Chapter 22, Problem 20Q

To determine

In case the question requires us to explain monetary authorities should focus on money supply rather than on interest rates.

Concept Introduction:

Velocity of money: Velocity of money is the average number of time the unit of money is used to purchase goods and services in the economy in a given period of time. Rate at which money changes hands per year to buy things is known as velocity of money. The velocity of money is the rate at which people use cash. It is the turnover in the money supply. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.

Liquidity preference theory: Late Lord J. M. Keynes propounded the Liquidity Preference Theory to explain the interest rate determination with the help of demand and supply of money.

Liquidity is a term used to describe how quickly an asset can be converted into cash. If you keep the money in some other form of asset, or in bank, you will actually have a separation with the liquid form. Liquidity is the easiness of holding cash form of money rather than any other form. Interest rate is considered as the compensation for separation with the liquidity form of money.

M1Money: M1 money consists of the most liquid segment of the money supply. It mainly consists of currency and assets that can be quickly converted to cash. It includes physical currency and coin, demand deposits, travellers’ checks, other checkable deposits.

M2 Money: M2 includes M1 money and near money. Near money generally refers to savings deposits, money market securities, mutual funds and other short term time deposits. M2 are the assets which are less liquid as compared to M1 but not as exchange medium, but they can be promptly converted into cash.