THE ASSET MARKET, Chapter 7

MONEY, AND PRICES

 THE ASSET MARKET, MONEY,
AND PRICES
In Chapters 3 and 4 we discussed the labor market and the goods market, two of the
three markets in our model of the macroeconomy. In this chapter we consider the
third market, the asset market. By asset market we mean the entire set of markets in
which people buy and sell real and financial assets, including, for example, gold,
houses, stocks, and bonds.
WHAT IS MONEY?
In economics the meaning of the term money is different from its everyday meaning.
People often say money when they mean income or wealth, as in: That job pays good
money, or Her family has a lot of money. In economics, however, money refers
specifically to assets that are widely used and accepted as payment.
Historically, the forms of money have ranged from beads and shells to gold and
silver—and even to cigarettes.
In modern economies the most familiar forms of money are coins and paper money,
or currency. Another common form of money is checkable deposits, or bank
accounts on which checks can be written for making payments
THE FUNCTIONS OF MONEY
MEDIUM OF EXCHANGE

In an economy with no money, trading takes the form of barter, or the direct
exchange of certain goods for other goods. Even today some people belong to barter
clubs, in which members swap goods and services among themselves. Generally,
though, barter is an inefficient way to trade because finding someone who has the
item you want and is willing to exchange that item for something you have is both
difficult and time-consuming. In a barter system, if one of the authors of this book
wanted a restaurant meal, he would first have to find a restaurateur willing to trade
his blue-plate special for an economics lecture—which might not be easy to do.
In functioning as a medium of exchange, or a device for making transactions,
money permits people to trade at less cost in time and effort
THE FUNCTIONS OF MONEY
UNIT OF ACCOUNT

As a unit of account, money is the basic unit for measuring economic value. In
the United States, for example, virtually all prices, wages, asset values, and debts are
expressed in dollars. Having a single, uniform measure of value is convenient. For
example, pricing all goods in the United States in dollars—instead of some goods
being priced in yen, some in gold, and some in Microsoft shares—simplifies
comparison among different goods.
THE FUNCTIONS OF MONEY
STORE OF VALUE

As a store of value, money is a way of holding wealth. An extreme example is a

miser who keeps his life’s savings in cash under the mattress. But even someone who
spends his cash wages fifteen minutes after receiving them is using money as a store
of value for that short period.
In most cases, only money functions as a medium of exchange or a unit of account,
but any asset—for example, stocks, bonds, or real estate—can be a store of value. As
these other types of assets normally pay the holder a higher return than money does,
why do people use money as a store of value? The answer is that money’s usefulness
as a medium of exchange makes it worthwhile to hold, even though its return is
relatively low.
MEASURING MONEY: THE
MONETARY AGGREGATES
Money is defined as those assets that are widely used and accepted in payment. This
definition suggests a hard-and-fast line between assets that should be counted as
money and those that should not. Actually, the distinction between monetary assets
and nonmonetary assets isn’t so clear.
Because assets differ in their “moneyness,” no single measure of the amount of
money in the economy—or the money stock, as it is often called—is likely to be
completely satisfactory. For this reason, in most countries economists and
policymakers use several different measures of the money stock. These official
measures are known as monetary aggregates
THE M1 MONETARY
AGGREGATE
The most narrowly defined official money measure, M1, consists primarily of
currency and balances held in checking accounts. More precisely, M1 is made up
of currency (including U.S. currency circulating outside the United States; and
travelers’ checks held by the public, and transaction accounts that allow depositors to
write checks, transfer funds to other accounts, and use ATMs (automated teller
machines) and debit cards. M1 is perhaps the closest counterpart of the theoretical
definition of money because all its components are actively used and widely
accepted for making payments.
THE M2 MONETARY
AGGREGATE
Everything in M1 plus other assets that are somewhat less “moneylike”
compose M2. The main additional assets in M2 include savings deposits, small-
denomination (under $100,000) time deposits, noninstitutional holdings of money
market mutual funds (MMMFs), and money market deposit accounts (MMDAs). All
of these accounts have limits on the number of checks or other transfers that can be
written each month. Time deposits are interest bearing deposits with a fixed term
(early withdrawal usually involves a penalty). As mentioned, MMMFs invest their
shareholders’ funds in short-term securities, pay market-based interest rates, and
allow holders to write a limited number of checks. MMDAs are like MMMFs,
except they are offered by banks or thrift institutions such as savings and loan
associations
THE MONEY SUPPLY
The money supply is the amount of money available in an economy.1 In modern
economies the money supply is determined by the central bank—in the United
States, the Federal Reserve System.
To grasp the basic idea, however, let’s consider the simple hypothetical situation in
which the only form of money is currency. In this case, to increase the money supply
the central bank needs only to increase the amount of currency in circulation. How
can it do so?
OPEN-MARKET OPERATIONS
Open-market purchase
One way—which is close to what happens in practice—is for the central bank to use
newly minted currency to buy financial assets, such as government bonds, from the
public. In making this swap, the public increases its holdings of money, and the
amount of money in circulation rises. When the central bank uses money to purchase
government bonds from the public, thus raising the money supply, it is said to have
conducted an open-market purchase.
OPEN-MARKET OPERATIONS
Open-market sale
To reduce the money supply, the central bank can make this trade in reverse, selling
government bonds that it holds to the public in exchange for currency. After the
central bank removes this currency from circulation, the money supply is lower.
When the central bank sells government bonds to the public to reduce the money
supply, the transaction is an open-market sale.
Open-market purchases and sales together are called open-market operations.
QUIZ 3
PORTFOLIO ALLOCATION AND THE
DEMAND FOR ASSETS
A consumer, a business, a pension fund, a university, or any other holder of wealth
must decide how to distribute that wealth among many types of assets. The set of
assets that a holder of wealth chooses to own is called a portfolio. The decision about
which assets and how much of each asset to hold is called the portfolio allocation
decision.
PORTFOLIO ALLOCATION AND THE
DEMAND FOR ASSETS
Expected Return
The rate of return to an asset is the rate of increase in its value per unit of time. For example,
the return on a bank account is the interest rate on the account. The return on a share of stock
is the dividend paid by the stock plus any increase in the stock’s price. Clearly, a high return
is a desirable feature for an asset to have: All else being equal, the higher the return a wealth
holder’s portfolio provides, the more consumption she can enjoy in the future for any given
amount of saving done today.
Of course, the return on an asset is not always known in advance. Stock prices may go up or
down, for example. Thus holders of wealth must base their portfolio allocation decisions on
expected returns, or their best guesses about returns on assets. Everything else being equal,
the higher an asset’s expected return (after subtracting taxes and fees such as brokers’
commissions), the more desirable the asset is and the more of it holders of wealth will
want to own.
PORTFOLIO ALLOCATION AND THE
DEMAND FOR ASSETS
Risk
The uncertainty about the return an asset will earn relates to the second important
characteristic of assets—riskiness. An asset or a portfolio of assets has high risk if
there is a significant chance that the actual return received will be very different from
the expected return. An example of a risky asset is a share in a start-up Internet
company that will be worthless if the company fails but will grow in value by a
factor of ten if the company succeeds. Because most people don’t like risk, they hold
risky assets only if the expected return is higher than that on relatively safe assets,
such as government bonds. The risk premium is the amount by which the expected
return on a risky asset exceeds the return on an otherwise comparable safe asset.
PORTFOLIO ALLOCATION AND THE
DEMAND FOR ASSETS
Liquidity
Besides risk and return a third characteristic, liquidity, affects the desirability of assets. The
liquidity of an asset is the ease and quickness with which it can be exchanged for goods,
services, or other assets. Because it is accepted directly in payment, money is a highly liquid
asset. An example of an illiquid asset is your automobile: Time and effort are required to
exchange a used car for other goods and services; you must find someone interested in
buying the car and arrange legal transfer of ownership. Between liquid money and illiquid
autos are many assets, such as stocks and bonds, of intermediate liquidity. A share of stock,
for example, can’t be used directly to pay for groceries as cash can, but stock can be
transformed into cash with a short delay and at the cost of a broker’s fee.
Everything else being equal, the more liquid an asset is, the more attractive it will be to
holders of wealth.
PORTFOLIO ALLOCATION AND THE
DEMAND FOR ASSETS
Time to Maturity
Financial securities have a fourth and final key characteristic, which is their time to
maturity. Time to maturity is the amount of time until a financial security matures
and the investor is repaid his or her principal. Considering time to maturity is
especially relevant for all types of bonds, as an investor can purchase bonds that will
mature at any time—in one day, one week, one month, one year, or thirty years.
ASSET DEMANDS
Typically, there is a trade-off among the four characteristics that make an asset
desirable: a high expected return, safety (low risk), liquidity, and time to maturity.
For example, a safe and liquid asset with a short time to maturity, such as a checking
account, is likely to have a low expected return. The essence of the portfolio
allocation decision is determining which assets, taken together, achieve the wealth
holder’s preferred combination of expected return, safety, liquidity, and time to
maturity. In addition to the risk of each asset separately, the investor should also
consider diversification, the idea that spreading out his or her investment in
different assets can reduce his or her overall risk, because when one asset has a low
return, another may have a high return
THE DEMAND FOR MONEY
The demand for money is the quantity of monetary assets, such as cash and checking
accounts, that people choose to hold in their portfolios. Choosing how much money to
demand is thus a part of the broader portfolio allocation decision. In general, the
demand for money—like the demand for any other asset—will depend on the
expected return, risk, liquidity, and time to maturity of money and other assets.
In practice, two features of money are particularly important. First, money is the
most liquid asset. This liquidity is the primary benefit of holding money.
Second, money pays a low return (indeed, currency pays a zero nominal return). The
low return earned by money, relative to other assets, is the major cost of holding
money. People’s demand for money is determined by how they trade off their desire
for liquidity against the cost of a lower return.
THE MONEY DEMAND
FUNCTION

Md = the aggregate demand for money, in nominal terms;

P = the price level;
Y = real income or output;
i = the nominal interest rate earned by alternative, nonmonetary assets;
L = a function relating money demand to real income and the nominal interest rate.
VELOCITY AND THE QUANTITY
THEORY OF MONEY
A concept related to money demand, which at times is used in discussions of
monetary policy, is velocity. It measures how often the money stock “turns over”
each period. Specifically, velocity is nominal GDP (the price level, P, times real
output, Y) divided by the nominal money stock, M. If we let V represent velocity,
V = (nominal GDP) / nominal money stock = PY /M
If velocity rises, each dollar of the money stock is being used in a greater dollar
volume of transactions in each period, if we assume that the volume of
The quantity theory of money asserts that real money demand is proportional to
real income.
Md /P = kY
 ASSET MARKET
EQUILIBRIUM
Under the simplifying assumption that assets can be
grouped into two categories—money and nonmonetary
assets—the asset market is in equilibrium if the
quantity of money supplied equals the quantity of
money demanded. When all markets are in equilibrium
(the economy is at full employment), the level of output
is determined by equilibrium in the labor market, the
real interest rate is determined by equilibrium in the
goods market, and the price level is determined by
equilibrium in the asset market. The equilibrium price
level is proportional to the nominal money supply.
MONEY GROWTH AND
INFLATION
The inflation rate equals the growth rate of the nominal money supply minus the
growth rate of real money demand. The growth rate of real money demand in turn
depends primarily on the real income growth rate. Expected inflation depends on
expected growth rates of the nominal money supply and real income. For a given
real interest rate, the nominal interest rate responds one-for-one to changes in
expected inflation.