetary aggregates. Discuss the likely validity of their implications for elasticity of demand for M1 and M2 with respect to wealth. What are their implications for the elasticity of M1 and
Does the existence of a speculative demand component increase or decrease the interest elasticity of the overall demand for money? When would broader monetary aggregates have higher interest elasticities than narrower ones, especially M1?
Consider a two-asset model with money paying the fixed interest rate Rm and the bonds paying the return R with expected value μb and standard deviation σb. The government imposes a tax on the excess return (R – Rm) on bonds, with a corresponding refund if the return is negative. What will be
Consider a two-asset model with money paying the positive given interest rate Rm and the bonds paying a return R which has the expected value μb and standard deviation σb.Show diagrammatically the effects of the following for the proportions held of the two assets:i. The government imposes a tax
Suppose that the individual has the quadratic utility function:U(W) = a+bW +cW2 where W is wealth.i. Derive the restrictions ona, b, c for a risk averter.ii. Derive the expected utility function in terms of μ and σ.iii. Given the plausible assumptions on the utility of wealth, in what range of W
Use your answers to the above questions to discuss Keynes’s assertion on the high volatility of the speculative demand for money. Is this assertion still valid? Discuss.
In the preceding two questions, what are likely to be the determinants of η and ε in your economy? How volatile are these shifts likely to be over the business cycle?
Again, assume that there are only two assets, money with μm = 0 and σm = 0 and bonds with μb, σb > 0, and that the individual has a CARA utility function, so that he maximizes:EU(W) = μt −½γtσ2 tNow assume that σ fluctuates such that σt = σ0 + εt and σt+1 = σ0 − εt . Derive the
Assume that there are only two assets, money with μm = 0 and σm = 0 and bonds withμb, σb > 0, and that the individual has a CARA utility function, so that he maximizes:EU(W) = μt −½γtσ2 tNow assume that γ fluctuates such that γt = γ0 + ηt and γt+1 = γ0 − ηt . Derive the
Assuming a riskless asset called money and two risky assets, analyze the individual’s asset demand for money. What will be the general form of the money demand function?Further, assuming that the two assets have perfectly negatively correlated returns, derive the implied demand function for
If the speculative demand for M1 is zero in the modern financially developed economy, is it also zero for some of the broader money aggregates? If not, what are the appropriate scale determinants of the speculative demand for M1 and the broader money aggregates?
“The more volatile are the returns on bonds and stocks, the greater is the demand for money.” Can you derive this proposition from Tobin’s liquidity preference model? Does it apply to interest-bearing as well as non-interest-bearing money?
Does Tobin’s theory imply the potential for volatility that Keynes attributed to the speculative demand for money?
Compare and contrast Keynes’s theory of the speculative demand for money with Tobin’s portfolio selection theory utilizing the expected utility hypothesis.
Are transactions demand models useless, as Sprenkle (1969) argued? If they are, how would you explain the demand for M1 or just for demand deposits in the economy?
Can the transactions demand model be used to explain why financial innovations in recent decades have reduced the transactions demand for M1?
How would you incorporate security considerations/costs into the transactions demand model? What would this imply for the demand for currency in a relatively insecure urban environment (a) compared with a relatively safe one, (b) when owner-identified smart cards become available? Do these factors
Assuming that a firm has 25 branches, derive its demand for transactions balances and the income and interest rate elasticities if (a) each branch manages its funds separately,(b) there is central money management at the head office.
Why do modern societies use checking accounts when currency has lower brokerage costs than such accounts? Discuss.
Derive the income and interest-rate elasticities in Baumol’s inventory model of the transaction demand for demand deposits if interest is paid on demand deposits.
Explain why there is always a certain percentage of households that do not hold checking accounts even though they do use currency for transactions.
“The nominal income elasticity of the transactions money demand is likely to differ among different sample periods for a given country and among countries.” Discuss.
“Keynes’s transactions demand function may not have been that unrealistic for the nineteenth and early twentieth centuries in Western, and other, economies.” Discuss this statement.
Compare the cost minimization and the profit maximization approaches to the derivation of the transactions demand for money. What insights do we get for the transactions money demand from using the profit maximization approach that are not apparent from the cost minimization approach?
Present Baumol’s inventory analysis for the transactions demand for money.
“Putting money into the utility and production functions is difficult to reconcile with the Walrasian general equilibrium model.” “Putting money in the utility and production functions does provide a way of theorizing about the benefits from the medium of payments role that money plays in the
Assume that the specific production function of the representative firm is:F(K,L,mf) = AKαLβmf γwhere F(.) is the firm’s production function, K is its capital stock, L is its employment and m is its holdings of real balances. Derive the relevant demand and supply functions for the firm,
Also assume that, each period, he receives an exogenously specified pension in nominal terms and also earns labor income from his labor supply. Derive the relevant demand and supply functions for the individual, stating any assumptions that you need to make. Are these functions invariant with
Assume that the representative individual has the specific utility function:U(c,n,mh) = U(c+mh −h(n))where c is the purchase of commodities, n is the supply of labor, mh is real balances held by the individual, and h(n) represents the dislike for work or the loss of leisure due to labor supplied,
Why is so much attention paid to initial endowments in the individual’s utility analysis?Suppose that initial endowments were left out of such analysis. What analytical consequences would this imply for neutrality and dichotomy, and for the role of money in the macroeconomy?
Discuss: if all prices, including nominal wages, are flexible, money must be neutral.
Does the neutrality of money hold in hyperinflations? Discuss.
How important are deviations from the neutrality of money likely to be at single-digit but constant rates of inflation? How important are deviations from the neutrality of money likely to be at single-digit but variable and highly uncertain rates of inflation?
Discuss the relationship between the neutrality (and super-neutrality) of money and the quantity theory of money. Does either of them imply the other?
Discuss the relationship in Walrasian general equilibrium analysis between the neutrality and super-neutrality of money and the classical dichotomy. Does either of them imply the other?
For the Walrasian model, discuss the statement: if nominal wages and prices are fully flexible, then neither a one-time increase in the money supply nor an increase in the rate of monetary growth will have any effect on the level of output in general equilibrium.
Define the neutrality of money.Provide at least a rough proof that money is neutral in a Walrasian general equilibrium.Can disequilibrium occur in the Walrasian model? If it can, would money neutrality also exist in disequilibrium in this model? If not, why is money neutrality usually identified
What were the views of Keynes and Friedman on the exogeneity or endogeneity of the money supply? What justifies their views?What were the views of Wicksell on the exogeneity or endogeneity of the money supply? What justifies his views?
On what does the demand for money depend: current income, wealth or permanent income? Or does it directly depend upon neither of them but on the consumption expenditures of households and the output of firms? If so, why is money demand usually specified as a function of income?
Discuss the following statement: Friedman’s critique of Keynesian liquidity preference theory, and especially of the Keynesian speculative motive, is more concerned with the stability rather than with the interest elasticity of money demand.
What were the similarities and differences between Keynes’s and Friedman’s demand functions for money? In which tradition (Keynesian, quantity theory or traditional classical) did Friedman’s analysis belong?Discuss Friedman’s views on velocity and present his velocity function.
For Friedman, the money-demand function was highly stable. This made the moneyincome multiplier highly stable, so that changes in the money supply had a strong impact on nominal national income. What were Friedman’s reasons for his assertion on the stability of money demand?Has the money demand
For Keynes, the speculative component of money demand was volatile. This made the demand for money and the money multiplier volatile, so that monetary policy became an unreliable tool for stabilization. What were Keynes’s reasons for his assertion on volatility? Do you think such volatility
Can overall money demand be legitimately separated into three additive components according to Keynes’s motives for holding money? If not, what is the justification for doing so?
Discuss the following statement: Friedman’s analysis of the demand for money belongs in the Keynesian rather than the quantity theory tradition, so that his analysis should be taken as a statement of, or slight modification to, Keynesian ideas in monetary economics.
Discuss the following statement: Wicksell’s analysis of the pure credit economy belongs in the Keynesian rather than the quantity theory tradition, so that Wicksell’s analysis should be taken as the precursor of Keynesianism in monetary economics.
Compare the contributions of Pigou, Keynes and Friedman on the interest elasticity of the demand for money.
Given Pigou’s elucidation of his two “provisions” for holding money, was Keynes’s exposition of his three “motives” a revolutionary change or merely an extension of the money demand analysis to an economy in which the bond and stock markets were becoming increasingly visible and
Compare the approaches of Fisher’s transactions and Pigou’s cash balances to the quantity theory. Are there any similarities between them? If so, in which respects?Or should they be treated as different approaches altogether?
Discuss the statements:“The quantity theory and the quantity equation are one and the same in the sense that each implies the other.”“The quantity theory assumes the constancy of velocity.”
“Under the modern classical approach, there is no sensible role for demand management policies in both the short-run and the long-run.” Why not? Discuss.
“The 1970s monetarism was a hybrid between the classical and the Keynesian paradigms.” Discuss.
Why is the IS–LM analysis inappropriate for an economy in which the central bank sets the interest rate exogenously? How would the money supply be determined in this context?
What aspects of the economy should the central bank examine in making its decision on whether to use the money supply or the interest rate as its primary/exogenous monetary policy instrument?
For a designated country of your choice, what is the appropriate assumption for macroeconomic analysis on the exogeneity or endogeneity of the money supply? What justifies this assumption?
Even if it is assumed that the central bank holds the money supply exogenous, why is it inappropriate to use the IS–LM equations/curves only for the determination of real output for both the closed and open economies? Frame your answer in terms of the implications of Walras’s law.
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