Macroeconomic Analysis I

Topic 6

The Asset Market, Money and Prices

(Abel, Bernanke & Croushore: Chapter 7)

1
 Learning Objectives

• Discuss the functions of money

• Discuss the factors that affect how people choose which

assets they own

• Examine the macroeconomic variables which affect the

demand for money

• Discuss the fundamentals of asset market equilibrium

• Discuss the relationship between money growth and

inflation

2
 What Is Money?
Money: assets that are widely used and accepted as
payment

The functions of money

1
– Medium of exchange
2
– Unit of account
3 – Store of value

3
 What Is Money?
The functions of money
– Medium of exchange
• Barter is inefficient—double coincidence of wants
• Money allows people to trade their labor for
money, then use the money to buy goods and
services in separate transactions
• Money thus permits people to trade with less cost
in time and effort
• Money allows specialization, so people don’t have
to produce their own food, clothing, and shelter

4
 What Is Money?
The functions of money
– Unit of account
• Money is basic unit for measuring economic value
• Simplifies comparisons of prices, wages, and
incomes
• The unit-of-account function is closely linked with
the medium-of-exchange function
• Countries with very high inflation may use a
different unit of account, so they don’t have to
constantly change prices

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 What Is Money?
The functions of money
– Store of value
• Money can be used to hold wealth
• Most people use money only as a store of value
for a short period and for small amounts,
because it earns less interest than money in the
bank

6
Portfolio Allocation and the Demand for Assets
– How do people allocate their wealth among various
assets? The portfolio allocation decision

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 Portfolio Allocation and the Demand for Assets
Expected return
– Rate of return = an asset’s increase in value per unit
of time
• Bank account: Rate of return = interest rate
• Corporate stock: Rate of return = dividend yield +
percent increase in stock price

– Investors want assets with the highest expected

return (other things equal)

– Returns not known in advance, so people estimate

their expected return

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 Portfolio Allocation and the Demand for Assets
Risk
– Risk is the degree of uncertainty in an asset’s return

– People do not like risk, so they prefer assets with

low risk (other things equal)

– Risk premium: the amount by which the expected

return on a risky asset exceeds the return on an
otherwise comparable safe asset

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 Portfolio Allocation and the Demand for Assets
Liquidity
– Liquidity: the ease and quickness with which an asset
can be traded

– Money is very liquid

– Assets like automobiles and houses are very illiquid

i.e. incur long time and large transaction costs to
trade them

– Stocks and bonds are fairly liquid

– Investors prefer liquid assets (other things equal)

10
 Portfolio Allocation and the Demand for Assets
Time to maturity
– Time to maturity: the amount of time until a financial
security matures and the investor is repaid the
principal

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 Portfolio Allocation and the Demand for Assets
Types of assets and their characteristics
– People hold many different assets, including money,
bonds, stocks, houses, and consumer durable goods
• Money has a low return, but low risk and high
liquidity
• Bonds have a higher return than money, but have
more risk and less liquidity
• Stocks pay dividends and can have capital gains
and losses, and are much more risky than money
• Ownership of a small business is very risky and not
liquid at all, but may pay a very high return
• Housing provides housing services and the
potential for capital gains, but is quite illiquid
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 Portfolio Allocation and the Demand for Assets
In touch with data and research: Capital Flows and
Property Prices
• When individuals decide what kinds of assets to invest
in with their wealth, most look first at assets in their
home countries because of their knowledge of these
markets.

• Increasingly, however, people also look overseas for

investment opportunities. These investments can
include buying foreign stocks, bonds, and real estate.

• These flows of funds across national boundaries looking

for a return are called capital flows. Figure 7.1 shows
net private capital inflows into emerging economies
13
Figure 7.1, Net private capital inflows into emerging
economies (billions of U.S. dollars)

Source: Copyright 2012. The Institute of International Finance, Inc.

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 Portfolio Allocation and the Demand for Assets
Asset Demands
– Trade-off among expected return, risk, liquidity, and
time to maturity

– Assets with low risk and high liquidity, like checking

accounts, have low expected returns

– Investors consider diversification: spreading out

investments in different assets to reduce risk

– The amount a wealth holder wants of an asset is his

or her demand for that asset

– The sum of asset demands equals total wealth

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 The Demand for Money
The demand for money is the quantity of monetary assets
people want to hold in their portfolios
– Money demand depends on expected return, risk,
and liquidity

– Money is the most liquid asset

– Money pays a low return

– People’s money-holding decisions depend on how

much they value liquidity against the low return on
money

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 The Demand for Money
Key macroeconomic variables that affect money demand
(A) – Price level

(b) – Real income

(C
) – Interest rates

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 The Demand for Money
Price level
– The higher the price level, the more money you need
for transactions

– Prices are 10 times as high today as in 1935, so it

takes 10 times as much money for equivalent
transactions

– Nominal money demand is thus proportional to the

price level

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 The Demand for Money
Real income
– The more transactions you conduct, the more money
you need

– Real income is a prime determinant of the number of

transactions you conduct

– So money demand rises as real income rises

19
 The Demand for Money
Interest rates
– An increase in the interest rate or return on
nonmonetary assets decreases the demand for
money

– Though there are many nonmonetary assets with

many different interest rates, because they often
move together we assume that for nonmonetary
assets there’s just one nominal interest rate, i

20
 The Demand for Money
The money demand function:
Md = P × L(Y, i) (7.1)
• Md is nominal money demand (aggregate)
• P is the price level
• L is the money demand function
• Y is real income or output
• i is the nominal interest rate on nonmonetary
assets

21
 The Demand for Money
The money demand function
– As discussed above, nominal money demand is
proportional to the price level

– A rise in Y increases money demand

– A rise in i reduces money demand

t interest
of

nonmonetary
assets

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 The Demand for Money
The money demand function
)
– Alternative expression: i
nominal (

nominal -

Md = P × L(Y, r + πe)
-0 (7.2)
• A rise in r or πe reduces money demand
Md 4 0%
'
⇒ I
P t l0%
'

– Alternative expression:
Md /P = L(Y, r + πe) (7.3)

ur
.

Real
money
demand

23
 The Demand for Money
Other factors affecting money demand
(a) – Wealth: A rise in wealth may increase money

demand, but not by much

(b) – Risk holding

money ⇒ litlensk hold less nonmonetary assets

• Increased riskiness in the economy may increase

money demand
• Times of erratic inflation bring increased risk to
money, so money demand declines

24
 The Demand for Money
Other factors affecting money demand
– Liquidity of alternative assets: Deregulation,
competition, and innovation have given other assets

:
more liquidity, reducing the demand for money

d) – Payment technologies: Credit cards, ATMs, and

other financial innovations reduce money demand

25
 The Demand for Money
Elasticities of money demand
– How strong are the various effects on money
demand?

– Statistical studies on the money demand function

show results in elasticities

– Elasticity: The percent change in money demand

caused by a one percent change in some factor

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 The Demand for Money
Elasticities of money demand
Y – Income elasticity of money demand
• Positive: Higher income increases money demand
• Less than one: Higher income increases money
demand less than proportionately
• Goldfeld’s results: income elasticity = 2/3

L – Interest elasticity of money demand

• Small and negative: Higher interest rate on
nonmonetary assets reduces money demand
slightly
/
difffptorhonaiity

p – Price elasticity of money demand is unitary, so

money demand is proportional to the price level
27
 The Demand for Money
Velocity and the quantity theory of money
– Velocity (V) measures how much money “turns
over” each period

– V = nominal GDP / nominal money stock

V = PY / M (7.4)
MV =
PY
in -

total amount Of ( Nominal GDP )

money generated
to
buy the
goods
in

the
economy

mffa¥YmP
( Monetary ) ( Real )

Output
MV=PY Money

|
( Y )
( M )

"
money
.gs#E$Foo.o.
,
,

V=2
28
 The Demand for Money
Velocity and the quantity theory of money
– Quantity theory of money: Real money demand is
proportional to real income
=P '4v⇒
'4M⇒ 1¥ Ctr
M
=P = Y)

• If so, v

KY =

Md / P = kY (7.5) 'T=K ) ( let

←money
demand .

• Assumes constant velocity, where velocity isn’t

affected by income or interest rates

29
 Asset Market Equilibrium
Asset market equilibrium—an aggregation assumption
– Assume that all assets can be grouped into two
categories, money and nonmonetary assets
• Money includes currency and checking accounts
– Supply is fixed at M

• Nonmonetary assets include stocks, bonds, land,

etc.
– Pays interest rate i = r + πe
– Supply is fixed at NM

30
 Asset Market Equilibrium
Asset market equilibrium occurs when quantity of money
supplied equals quantity of money demanded
• md + nmd = total nominal wealth of an individual

• Md + NMd = aggregate nominal wealth (7.6)

(from adding up individual wealth)

• M + NM = aggregate nominal wealth (7.7)

(supply of assets)

• Subtracting Eq. (7.7) from Eq. (7.6) gives

(Md – M) + (NMd – NM) = 0 (7.8)
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 Asset Market Equilibrium
• Thus, excess demand for money (Md – M) plus excess
demand for nonmonetary assets (NMd – NM) equals 0

• Hence, if money supply equals money demand,

nonmonetary asset supply must equal nonmonetary asset
demand; then entire asset market is in equilibrium
D= M
Thus M

N Md =
NM

entire asset market is in equilibrium

32
 Asset Market Equilibrium
The asset market equilibrium condition
M / P = L(Y, r + πe) (7.9)
W
real money supply = real money demand
LS

– M is determined by the central bank

(A)
^

Eb– π
?
in
}
;
- .

1
↳ 2 assumptions

÷
:

)
N°

N
e is fixed (for now)
¥PEdnuaEomn

" – The labor market determines the level of employment;

using employment in the production function
: >
No N

determines Y

s – Given Y, the goods market equilibrium condition

determines r
§¥c#G
T s

( Y .

C- G) =I
. ...

.÷
1
|fEaEfIEIum
33
l I
- ,

s I :
=

>
10=501 Ata )
 Asset Market Equilibrium
The asset market equilibrium condition
– With all the other variables in Eq. (7.9) determined,
the asset market equilibrium condition determines
the price level
P = M / L(Y, r + πe) (7.10)

• The price level is the ratio of nominal money

supply to real money demand

• For example, doubling the money supply would

double the price level

34
 Money Growth and Inflation
The inflation rate is closely related to the growth rate of
the money supply
– Rewrite Eq. (7.10) in growth-rate terms:
ΔP/P = ΔM/M – ΔL(Y,r + πe)/L(Y,r + πe) (7.11)
That -
rate of demand
growth money
level money supply
yafl price
.

– If the asset market is in equilibrium, the inflation rate

ynflatiofgwwfhrateo
neonstanntinlongrun
equals the growth rate of the nominal money supply
minus the growth rate of real money demand

a (F)

Oct =
Oda .

obb

35
 Money Growth and Inflation
To predict inflation we must forecast both money supply
growth and real money demand growth
• In long-run equilibrium, we will have i constant, so
let’s look just at growth in Y it He

• Let Y be the elasticity of money demand with

respect to income
elasticity of

¢
income

• Then from Eq. (7.11), Money

demand

π = ΔM/M – ΔY/Y .tn (7.12)

infants
m§¥names
# ,
Y

real growth
( )
• Example: If ΔY/Y = 3%, Y = 2/3, ΔM/M = 10%,
(213)
then π = 8% ( 3% )
T=lO%
-

=8%

36
 Money Growth and Inflation
Application: money growth and inflation in the European
countries in transition
– Both the growth rates of money demand and money
supply affect inflation, but (in cases of high inflation)
usually growth of nominal money supply is the most
important factor ( GDP growth )

• For example, if Y = 2/3 and ΔY/Y

( ) = 15%, then
ΔL/L = 10% (= 2/3 15%); or if ΔY/Y = –15%, then
ΔL/L = –10%
• So money demand does not vary much, no matter
how well or poorly an economy is doing
• But nominal money supply growth differs across
countries by hundreds of percentage points, so
large inflation differences must be due to money
supply, not money demand
37
 Money Growth and Inflation
Application: money growth and inflation in the European
countries in transition
– Fig. 7.4 shows the link between money growth and
inflation in these countries during the period 1995-
2001; inflation is clearly positively associated with
money growth

38
Figure 7.4 The relationship between money growth and inflation

%
→
Source: Money growth rates and consumer price inflation from International Financial Statistics, February 2003,
International Monetary Fund. Figure shows European countries in transition for which there are complete data.
39
 Money Growth and Inflation
Application: money growth and inflation in the European
countries in transition
– So why do countries allow money supplies to grow
quickly, if they know it will cause inflation?
• They sometimes find that printing money is the
only way to finance government expenditures

• This is especially true for very poor countries, or

countries in political crisis

40