### 10/28/08 **Final Version** - Chapter 7: Sections 1 5 (pages 248
272). If you printed the
previous version, please start at How Inflation is
determined?

# The Asset Market, Money, and
Prices

# The Asset Market

## The
asset market is the entire set of markets in which people trade real and
financial assets.

###
Real assets: include tangible resources (plant,
buildings, and land) and physical goods (houses, automobiles, jewelry)

###
Financial assets: claims to ownership or to receive
income from others (money, bonds, equities)

## An
asset possesses an exchange value and forms part of the wealth of an individual

###

# Definition of Money

##
The term **money** in economics is given to any
asset that can be used to make payments.

##

## Types
of Money:

###
Commodity money is
money that has an intrinsic value (an alternative use).

###
Fiat money is money by
government decree. It has no intrinsic value (coins and paper currency).

##

# Functions of Money

## §
**Medium of exchange**

we use it to make transactions

## §
**Unit of account**

the common unit by which everyone measures prices and values** **

## §
**Store of value**

transfers purchasing power from the present to the future

##

##

# An Economy without Money

##
will have to rely on barter.

## Barter
is the direct exchange of certain goods for other goods.

## It
is *inefficient* because it requires a *double coincidence of wants*.

## People
will choose to produce most of the goods they consume (self-sufficiency)

# Money as a Medium of Exchange

## Increases
Efficiency

###
Money facilitates transactions

###
It *reduces transaction costs* (it permits people
to trade with less cost in time and effort)

## Money
raises productivity by allowing people to *specialize* in activities at
which they are most skilled.

# Money as a Unit of Account

## Provides
a uniform measure of value (prices of all goods and services are quoted in U.S.
dollars)

## Simplifies
comparisons of prices, wages and incomes.

##

###

# Money as a Store of Value

##
Any asset (including
money) can be used as a store of value (stocks, bonds, real state).

##
Money is *not perfect*
as a store of value

###
It earns no return or
relatively low

###
The value of money falls
with inflation

# Moneys Liquidity

##
The ease with which
money is converted into other things (goods and services) is sometimes called
moneys *liquidity*

###
There are different
measures of the money stock according to the liquidity of the assets.

##

# How to Measure Money: Monetary Aggregates

##
**Monetary aggregates** are the different official measures
of the money stock.

##

## §
M1: Narrowest measure of money. All of its components
are used and widely accepted as means of payment.

##

##

##

# How to Measure Money: Monetary Aggregates

## §
M2: A broader measure of money. It includes all the
assets in M1 and other assets that are less money like

##

# U.S. Monetary Aggregates, 2007

# The Money Supply

## The
**money supply** is the amount of money available in an economy.

###
The money supply is the money stock the sum of the
outstanding amounts of various types of assets (money like assets).

###
It may be M1or M2.

###

## It
is determined by the central bank (the Federal Reserve System in the U.S.)

# How do Central Banks Control the Money Supply?

##
**Assume**: Currency is the only form of money in the economy.

## The primary way in which the Fed controls the money supply is trough

## Open-Market
Operations (OMO) are the purchase and sale of government bonds in the open
market (to the public) by the Fed.

###
Conducts an open-market
purchase to increase the money supply use newly printed money to buy financial
assets from the public.

###
Conducts an open-market
sale to reduce the money supply sells government bonds to the public in
exchange of currency.

# How do Central Banks Control the Money Supply? (cont.)

## The
central bank can buy newly issued government bonds directly from the government
itself (treasury).

###
This is the same as the government financing its
expenditures directly by printing money.

####

# The real
money supply curve: exogenous money supply

# Portfolio Allocation and the Demand for Assets

##
Wealth is the value of
assets minus the value of liabilities.

## How people allocate their wealth among many
different assets?

##
A portfolio is the set of assets that a
holder of wealth chooses to own.

##
A **portfolio
allocation decision** refers to the decision people make about which assets
and how much of each asset to hold.

###
Portfolio allocation
decision depends on four characteristics of the assets.

# Four Characteristics of Assets

## Expected
Return is the rate at which the value of the asset increases per unit of
time.

###
All else being equal, the higher the expected rate of
return of an asset; the more people want to hold this asset.

####
The nominal interest rate (*i*) non-monetary assets pay.

####
The nominal interest rate (*i*^{m}) the bank pays on a bank account.

####
The rate of return of a share of a stock is the
dividend yield plus the percentage increase in the price of stock.

# Four Characteristics of Assets

## Risk
is the degree of uncertainty in an assets return.

###
An asset is risky if the probabilities that the actual
return received will be significantly different from the expected return.

###
People are usually *risk
averse*. All else being equal, they prefer assets with a lower risk.

###
They ask a *risk
premium* in order to hold risky assets.

####
Risky assets must pay a higher expected return compare
to a relatively safe asset.

##

# Four Characteristics of Assets

## Liquidity
is the ease at which the asset can be converted into money (be accepted in
exchange of goods and services).

###
Money is the most liquid asset.

###
Liquidity provides flexibility to the holders of wealth
in case of emergencies.

###
All else being equal, the more liquid an asset is; the
more attractive it will be to holders of wealth.

# Four Characteristics of Assets

##
Time to Maturity It is
the amount of time until an asset matures and the financial investor is repaid
the principal.

##
According to *the* *expectations theory of the term structure of interest rate*:

###
Investors compare
returns on bonds that are similar in all respects except their terms of
maturity.

###
Since people are risk
averse, they ask a risk premium to hold a longer-term asset.

####
The longer the maturity
of the asset; the riskier the asset is.

###
Thus, long-term interest
rates usually exceed short-term interest rates.

###
In equilibrium, holding
different types of bonds over the same period yields the same expected return.

###

# Solved Problem:

##
Suppose that you could buy a one-year bond today, which has an
interest rate of 3%. If you wait a year and buy a one-year bond then, the
interest rate will be 4%. Two years from now, a one-year bond is expected to
offer an interest rate of 5%.

###
According to the expectations theory of the term
structure of interest rates, what is the interest rate on a two-year bond
today?

###
What is the interest rate on a three-year bond today?

# Asset Demands

##
Asset demands refers to
the amount of these assets the holder of wealth wants to own in his portfolio.

##
There is a trade-off
among these characteristics: expected return, risk, liquidity and maturity.

###
The investor considers *diversification* to reduce his overall risk.

##
**Total Wealth** is equal to the sum of all assets demands.

###
Classify the assets into
two types:

####
Monetary assets (cash,
checking accounts)

####
Non-monetary assets
(bonds, stocks, etc.)

###

##

# Solved Analytical Problem # 1

(page 279) a) and c)

##
All else being equal, how would each of the following affect
the demand for M1 and the demand for M2?

## §
The maximum number of checks per month that can be
written on money market mutual funds and money market deposit accounts is
raised from three to thirty.

## §
The stock market crashes, and further sharp declines in
the market are widely feared.

# Solved Problem:

## Mr.
Midas has wealth of **$100,000** that he invests entirely in money (checking
account) and government bonds. He wants to keep at least $50,000 in bonds at
all times, and will shift $5,000 into bonds from his checking account for each
percentage point that the interest rate on bonds exceeds the interest rate on
his checking account. If the interest rate on checking accounts is 0% and the
interest rate on bonds is 5%, how much does Mr. Midas keep in his checking
account?

# Solution Numerical Problem:

## First,
write an algebraic formula that gives Mr. Midas demand for money.

## *M*^{d}** = $100,000 [$50,000 + ((***i* *i*^{m}) $5,000]

## Second,
Plug in the values of both interest rates in the formula and calculate the Mr.
Midas money demand.

### *M*^{d}** = $100,000 [$50,000 + ((5% 0%) $5,000]**

### *M*^{d}** = $25,000**

###

# The Demand for Money

## The
demand for money (*M*^{d}) is the quantity of **monetary assets**
that people choose to hold in their portfolios.

## The
demand for money is determined by the trade-off between liquidity and the rate
of return.

###
Liquidity is the *major
benefit* of holding money.

###
The *major
cost of* holding money is that it pays no rate of return or a very
low rate of return relative to other interest bearing assets.

# Key Macroeconomic Variables that Affect Money Demand

##
Macroeconomic variables
affect money demand through two channels:

###
People need money to
make transactions

####
People need more money
when the price level or production increases.

###
The rate of return on
other assets is the opportunity cost of holding money

####
People reduce their money
holdings when the interest rate on money falls or the expected return on alternative
assets rises.

##
Key macroeconomic
variables that influence money demand are:

###
Price level

###
Real Income

###
Interest rates

# The Price Level

##
Recall: the purchasing
power of money (the value of money) is the reciprocal of the price level.

##

##

##
The higher the price
level; the lower the purchasing power of money θ the more dollars people want to hold to conduct their
transactions θit increases the **nominal**
demand for money.

##
The nominal demand for
money is *proportional** *to the price level.

###
A 1% increase in the
price level leads to a 1% increase in the nominal money demand.

##

# Price Level and Money Demand

## A
higher price level increases the **nominal** money demand proportionally.

## Goldfeld
confirmed empirically this result.

# Real Income

## Real
income is a very important factor that determines the number of transactions
people have to make.

## The
greater the output produced (higher real income); the more transactions people
have to make θ
the greater need for liquidity.

## Money
demand increases as real income rises, though *not in the same proportion*.

###
A 1% increase in real income leads to less than a 1%
increase in money demand.

##

##

# Interest Rates

##
For a given risk and
liquidity, the demand for money depends on the expected rate of return of both
money and alternative non-monetary assets.

###
An increase in the
expected rate of return on non-monetary assets decreases the demand for money
because it increases the opportunity cost of holding money.

###
An increase in the
expected rate of return on money increases money demand because people trade
off liquidity for return.

##
Assume: there is just
one interest rate on non-monetary assets and one interest rate on monetary
assets.

# Elasticities of Money Demand

## Elasticities
of money demand measure the percentage change in the money demand due to a one
percent change in any of the factors that affect the aggregate demand for
money.

## Measure
the sensitivity of money demand to changes in

###
Income

###
Interest

###

# Income Elasticity of Money Demand

## Income
Elasticity of Real Money Demand ( )

##

###
The income elasticity is positive ΰ
higher income increases money demand

##

## Goldfeld
reported (1973) the income elasticity of money demand in the long run equal to
2/3 (less than 1)

###
Money demand is income inelastic

# Interest Elasticity of Money Demand

## Interest
Elasticity of Money Demand ( )

##

###
The interest elasticity is negative ΰ
higher interest rate on non-monetary assets reduces money demand.

##

## Goldfeld
reported (1973) the interest elasticity of money demand to be small between
0.1 and 0.2.

# The Nominal Money Demand Function

##
The money demand function is the *mathematical
expression* of the relationship between
money demand and its key determinants.

##
Where:

###

# The Nominal Money Demand Function (cont.)

## Since
, then

##
An alternative way to write the demand for money is:

##

###
For *a
given expected inflation rate*, an increase in real interest rate
raises nominal interest rate and reduces money demand.

###
For *a
given real interest rate*, an increase in the expected rate of
inflation raises nominal interest rate and reduces money demand.

# The Real Money Demand

##
The demand for money in **real** terms is called the demand for real
balances.

###
It measures the demand for money in terms of the goods and
services it can buy.

###
It is the nominal money demand divided by the price level.

# Other Factors that Influence Money Demand

##
Wealth: since money is one asset to hold wealth ΰ
and increase in wealth will increase money demand.

##
Risk: If the risk of non-monetary assets increases, people will demand
safer assets, such as money.

##
Liquidity of alternative assets: As alternative assets become more
liquid, the demand for money decreases.

##
Payment technologies: technologies available for making and receiving
payments affect the money demand.

###
Introduction of credit cards, use
of ATMs, use of cell phones to make payments.

# Summary 9 (page 260)

# Numerical Example: Problem No. 2 Page 278

##
Money demand in an economy in which no interest rate is paid on money is:

##

##

##
Suppose that P = 100, Y = 1000, and *i*= 0.10. Find real money
demand, nominal money demand.

## §
Suppose that **P doubles from P =
100 to P = 200**. Find real money demand, nominal money demand.

# Solutions Solved Problem:

## §
The real money demand is:

##

###
Replacing values:

###

###
**Real money demand = 600
**

###

###
The nominal money demand is:

####
Replacing values:

###

###
**Nominal money demand = 60,000.
**

# When price level doubles

## §
The real money demand is:

##

###
Replacing values:

###

###
**Real money demand = 600; It does
not change because neither Y, nor ***i* has changed.

###

##
The nominal money demand is:

###
Replacing values:

###

###
**Nominal money demand is 120,000.
It doubles.
**

# Related with Numerical Example: Problem No. 2 Page 278

##
Money demand in an economy in which no interest rate is paid on money is:

##

##

##
Suppose that P = 100, Y = 1,100, and *i*= 0.10. Find real money
demand, nominal money demand.

###
Real Money demand is:

###

###
Nominal Money demand is:

##

# Related with Numerical Example: Problem No. 2 Page 278

##
Calculate the income elasticity of demand for money when income changes
from 1,000 to 1,100 and all the other variables remain the same.

##

##

# Velocity and The Quantity Theory of Money

##
Velocity of money (*V*) measures the number of times a dollar
changes hands during a specified period of time.

##
It comes from one of the earliest theories of money demand The
Quantity Theory of Money.

##
The Quantity Theory of Money departs from the *equation of exchange*
or quantity equation.

# Velocity of Money

##
To find the velocity of money, solve the quantity equation for the
velocity:

##

# From the Quantity Equation to the Quantity Theory of Money

**Two important assumptions**:

##
**Velocity of money is constant**
and does not depend on income or interest rate.

##
Money market is at equilibrium; thus, **money stock** (money supplied
in the economy) **is equal to money demand**:

##

##
Naming:

##

##
Then,

##

# The Quantity Theory of Money and the Real Money Demand

##
According to the Quantity Theory of Money the real money demand is
proportional to real income

# Numerical Example: Problem No. 2 (Page 278)

##
Money demand in an economy in which no interest rate is paid on money is:

##

##

##

## §
Suppose that P = 100, Y = 1000, and
*i*= 0.10. Calculate the velocity of money.

## §
The P doubles from P = 100 to P =
200, find the velocity of money.

# Solution:

##
Find the velocity of money using the quantity theory of money:

##

## §
Assume *M* = *M*^{d }and
recall from the previous exercise that* M = *60,000

##

##

##

^{§
}If P = 200 θ
^{
}

*
*

# Numerical Problem: Exercise 4

(Page 278)

##
Assume that the quantity theory of money holds and that velocity is
constant at 5. Output is fixed at its full-employment value of 10,000, and the
price level is 2.

## §
Determine the real demand for money
and the nominal demand for money.

## §
If the government fixes the nominal
money supply at 5000, with output fixed at its full-employment level and with
the assumption that prices are flexible, what will be the new price level?

# Solutions:

## §
To calculate the real money demand,
use the formula:

##

##

##

##

##
The nominal money demand = 2000 x 2 = $4000

##

## §
If M = 5000; the P = M/2000 =
5000/2000 = 2.5

# Asset Market Equilibrium

##
The asset market is in equilibrium when, in aggregate, the quantity of
each asset demanded by holders of wealth equals the available supply of that
asset.

##
All assets are grouped into two categories:

###
Money assets (currency and checking
accounts)

####
They are assumed to have the same
risk and liquidity

####
Pay interest *i*^{m}
or pay zero interest

####
Their supply is fixed at M (M1 or
M2)

###
Nonmonetary assets (stocks, bonds,
land, etc.)

####
They are assumed to have the same
risk, liquidity, and pay the same interest rate, *i*.

####
Their supply is fixed at NM

# Asset Market Equilibrium

##
The total nominal wealth of one individual:

##

##
At the macroeconomic level:

##

##
At equilibrium:

##
If the asset market is at equilibrium, then

##

##

##
If the money market is in
equilibrium, then the nonmonetary asset market is also in equilibrium.

# Asset Market Equilibrium

##
**Asset market equilibrium** occurs when the money market is in
equilibrium; money demand equals money supply (money stock).

##
Equilibrium condition in **nominal terms**:

##

##
Equilibrium condition in **real terms**:

# The Asset Market Equilibrium Condition

##
Recall, in the **long run**:

###
The economy is at *full
employment* ΰ
*all* markets
are in equilibrium

###
Labor market is at equilibrium and the employment is the
full-employment level ΰ
*output is the
full-employment output*.

###
The *real
interest rate is determined in the goods market*, when saving and
investment are equal (for a closed economy).

###
Money supply is determined by the Fed through its open market
operations

###

# The Asset Market Equilibrium Condition

##
Assume:

###
The expected inflation rate is fixed.

##
Then, the only variable to be determined is the price level.

###
Solve the asset market equilibrium condition in real terms for the
price.

###

# How Inflation is determined?

##
The **inflation rate** is the percentage change in the price level.

##
Expressing the previous equation in growth rates

##

##

##

##
depends
on:

####
the *growth
rate of the nominal money* *supply
*

####

####
the *growth
rate of the real money demand*.

#####
Which depends on real income and the nominal interest rate.

##

###

##

# In a Long-Run Equilibrium

##
Real interest rate is constant and determined in the goods market.

##
Assuming a constant growth rate of money supply, *expected
inflation would be constant* equal to actual inflation rate.

##
Then, *nominal
interest rate is also constant*.

# In a Long-Run Equilibrium (cont.)

##
A change in the real money demand will depend only on the change in real
income.

##

##

##

##
Where

##

##

##

# Solved Numerical Problem: Exercise 5 (a) (Page 278)

##
Consider an economy with a constant nominal money supply, a constant
level of real output *Y =* 100, and a constant real interest rate, *r*
= 0.10. Suppose that the income elasticity of demand is 0.5 and the interest
elasticity of money demand is 0.1.

## §
By what percentage does the equilibrium price level differ from
its initial value if output increases to *Y =* 106 (and *r* remains at
0.10).

# Solution Numerical Problem 5 (a):

##
To solve this problem, we calculate the inflation rate using the
following formula:

##

##

##
But, in this problem, the money supply is constant,
then:

##

##

##

# Solved Numerical Problem: Exercise 5 (b) Page 278

##
Consider an economy with a constant nominal money supply, a constant
level of real output *Y =* 100, and a real interest rate, *r* = 0.10.
Suppose that the income elasticity of demand is 0.5 and the interest elasticity
of money demand is 0.1.

## §
By what percentage does the equilibrium price level differ from
its initial value if the real interest increases to *r =* 0.11 (and Y
remains at 100).

# Solution:

##
To solve this problem, we calculate the inflation rate using the
following formula:

##

##

##
Again, the money supply is constant, then:

##

##

##

# Solved Analytical Problem 4 (a)

(Page 279)

##
Assume that prices and wages adjust rapidly, so that markets for labor,
goods, and assets are always in equilibrium. What are the effects of a temporary
**increase in government purchases** on:

## §
Output.

## §
The real interest rate.

## §
The current price level.

# Solved Analytical Problem 4 (c)

(Page 279)

##
Assume that prices and wages adjust rapidly, so that markets for labor,
goods, and assets are always in equilibrium. What are the effects of a temporary
**increase in labor supply** on:

## §
Output.

## §
The real interest rate.

## §
The current price level.

# The Expected Inflation Rate and the Nominal Interest Rate

##
If r is given and determined in the goods market, the nominal interest
rate changes one-to-one to changes in the expected inflation rate.

##

##

##
Any factor that affects expected inflation will affect the nominal
interest rate

###
If people expect an increase in
money growth; they would expect a higher inflation rate.

Expected inflation rate would be equal to actual
inflation rate when money and income growth are stable.
The End

Important
Information about your test on Friday, October 31st

__Material:__
Chapter 3: Sections 3, 4, and 5. Review also section 2 to analyze changes in
equilibrium in the labor market.

Chapter
4: All the sections, including the appendix. Concentrate on topics covered in
class.

Chapter
7: All the sections, again, concentrate on topics covered in class.

Please,
arrive early and occupy front rows first. Do not use the last rows and do not
leave any empty seat (unless is broken).

Bring
calculator, No. 2 pencils, eraser and your PantherSoft I.D. (or your license).

Leave
your book bag, notebooks, textbook at the front of the classroom, before taking
a seat.

Study
and practice with your study guide. Good Luck.