Transcript Chapter 7

Chapter 7
The Asset Market, Money, and
Prices
Goals of Chapter 7
• A) What money is and why people hold it
• B) The decision about money demand is
part of a broader portfolio decision
• C) Equilibrium in the asset market occurs
when money supply equals money
demand
• D) The price level is related to the level of
the money supply
I.
What Is Money? (Sec. 7.1)
• A) The functions of money
• 1. Medium of exchange
• 2. Unit of account
• 3. Store of value
B)
Measuring money—the monetary aggregates
• 1. Distinguishing what is money from what
isn’t money is sometimes difficult
• 2. The M1 monetary aggregate
• 3. The M2 monetary aggregate
M2 = M1 + less moneylike assets
• 4. M3 = M2 + less moneylike assets
• 5. Weighted monetary aggregates
• The Fed’s money measures add up all the
amounts in each category directly
D)
The money supply
• 1. Money supply = money stock = amount
of money available in the economy
• 2. How does the central bank of a country
increase the money supply?
• 3. Throughout text, use the variable M to
represent money supply; this might be M1,
M2, or some other aggregate
I.
Portfolio Allocation and the Demand for Assets
(Sec. 7.2)
• How do people allocate their wealth among various
assets? The portfolio allocation decision
• A) Expected return
• 1. Rate of return = an asset’s increase in value per unit
of time
• 2. Investors want assets with the highest expected
return (other things equal)
• B) Risk
• C) Liquidity
• D) Asset demands
• Trade-off among expected return, risk, and liquidity
III.
The Demand for Money (Sec. 7.3)
• A) The demand for money is the quantity
of monetary assets people want to hold in
their portfolios
• B) Key macroeconomic variables that
affect money demand
• 1. Price level
• 2. Real income
• 3. Interest rates
C)
•
•
•
•
•
•
•
The money demand function
1. Md = PL(Y, i) (7.1)
a. Md is nominal money demand (aggregate)
b. P is the price level
c. L is the money demand function
d. Y is real income or output
e. i is the nominal interest rate on nonmonetary assets
2. As discussed above, nominal money demand is proportional to
the price level
• 3. A rise in Y increases money demand; a rise in i reduces money
demand
•
4. We exclude im from Eq. (7.1) since it doesn’t vary much
• 5. Alternative expression:
•
Md = PL(Y, r + pe)
(7.2)
•
A rise in r or e reduces money demand
• 6. Alternative expression:
•
Md/P = L(Y, r + pe)
(7.3)
D) Other factors affecting money
demand
• 1. Wealth: A rise in wealth may increase
money demand, but not by much
• 2. Risk
• money, so money demand declines
• 3. Liquidity of alternative assets:
• 4. Payment technologies
E)
Elasticities of money demand
• 1. How strong are the various effects on money
demand?
• 2. Statistical studies on the money demand
function show results in elasticities
• 3. Elasticity: The percent change in money
demand caused by a one percent change in
some factor
• 4. Income elasticity of money demand
• 5. Interest elasticity of money demand
• 6. Price elasticity of money demand is unitary,
F)
Velocity and the quantity theory of money
• 1. Velocity (V) measures how much money
“turns over” each period
• 2. V = nominal GDP/nominal money stock =
PY/M
• 3. Quantity theory of money: Real money
demand is proportional to real income
•
Md/P = kY (7.5)
• Assumes constant velocity, where velocity isn’t
affected by income or interest rates
• But velocity of M1 is not constant; it rose steadily
from 1960 to 1980 and has been erratic since
then
G)
Application: financial regulation, innovation, and the
instability of money demand
• 1. Goldfeld (1973) found a stable money (M1)
demand function
• 2. But late 1974 to early 1976, M1 demand fell
relative to that predicted by the model
• 3. And in the early 1980s, M1 demand rose
relative to that predicted by the model
• 4. Why did money demand shift erratically?
•
Increased innovation and changes in the
financial system (see text Figure 7.2)
• 5. Developments in the 1990s
IV.
Asset Market Equilibrium (Sec. 7.4)
• A) Asset market equilibrium—an aggregation
assumption
• 1. Assume that all assets can be grouped into two
categories, money and nonmonetary assets
• a. Money includes currency and checking accounts
• b. Nonmonetary assets include stocks, bonds, land, etc.
• 2. Asset market equilibrium occurs when quantity of
money supplied equals quantity of money demanded
M + NM = aggregate nominal wealth (supply of assets)
(7.7)
• So the excess demand for money (Md – M) plus the
excess demand for nonmonetary assets (NMd – NM)
equals 0.
•
•
•
•
B) The asset market equilibrium condition
1. M/P = L(Y, r + e) (7.9)
real money supply = real money demand
2. With all the other variables in Eq. (7.9)
determined, the asset market equilibrium
condition determines the price level
• P = M/L(Y, r + pe) (7.10)
V.
Money Growth and Inflation (Sec. 7.5)
• A) The inflation rate is closely related to the
growth rate of the money supply
• Rewrite Eq. (7.10) in growth-rate terms:
•
DP/P = DM/M – DL(Y, r + pe )/L(Y, r + pe )
(7.11)
• 2. If the asset market is in equilibrium, the
inflation rate equals the growth rate of the
nominal money supply minus the growth rate of
real money demand
•
3. To predict inflation we must forecast both
money supply growth and real money demand
growth
B)
Application: money growth and inflation in the European
countries in transition
• 1. Though the countries of Eastern Europe are
becoming more market-oriented, Russia and
some others have high inflation because of rapid
money growth
• 2. 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
• 3. Figure 7.3 shows the link between money
growth and inflation in these countries; inflation
in clearly positively associated with money
growth
• 4. So why do countries allow money supplies to
grow quickly, if they know it will cause inflation?
C)
The expected inflation rate and the nominal
interest rate
• 1. For a given real interest rate (r), expected
inflation (e) determines the nominal interest rate
(i = r + pe)
• 2. What factors determine expected inflation?
• a. People could use Eq. (7.12), relating inflation
to the growth rates of the nominal money supply
and real income
• 3. Text Figure 7.4 plots U.S. inflation and nominal
interest rates