Homework 5

Economics 470/570
Winter 2005
Review Question Set for Week #5

Definitions

Monetary aggregate

Velocity of money

Output gap

Short Answer

1. Show that if the Fed controls either the federal funds rate or bank reserves, then the variance of the other variable increases.

2. Can the Fed control bank reserves exactly? Explain. Why is this important?

3. What is the Taylor rule? How is it used? How well does it predict Fed policy?

4. What is meant be the phrase “money is a veil” in the classical model? What is the role of money in the classical model?

5. What is the difference between real and nominal money? Do changes in nominal money also change real money in the classical model? Explain.

6. What is the difference between real and nominal interest rates? How do the ex-ante and ex-post real interest rates differ?

7. Represent the classical model using an AD-AS diagram and show that changes in money, government spending, and taxes do not affect real output. What is the AD curve in the classical model?

Essay

1. Explain the reasons for the Fed’s decision to adopt an interest rate target rather than a monetary aggregate target.

2. State Say’s law. What is the significance of this in terms of government stabilization policy? Explain why Malthus does not believe in Say’s law. How does classical interest theory answer address Malthus’ criticism of Say’s law?

3. Explain classical interest theory. Be sure to explain why the investment function slopes downward and the saving function slopes upward.

4. Explain the quantity theory of money. Explain the Cambridge approach and illustrate that it leads to the same identity as the quantity theory. What assumptions are imposed to arrive at a theoretical statement?

5. What is the money demand function in the classical model? What factors determine velocity? How do these factors affect money demand?