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

Money’s Liquidity

•      The ease with which money is converted into other things (goods and services) is sometimes called money’s 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 (im) 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 asset’s 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.

    Md = $100,000 – [$50,000 + ((i – im) $5,000]

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

•      Md = $100,000 – [$50,000 + ((5% – 0%) $5,000]

•      Md = $25,000

 

The Demand for Money

•      The demand for money (Md) 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 = Md 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 im 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.