178.

200 Intermediate Macroeconomics

Tutorial (11)
Investment, Money Supply & Demand

1
Short Answer Questions (from textbook)

1. Question 1 of Problems and Applications

on P481.

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Short Answer Questions (from textbook)

To answer the questions, we first recall the

following neoclassical investment function:
I = In[MPK – (PK/P)(r + δ)] + δK
where
MPK is marginal product of capital,
(PK/P)(r + δ) is the cost of capital,
and δK is the amount of depreciation of the
capital stock.
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Short Answer Questions (from textbook)

a. Hint:
The rise in the real interest r increases the cost of
capital (PK/P)(r + δ). Investment thus declines
because firms no longer find it as profitable to
add to their capital stock. Nothing happens
immediately to the real rental price of capital,
because the marginal product of capital does not
change.

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Short Answer Questions (from textbook)

b. Hint:
If an earthquake destroys part of the capital stock,
then the marginal product of capital MPK rises
because of diminishing marginal product (recall in
chapter 3, capital is subject to diminishing maginal
product). Hence, the real rental price of capital
R/P increases. Because the MPK rises relative to
the cost of capital (which does not change), firms
find it profitable to increase investment.
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Short Answer Questions (from textbook)

c. Hint:
If an immigration of foreign workers
increase the size of the labor force, then the
marginal product of capital rises (recall
1−α
MPK = αA( L / K ) , L ↑⇒ MPK ↑ ).
Because the MPK rises relative to the cost
of capoital (which does not change), firms
find it profitable to increase invcestment.

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Short Answer Questions (from textbook)

2. Question 2 of Problems and Applications

on P481.

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Short Answer Questions (from textbook)

Hint:
According to the neoclassical investment function,
a one-time tax levied on oil reserves does not
affect the MPK. The reason is that the oil
companies must pay the tax no matter how much
capital they have. Because neither the benefit of
owning capital (the MPK) nor the cost of capital
are changed by the tax, investment does not
change either.
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Short Answer Questions (from textbook)

(continued)
However, if the firm faces financing
constraints, then the amount it invests
depends on the amount it currently earns.
Because the tax reduces current earnings, it
also reduces investment.

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Short Answer Questions (from textbook)

3. Question 4 of Problems and Applications

on P481.

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Short Answer Questions (from textbook)

Hint:
A stock market crash implies that the market value
of installed capital falls. Therefore, Tobin’s q – the
ratio of the market value of installed capital to its
replacement cost – also falls. This causes
investment and hence aggregate demand to fall. If
the Fed seeks to keep output unchanged, it can
offset this aggregate-demand shock by running an
expansionary monetary policy.
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Short Answer Questions (from textbook)

4. Question 4 of Questions for Review on

P498.

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Short Answer Questions (from textbook)
Hint:
Portfolio theories of money demand emphasize
the rule of money as a store of value. These
theories stress that people hold money in their
potifolio because it offers a safe nominal return.
Therefore, portfolio theories suggest that the
demand for money depends on the risk and return
of money as well as all the other assets that people
hold in their portfolios. In addition, the demand
for money depends on total wealth because wealth
measures the overall size of the portfolio.
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Short Answer Questions (from textbook)

(continued)
In contrast, transactions theories of money
demand stress the role of money as a medium of
exchange. These theories stress that people hold
money in order to make purchases. The demand
for money depends on the cost of holding money
(the interest rate) and the benefit (the ease of
making transactions). Monry demand, therefore,
depends negatively on the interest rate and
positively on income.
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Short Answer Questions (from textbook)

5. Question 5 of Questions for Review on

P498.

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Short Answer Questions (from textbook)

Hint:
The Baumol-Tobin model analyzes how people
trade off the costs and benefirts of holding money.
The benefit of holding money is convenience:
people hold money to avoid making a trip to the
bank every time they wish to purchase something.
The cost of this convenience is the forgone interest
they would have received had they left the money
deposited in a saving account.
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Short Answer Questions (from textbook)

(continud)
iY
The formula N * = reveals the followings:
2F
As i increases, the optimal number of trips to the
bank increase because the cost of holding money
becomes greater. As Y increases, the optimal
number of trips to the bank increases because of
the need to make more transactions. As F
increases, the optimal number of trips to the bank
decreases because each trip becomes more costly.
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Short Answer Questions (from textbook)
(continued)
On the other hand, examining the optimal number
of trips to the bank provides insight into average
money holdings – that is, money demand. More
frequent trips to the bank decrease the amount of
money people hold. By the definition of the
average money holding Y/(2N*), we have
Average Money Holding =
Y2 2 FY 2 YF
Y /( 2 N *) = = =
iY 4iY 2i
4
2F 18
Short Answer Questions (from textbook)

(continued)
Thus, the Baumol-Tobin model tells us that
money demand depends positively on
expenditures and negatively on the interest
rate.

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Multiple-Choice Questions
(2005 Exam Question)
(1) If the price of capital goods rises at the same rate
as the price of other goods, the real cost of
capital may be written as:
• (PK/P)(r + δ)
• (PK/P)(r - δ)
• (P/PK)(i + δ)
• (P/PK)(i - δ)
Answer: a.
Hint: P465.

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Multiple-Choice Questions
(2005 Exam Question)
(2) Firms find it profitable to add to their capital
stock if the :
b. Real cost of capital exceeds the marginal
product of capital.
c. Marginal product of capital exceeds the real cost
of capital.
d. Marginal product of capital exceeds the real
interest rate.
e. Rental price of capital exceeds the marginal
product of capital.
Answer: b. Hint: P466. 21
Multiple-Choice Questions
(2005 Exam Question)

(3) Expensionary monetary policy spurs investment

in the short run via:
a. A decrease in inflation.
b. A decrease in the cost of capital.
c. An increase in the rental price of capital.
d. All of the above.
Answer: b.
Hint: r↓→ (PK/P)(r + δ) ↓.
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Multiple-Choice Questions
(2005 Exam Question)

(4) An event that decreases the marginal product of

capital will:
b. Shift the investment function to the left.
c. Shift the investment function to the right.
d. Raise the real cost of capital.
e. Raise the rate of depreciation.
Answer: a.
Hint: MPK ↓→I ↓
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Multiple-Choice Questions
(2005 Exam Question)
(5) All of the following staements about the q-theory of
investment are true EXCEPT:
b. Tobin’s q is equal to the market value of installed capital
divided by the replacement cost of installed capital.
c. If Tobin’s q is greater than 1.0, firms will allow their
capital to wear out without replacing it.
d. It assumes that stock prices play an influential role in
investment decisions.
e. It implies that investment depends on the current and
expected future profits from installed capital.
Answer: b.
Hint: P469.
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Multiple-Choice Questions
(2005 Exam Question)

(6) According to the accelerator model of

investment, investment:
b. Is high when the real interest rate is low.
c. Remains fairly constant at all times
d. Is high when output grows rapidly.
e. Is high when corporate profits are high.
Answer: c.
Hint: P477.
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Multiple-Choice Questions
(2005 Exam Question)

(7) If the monetary base doubles and both the

currency-deposit and reserve-deposit ratios
remain constant, the money supply will:
• Fall by half.
• Remain constant.
• Double.
• Increase by a factor of 2× [(1+cr)/(cr+rr)].
Answer: c.
Hint: P486.
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Multiple-Choice Questions
(2005 Exam Question)

(8) An increase in the currency-deposit ratio leads to

a(n):
b. Increase in the money supply.
c. Decrease in the money supply.
d. Increase in the money multiplier.
e. Increase in the reserve-deposit ratio.
Answer: b.
Hint: P487.
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Multiple-Choice Questions
(2005 Exam Question)

(9) An open-market operation occurs when:

b. There is an emergency appendectomy at the
farmer’s market.
c. The Fed buys government bonds from the
public.
d. The Fed sells government bonds to the public.
e. Both b and c.
Answer: d.
Hint: P487.
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Multiple-Choice Questions
(2005 Exam Question)

(10) A reduction in reserve requirements will not

significantly affect the money supply if:
b. Banks do not change their reserve-deposit ratios.
c. The currency-deposit ratio does not change.
d. The amount of excess reserves held by banks
does not change.
e. The monetary base does not change.
Answer: a.
Hint: P487.
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Multiple-Choice Questions
(2005 Exam Question)

(11) A decrease in the discount rate will increase the

money supply by:
b. Increasing the money multiplier.
c. Increasing the amount of reserves banks borrow
from the Fed.
d. Decreasing the reserve-deposit ratio.
e. Increasing the currency-deposit ratio.
Answer: b.
Hint: P488.
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Multiple-Choice Questions
(2005 Exam Question)

(12) A decrease in the reserve-deposit ratio will

increase the money supply by:
b. Increasing the monetary base.
c. Increasing the monetary multiplier.
d. Decreasing the currency-deposit ratio.
e. Decreasing the discount rate.
Answer: b.
Hint: PP486-487.
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