178.200 06-11

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178.200 Intermediate MacroeconomicsTutorial (11)

Investment, Money Supply & Demand

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Short Answer Questions (from textbook)

1. Question 1 of Problems and Applications on P481.

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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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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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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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c. Hint: If an immigration of foreign workers

increase the size of the labor force, then the marginal product of capital rises (recall

). Because the MPK rises relative to the cost of capoital (which does not change), firms find it profitable to increase invcestment.

MPKLKLAMPK ,)/( 1

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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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(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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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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4. Question 4 of Questions for Review on P498.

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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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(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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5. Question 5 of Questions for Review on P498.

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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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(continud)

The formula reveals the followings:

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.

F

iYN

2*

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(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 =

i

YF

iY

FY

FiY

YNY

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2

24

*)2/(22

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(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:

a. (PK/P)(r + δ) b. (PK/P)(r - δ)c. (P/PK)(i + δ)d. (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 :a. Real cost of capital exceeds the marginal product

of capital.b. Marginal product of capital exceeds the real cost of

capital.c. Marginal product of capital exceeds the real

interest rate.d. Rental price of capital exceeds the marginal

product of capital.Answer: b. Hint: P466.

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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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(4) An event that decreases the marginal product of capital will:

a. Shift the investment function to the left.

b. Shift the investment function to the right.

c. Raise the real cost of capital.

d. 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:a. Tobin’s q is equal to the market value of installed capital

divided by the replacement cost of installed capital.b. If Tobin’s q is greater than 1.0, firms will allow their

capital to wear out without replacing it.c. It assumes that stock prices play an influential role in

investment decisions.d. It implies that investment depends on the current and

expected future profits from installed capital.Answer: b.Hint: P469.

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(6) According to the accelerator model of investment, investment:

a. Is high when the real interest rate is low.

b. Remains fairly constant at all times

c. Is high when output grows rapidly.

d. Is high when corporate profits are high.

Answer: c.

Hint: P477.

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(7) If the monetary base doubles and both the currency-deposit and reserve-deposit ratios remain constant, the money supply will:

a. Fall by half.b. Remain constant.c. Double.d. Increase by a factor of 2 [(1+cr)/(cr+rr)].Answer: c.Hint: P486.

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

a. Increase in the money supply.

b. Decrease in the money supply.

c. Increase in the money multiplier.

d. Increase in the reserve-deposit ratio.

Answer: b.

Hint: P487.

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(9) An open-market operation occurs when:a. There is an emergency appendectomy at the

farmer’s market.b. The Fed buys government bonds from the

public.c. The Fed sells government bonds to the public.d. Both b and c.Answer: d.Hint: P487.

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(10) A reduction in reserve requirements will not significantly affect the money supply if:

a. Banks do not change their reserve-deposit ratios.b. The currency-deposit ratio does not change.c. The amount of excess reserves held by banks

does not change.d. The monetary base does not change.Answer: a.Hint: P487.

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(11) A decrease in the discount rate will increase the money supply by:

a. Increasing the money multiplier.b. Increasing the amount of reserves banks borrow

from the Fed.c. Decreasing the reserve-deposit ratio.d. Increasing the currency-deposit ratio.Answer: b.Hint: P488.

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(12) A decrease in the reserve-deposit ratio will increase the money supply by:

a. Increasing the monetary base.

b. Increasing the monetary multiplier.

c. Decreasing the currency-deposit ratio.

d. Decreasing the discount rate.

Answer: b.

Hint: PP486-487.

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178.200 06-11