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NSS Exploring Economics 6

Chapter 10

Monetary policy and quantity theory of money

Questions
p.100
Think it over
1.
Suppose your parents give you more pocket money. What will you do and how does it affect
the economy?
2.
Suppose a central bank distributes money to the public. What effects will this have on the
economy?
Discuss
10.1
What are the possible macroeconomic goals of a central bank?
p.104
Test yourself
10.1
Briefly explain how the central bank can reduce the money supply by the following tools.
a. Open market operations
b. Discount rate
c. Required reserve ratio

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p.104
Discuss
10.2
How do the four tools of monetary policy affect the monetary base and the maximum
banking multiplier? Will they increase, decrease or remain unchanged? Fill in the table
below.
Monetary base

Maximum banking
multiplier (= 1/rrr)

a. Open market purchase of


government bonds
b. Reduction of the
discount rate
c. Reduction of the required
reserve ratio
d. Printing more money

10.3
Compare the three common tools of monetary policy open market operations, the discount
rate and the required reserve ratio.
a. Which tool is the easiest to implement?
b. Which tool can adjust the money supply most precisely?
p.109
Test yourself
10.2
Identify the types of tools used by the Peoples Bank of China to cool down the economy.
Explain how they work.
p.110
Fig. 10.7
How many times has the $100 note changed hands to conduct transactions of final products?
What is the nominal value of the final products exchanged?

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p. 113
Test yourself
10.3
Predict the changes in the real money supply (

M
) in the short run and long run when the
P

nominal money supply increases.


pp.117-120
Exercises
Multiple Choice Questions
1.
Which of the following statements about open market operations is INCORRECT?
A. Open market operations refer to the central banks purchase and sale of government
bonds in the market.
B. Open market operations affect the money supply by adjusting the banking multiplier.
C. If the central bank buys government bonds from the public, the money supply increases.
D. If the central bank sells government bonds to commercial banks, their reserves decrease
and they may have to call back loans.
2.
The discount rate is
A. the average deposit rate.
B. the best lending rate.
C. the interbank offer rate.
D. the borrowing rate of private banks from the central bank.
3**.
Refer to the following balance sheet of a banking system.
Assets ($)
Reserves
Loans

250
750

Liabilities ($)
Deposits

1,000

Suppose the central bank raises the required reserve ratio from 20% to 40%. If banks do not
borrow from the central bank to meet the reserve requirement, which of the following
statements about the above banking system is correct?
A. The amount of reserves will remain unchanged.
B. The money supply will increase.
C. The amount of loans will decrease to $625.

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D.

The amount of reserves will increase to $400.

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4.
The central bank can raise the money supply by
A. selling government bonds in the open market.
B. raising the discount rate.
C. cutting the required reserve ratio.
D. selling foreign currency in the open market.
5.
When the central bank reduces the money supply,
A. the price level will rise in the short run.
B. the real national income will remain unchanged in the short run.
C. the price level will remain unchanged in the long run.
D. the nominal national income will drop in the short run.
6.
The equation of exchange states that the total expenditure on final products is equivalent to
A. the total value of all transactions.
B. the total value of transactions on final products.
C. the asset demand for money.
D. the money supply.
7*.
The equation of exchange is an identity because
A. money is a medium of exchange.
B. by definition, the velocity of circulation of money is the ratio of nominal national
income to nominal money supply.
C. the equation is valid in all phases of a business cycle.
D. the nominal money supply and the nominal national income are always positively
related.
8.
The quantity theory of money
A. is the same as the equation of exchange.
B. is an identity.
C. assumes that the velocity of circulation of money is constant.
D. predicts that an economy always produces at the full employment level in the long run.

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9*.
The quantity theory of money predicts that in both the short run and long run, a rise in the
nominal money supply
A. will increase the real national income only.
B. will raise the price level only.
C. will have no effect on real variables.
D. will affect both the nominal national income and the price level.
10.
According to the quantity theory of money,
A. an increase in the price level must result in the same percentage increase in the nominal
money supply.
B. a decrease in the nominal money supply must result in a proportional decrease in the
price level in the short run.
C. a decrease in the nominal money supply must result in a proportional decrease in the
price level in the long run.
D. the central bank can raise the potential GDP of an economy by expansionary monetary
policies.
Short Questions
1.
What monetary policy may be implemented by the central bank to curb a rise in prices?
Suggest TWO tools of monetary policy and describe how they work.
(10 marks)
2.
Briefly explain why the equation of exchange is NOT useful in explaining the relation
between the nominal money supply and the nominal national income.
(6 marks)
3.
a.
b.

Give TWO assumptions made about the quantity theory of money.


State the predictions of the quantity theory of money.

(4 marks)
(6 marks)

4.
Inflation is always caused by a continuous increase in the nominal money supply. Do you
agree? Answer by applying the quantity theory of money.
(6 marks)

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Structured Questions
1.
The following table shows the balance sheet of a banking system.
Assets ($ billion)
Reserves
Loans
Investment

100
350
50

Liabilities ($ billion)
Deposits

500

Suppose no banks hold excess reserves and there is no cash leakage or injection.
a. i. Suppose the central bank sells $20 billion of government bonds to private banks in
the economy. What will the balance sheet of the banking system be immediately
after the transaction?
(3 marks)
ii. What will the maximum possible change in the money supply be?
(4 marks)
b*. Instead of selling government bonds, the central bank raises the required reserve ratio to
30%. What will the maximum possible change in the money supply be? Show the new
equilibrium on a balance sheet.
(6 marks)
2.

a.
b.

Suppose an economy has achieved full employment and the central bank buys
government bonds in the open market. Predict the change in the real national income
and the price level in the short run and the long run using the following tools:
The AS-AD model
(10 marks)
The quantity theory of money
(6 marks)

3.
a.

From the equation of exchange, derive the equation of the growth rate of the general
price level, gp = gm + gv gy. (gp, gm, gv and gy are the growth rates of P, M, V and Y,
respectively.)
(3 marks)
b*. Suppose the nominal money supply has a growth rate of 10%. As a result, the real
national income has a growth rate of 3% in the short run and 0% in the long run.
i. According to the equation of exchange, what are the growth rates in the price level
in the short run and long run, respectively?
(4 marks)
ii. According to the quantity theory of money, what are the growth rates in the price
level in the short run and long run, respectively?
(4 marks)

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Answers
P.100
Think it over
1. You will spend more on goods and services to satisfy more of your wants. However, the
increased expenditure is too small to have any effect on private consumption
expenditure and GDP.
2. People will spend more on goods and services to satisfy more of their wants.
Private consumption expenditure increases and so does aggregate demand. Hence, both
real GDP and the general price level increase in the short run. However, real GDP will
restore the initial full employment level but the price level will rise in the long run.
Discuss 10.1
Possible macroeconomic goals of a central bank include

achieving full employment utilising all resources efficiently;

stimulating economic growth improving peoples standard of living;

attaining equitable income distribution narrowing the income gap between the rich
and the poor;

maintaining price stability minimising the detrimental effects of inflation or


deflation;

keeping domestic currency stable facilitating international trade;

stabilising economic fluctuations reducing the harmful effects occasioned by


economic fluctuations.
P.104
Test Yourself 10.1
a. The central bank can reduce the money supply by selling government bonds in the
market. When people buy government bonds, cash in the hands of the public decreases.
Moreover, the public may withdraw money from their deposits. This results in multiple
contraction of money.
b. The central bank can reduce the money supply by raising the discount rate. As the cost
of borrowing from the central bank rises, banks need to call back loans to repay some of
their borrowing from the central bank. Multiple contraction of money results.
c. The central bank can reduce the money supply by raising the required reserve ratio. If
banks cannot fulfil the new reserve requirement, they may have to call back loans. This
results in multiple contraction of money.

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P.104
Discuss 10.2
Monetary base

Maximum banking
multiplier (= 1/rrr)

a. Open market purchase


of government bonds

Increases as the central


bank pays money to buy
government bonds from
the market

Unchanged

b. Reduction of the
discount rate

Increases as private banks


borrow more money from
the central bank

Unchanged

c. Reduction of the
required reserve
ratio

Unchanged

d. Printing more money

Increases as more money


is issued

Increases

Unchanged

Discuss 10.3
a. Open market operations are the easiest to implement as the operations are solely
determined by the monetary authority. There is no need to seek approval from the
legislative body or to inform anyone.
Discount rate adjustment is easy to implement as this is solely determined by the
monetary authority, but the monetary authority has to inform the banks.
Changing the required reserve ratio is the most difficult to implement as this is adjusted
through legislation which is complicated and time-consuming. It cannot be adjusted
frequently and the change may not be approved by the legislative body.
b.

Open market operations can adjust the money supply most precisely because the central
bank can frequently buy or sell government bonds by whatever amount is needed.
The discount rate is a passive and imprecise instrument since the central bank can attract
or discourage banks borrowing, but it cannot predetermine the exact amount they
borrow. Moreover, banks have other sources of funds.
The change in the required reserve ratio will affect the banking multiplier. Thus, even a
small change in the required reserve ratio can have a strong impact on the money supply.
However, it makes no sense to pass a law to alter the ratio by too small a percentage, say
0.1%. An adjustment in the required reserve ratio cannot precisely alter the money
supply.

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P.109
Test Yourself 10.2
Firstly, when the Peoples Bank of China raised the required reserve ratio, banks with a
reserve shortage would have to call back loans. Secondly, when it sold central bank bills (i.e.
open market sale), commercial banks would have fewer excess reserves to loan out and banks
with a reserve shortage would have to call back loans. Both would result in multiple
contraction of money. Thirdly, the Peoples Bank of China raised the nominal interest rate.
All of the above measures would raise the real interest rate and thus would lower private
consumption expenditure and gross investment expenditure. The consequent drop in
aggregate demand would lower real national income and the price level in the short run.
When the real national income was restored to its full employment level, there would be no
further change in the long run.
P.110
Fig 10.7
The $100 note has changed hands two times. The nominal value of the final products
exchanged is equal to $200.
P.113
Test Yourself 10.3
The equation of exchange is:
MV PY

M Y

P V

Assume that the velocity of circulation of money is a constant. In the short run, when
the nominal money supply increases, both P and Y increase. As Y increases but V
M
will increase in the short run.
P

remains unchanged, real money supply

In the long run, Y will stay at its full employment level and V remains unchanged.
Y
M
remains unchanged.
is a constant and hence real money supply
V
P

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pp.117-120
Exercises
Multiple Choice Questions
1. B.
Open market operations affect the money supply by adjusting the monetary base, instead
of the banking multiplier.
2. D
3. A
If there is a shortage of reserves, banks have to call back loans and multiple contraction
of deposits results. The process will continue until banks have sufficient required
reserves, i.e. the present reserves (assuming no cash injection or leakage) are equal to
the required reserves for the final amount of deposits after the multiple contraction
process.
Present reserves
= $250 = Final amount of required reserves = Final amount of deposits rrr
Final amount of deposits
= $250 40% = $625
Final amount of loans
= Final amount of deposits Required reserves = $625 $250 = $375
(Note: Students can refer to the Learning Tips 8.2 in Chapter 8 for more details.)
4. C
Options A, B and D are incorrect. They would reduce the money supply.
5. D
A reduction in the money supply would raise the nominal and real interest rates and
reduce aggregate demand. The fall in aggregate demand would lead to a fall in the price
level and the real national income in the short run, while the real national income would
be restored to its full employment level and the price level would fall further in the long
run.
6. B
7. B
Option C is incorrect. The statement is the result, not the cause.
Option D is incorrect. The statement is not the reason why the equation of exchange is
an identity. In addition, it is not the prediction of the equation of exchange but the
prediction of the quantity theory of money, which assumes that the velocity of
circulation of money is a constant.
8. C
Options A and B are incorrect. The equation of exchange is an identity which does not
make any prediction while the quantity theory of money is a theory with assumptions
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and predictions.
Option D is incorrect. The statement is an assumption, instead of a prediction about the
quantity theory of money.
9. D
The quantity theory of money predicts that a rise in the nominal money supply will raise
the real national income, the price level and the nominal national income in the short
run, but will only increase the price level and the nominal national income in the long
run.
10. C
Option A is incorrect. A change in the price level is the result, not the cause.
Option B is incorrect. MP by the same proportion only applies to the long run. In
the short run, as the real national income may decrease, M and P may not decrease by
the same proportion.
Option D is incorrect. According to the quantity theory of money, expansionary
monetary policy cannot affect the potential GDP.
P. 119
Short Questions
1. To curb a rise in prices, the central bank may implement contractionary monetary
policies. (1 mark)
The following are tools of a contractionary monetary policy:

Open market sale of government bonds When the central bank sells government
bonds to the public, buyers may withdraw money from banks. When it sells
government bonds to banks, banks reserves drop. In both cases, if banks
experience a shortage of reserves, they will call back loans and this will lead to
multiple contraction of money.

Raising the discount rate When the central bank raises the discount rate, banks
cost of borrowing from the central bank rises. Banks may call back loans to repay
their borrowings from the central bank and multiple contraction of money results.

Raising the required reserve ratio When the central bank raises the required
reserve ratio, if banks have a shortage of reserves, they will call back loans and this
will lead to multiple contraction of money.
(Any TWO of the above. 3 marks each.)
The contraction of money supply raises both nominal and real interest rates. Hence,
private consumption expenditure as well as gross investment expenditure falls and
aggregate demand decreases. This curbs the price rise. (3 marks)

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2.

The equation of exchange (MV PY) merely links the four variables together, without
suggesting any causal relationship among them. It does not predict which item(s) will be
the cause(s) of the change and which item(s) will then be affected. (3 marks)
When the nominal money supply changes, the other variables may or may not change.
No definite relation among the four variables can be derived from the equation, except
that the value on the right-hand side must be equivalent to the value on the left-hand
side. (3 marks)

3.

a.

b.

4.

The assumptions are:

The velocity of circulation of money seldom changes and is assumed to be


constant. (2 marks)

Real national income remains unchanged at the full-employment level in the


long run. (2 marks)
The predictions are:

When nominal money supply changes, nominal national income will change
in the same direction by the same proportion. (2 marks)

In the short run, both the real national income and the price level change in the
same direction as nominal money supply. (2 marks)

In the long run, only the price level changes with nominal money supply in the
same direction by the same proportion. (2 marks)

No. The quantity theory of money predicts that

in the short run: M V = PY and gm = gp + gy;

in the long run: M V = PY and gm = gp. (3 marks)


where gm, gp and gy are the growth rates of nominal money supply, relative price level
and real national income, respectively.
Since gp = gm gy , inflation in the short run may be caused by a rise in gm or a drop in gy
or some combined change between them. (2 marks)
In the long run, since gp = gm , inflation can only be caused by a continuous increase in
nominal money supply. (1 mark)

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pp.119-120
Structured Questions
1.
a. i. When banks buy government bonds, reserves decrease while investment
decreases.
Assets ($ billion)

Liabilities ($ billion)

Reserves 100 20 =80 (1 mark)


Loans
350 (0.5 marks)
Investment 50 + 20 = 70 (1 mark)
ii.

Deposits

500 (0.5 marks)

Since banks do not hold excess reserves, the required reserve ratio is 20%

$100
$500

billion
100% . (1 mark)
billion

The reduction in reserves would cause a multiple contraction process until the
present reserves equal the required reserves of final amount of deposits.
$80 billion = Final amount of deposits 20%
Final amount of deposits = $80 billion

1
= $400 billion (1 mark)
20%

The maximum change in deposits


= Final amount of deposits Original amount of deposits
= $400 billion $500 billion = -$100 billion (1 mark)
The maximum change in money supply
= Change in currency in the hands of the public + Change in demand deposits
= $0 + (-$100 billion) = -$100 billion (1 mark)
(Note: Students can use the alternative method in the textbook to answer this
question.)

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b.

After the increase in the required reserve ratio, a multiple contraction process results
until the present reserves equal the required reserves of the final amount of deposits.
$100 billion = Final amount of deposits 30%
Final amount of deposits = $100 billion

1
= $333 billion (1 mark)
30%

The maximum change in deposits


= Final amount of deposits Original amount of deposits
= $333 billion $500 billion = -$167 billion (1 mark)
The maximum change in money supply
= Change in currency in the hands of the public + Change in demand deposits
= $0 + (-$167 billion) = -$167 billion (1 mark)
Assets ($ billion)

Liabilities ($ billion)

Reserves
100 (1 mark)
Loans 350 167 = 183 (1 mark)
Investment
50 (0.5 marks)

Deposits

500 167 = 333


(0.5 marks)

(Note: Students can use the alternative method in the textbook to answer this question.)

2.
a.

When the central bank buys government bonds in the open market, currency flows from
the central bank to the market. Part of this is held by the public. Part is deposited into
banks and this leads to the multiple creation of money. As the money supply increases,
the nominal interest rate falls and so does the real interest rate. The consequent rise in
private consumption expenditure and gross investment expenditure raises aggregate
demand. (4 marks)
The increase in aggregate demand raises real national income and the price level in the
short run (from Y1 or Yf to YS2 and from P1 to PS2, respectively). The excess demand for
resources raises input prices and shifts the SRAS from SRAS1 to SRAS2. In the long run,
real national income remains unchanged (at Yf) but the price level rises further (to PL2).
(4 marks)

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(2 marks)
b.

The quantity theory of money assumes that the velocity of circulation of money is a
constant; and that real national income is a variable in the short run but a constant at the
full employment level in the long run. (2 marks)
In the short run, when the nominal money supply increases, both real national income
and the price level increase and the nominal national income increases by the same
proportion as the nominal money supply. (2 marks)
In the long run, only the price level and nominal national income increase by the same
proportion as the nominal money supply. Real national income is assumed to be a
constant. (2 marks)

3.
a.

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According to the equation of exchange MV PY,


M (1 + gm) V (1 + gv) = P (1 + gp) Y (1 + gy)
(1 + gm) (1 + gv) = (1 + gp) (1 + gy)
1 + gp + gy
1 + gm + gv
gp + gy
gm + gv
gm + gv gy
gp

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g +g g.
According to the equation of exchange MV PY, gp
m
v
y

b.

i.

10% + g 3%; (1 mark)


In the short run, gp
v

10% + g 0%. (1 mark)


In the long run, gp
v

Since gv is not given, the inflation rate or the growth rate of P cannot be
determined in both the short run and long run. (2 marks)

ii.

According to the quantity theory of money, gv = 0. Hence,


g + g g = g g .
gp
m
v
y
m
y

10% 3% = 7%. (2 marks)


In the short run, gp
10% 0% = 10%. (2 marks)
In the long run, gp

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