Macro_C07

8/3/2019 Macro_C07

1/75

The Asset Market,

Money, and Prices

Chapter 7

8/3/2019 Macro_C07

2/75

Chapter Outline

What Is Money?

Portfolio Allocation and the Demand forAssets

The Demand for Money

Asset Market Equilibrium

Money Growth and Inflation

8/3/2019 Macro_C07

3/75

What Is Money?

Money: assets that are widely used andaccepted as payment

The functions of money

Medium of exchange

Unit of account

Store of value

8/3/2019 Macro_C07

4/75

What Is Money?


Medium of exchange

Barter is inefficientdouble coincidence of wants

Money allows people to trade their labor for money,then use the money to buy goods and services inseparate transactions

Money thus permits people to trade with less cost intime and effort

Money allows specialization, so people dont have toproduce their own food, clothing, and shelter

8/3/2019 Macro_C07

5/75

What Is 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 differentunit of account, so they dont have to constantly

change prices

8/3/2019 Macro_C07

6/75

What Is Money?


Store of value

Money can be used to hold wealth

Most people use money only as a store of value for ashort period and for small amounts, because it earnsless interest than money in the bank

8/3/2019 Macro_C07

7/75

What Is Money?

In Touch with Data and Research:

Money in a prisoner-of-war camp

Radford article on the use of cigarettes as money

Cigarette use as money developed because barter wasinefficient

Even nonsmokers used cigarettes as money

Characteristics of cigarettes as money: standardized (sovalue was easy to ascertain), low in value (so change

could be made), portable, fairly sturdy Problem with having a commodity money like cigarettes:

cant smoke them and use them as money at the sametime

8/3/2019 Macro_C07

8/75

What Is Money?

Measuring moneythe monetaryaggregates

Distinguishing what is money from what isnt

money is sometimes difficult For example, MMMFs allow checkwriting, but give a

higher return than bank checking accounts: Are theymoney?

Theres no single best measure of the money stock

8/3/2019 Macro_C07

9/75

What Is Money?

Measuring money

The M1 monetary aggregate

Currency and travelers checks held by the public

Demand deposits (which pay no interest) Other checkable deposits (which may pay interest)

All components of M1 are used in makingpayments, so M1 is the closest money measureto our theoretical description of money

8/3/2019 Macro_C07

10/75

What Is Money?

Measuring money


M2 = M1 + less moneylike assets

Additional assets in M2: savings deposits

small (< $100,000) time deposits

noninstitutional MMMF balances

money-market deposit accounts (MMDAs)

8/3/2019 Macro_C07

11/75

Table 7.1 U.S. Monetary Aggregates (June2009)

8/3/2019 Macro_C07

12/75

What Is Money?

Measuring money


Savings deposits include passbook savings accounts

Time deposits bear interest and have a fixed term(substantial penalty for early withdrawal)

MMMFs invest in very short-term securities and allowcheckwriting

MMDAs are offered by banks as a competitor to

MMMFs

8/3/2019 Macro_C07

13/75

What Is Money?

In Touch with Data and Research:

Where have all the dollars gone?

In 2009, U.S. currency averaged about $2800

per person, but surveys show people only holdabout $100

Some is held by businesses and theunderground economy, but most is held abroad

Foreigners hold dollars because of inflation intheir local currency and political instability

8/3/2019 Macro_C07

14/75

What Is Money?

Where have all the dollars gone?

Since currency is 1/2 of M1 and over half ofcurrency is held abroad, foreigners hold over

1/4 of M1 The data show large fluctuations in M1 when major

events occur abroad, like military conflicts

The United States benefits from foreignholdings of our currency, since we essentially

get an interest-free loan

8/3/2019 Macro_C07

15/75

What Is Money?

The money supply

Money supply = money stock = amount ofmoney available in the economy

8/3/2019 Macro_C07

16/75

What Is Money?

The money supply

How does the central bank of a countryincrease the money supply?

Use newly printed money to buy financial assets fromthe publican open-market purchase

To reduce the money supply, sell financial assets tothe public to remove money from circulationanopen-market sale

Open-market purchases and sales are called open-market operations

8/3/2019 Macro_C07

17/75

What Is Money?

The money supply

How does the central bank of a countryincrease the money supply?

Could also buy newly issued government bondsdirectly from the government (i.e., the Treasury)

This is the same as the government financing itsexpenditures directly by printing money

This happens frequently in some countries (though isforbidden by law in the United States)

8/3/2019 Macro_C07

18/75

What Is Money?

The money supply

Throughout text, use the variable Mtorepresent money supply; this might be M1 or

M2

8/3/2019 Macro_C07

19/75


How do people allocate their wealth amongvarious assets? The portfolio allocation decision

8/3/2019 Macro_C07

20/75


Expected return

Rate of return = an assets increase in valueper 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 highestexpected return (other things equal)

Returns not known in advance, so peopleestimate their expected return

8/3/2019 Macro_C07

21/75


Risk

Risk is the degree of uncertainty in an assetsreturn

People dont like risk, so they prefer assetswith low risk (other things equal)

8/3/2019 Macro_C07

22/75


Liquidity

Liquidity: the ease and quickness with which anasset can be traded

Money is very liquid Assets like automobiles and houses are very

illiquid long time and large transaction coststo trade them

Stocks and bonds are fairly liquid Investors prefer liquid assets (other things

equal)

8/3/2019 Macro_C07

23/75


Time to maturity

Time to maturity: the amount of time until afinancial security matures and the investor is

repaid the principal Expectations theory of the term structure of

interest rates The idea that investors compare returns on bonds

with differing times to maturity

In equilibrium, holding different types of bonds overthe same period yields the same expected return

8/3/2019 Macro_C07

24/75


Time to maturity

Because long-term interest rates usuallyexceed short-term interest rates, a risk

premium exists: the compensation to aninvestor for bearing the risk of holding a long-term bond

8/3/2019 Macro_C07

25/75


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 riskand 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 forcapital gains, but is quite illiquid

8/3/2019 Macro_C07

26/75


Types of assets and their characteristics

Households must consider what mix of assetsthey wish to own

Table 7.2 shows the mix in 2006 and 2009,and illustrates the large declines in the value ofstocks and housing

8/3/2019 Macro_C07

27/75

Table 7.2 Household Assets, 2006 and 2009

8/3/2019 Macro_C07

28/75


In touch with data and research: thehousing crisis that began in 2007 People gained tremendous wealth in their

houses in the 2000s As house prices rose, houses becameincreasingly unaffordable, leading mortgagelenders to create subprime loans for peoplewho wouldnt normally qualify to buy houses

Most subprime loans had adjustable interestrates, with a low initial interest rate that wouldlater rise in a process known as mortgage reset

8/3/2019 Macro_C07

29/75


The housing crisis that began in 2007 As long as housing prices kept rising, both

lenders and borrowers thought the subprimeloans would work out, as the borrowers couldalways sell their houses to pay off the loans

But housing prices stopped rising as much,leading more subprime borrowers to default, sobanks began to tighten their lending standards,reducing the demand for housing and leadinghousing prices to start falling (text Fig. 7.1)

8/3/2019 Macro_C07

30/75

Figure 7.1 Increase in home prices from oneyear earlier, 1976-2009

Source: Federal Housing Finance Agency, www.fhfa.gov.

8/3/2019 Macro_C07

31/75


The housing crisis that began in 2007

Many homeowners lost their homes and financialinstitutions lost hundreds of billions of dollars because ofmortgage loan defaults

Because many mortgage loans had been securitized andwere parts of mortgage-backed securities, the increaseddefault rate on mortgages led to a financial crisis in Fall2008, as many investors simultaneously tried to sellrisky assets, including mortgage-backed securities and

stocks

8/3/2019 Macro_C07

32/75


Asset Demands

Trade-off among expected return, risk,liquidity, and time to maturity

Assets with low risk and high liquidity, likechecking accounts, have low expected returns

Investors consider diversification: spreadingout 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

8/3/2019 Macro_C07

33/75


The demand for money is the quantity ofmonetary assets people want to hold intheir portfolios

Money demand depends on expected return,risk, and liquidity

Money is the most liquid asset

Money pays a low return

Peoples money-holding decisions depend onhow much they value liquidity against the lowreturn on money

8/3/2019 Macro_C07

34/75


Key macroeconomic variables that affectmoney demand

Price level

Real income Interest rates

8/3/2019 Macro_C07

35/75


Price level

The higher the price level, the more money youneed for transactions

Prices are 10 times as high today as in 1935,so it takes 10 times as much money forequivalent transactions

Nominal money demand is thus proportional to

the price level

8/3/2019 Macro_C07

36/75


Real income

The more transactions you conduct, the moremoney you need

Real income is a prime determinant of thenumber of transactions you conduct

So money demand rises as real income rises

8/3/2019 Macro_C07

37/75


Real income

But money demand isnt proportional to realincome, since higher-income individuals use

money more efficiently, and since a countrysfinancial sophistication grows as its incomerises (use of credit and more sophisticatedassets)

Result: Money demand rises less than 1-to-1with a rise in real income

8/3/2019 Macro_C07

38/75


Interest rates

An increase in the interest rate or return onnonmonetary assets decreases the demand for

money An increase in the interest rate on money

increases money demand

This occurs as people trade off liquidity for

return

8/3/2019 Macro_C07

39/75


Interest rates

Though there are many nonmonetary assetswith many different interest rates, because

they often move together we assume that fornonmonetary assets theres just one nominalinterest rate, i

8/3/2019 Macro_C07

40/75


The money demand function

Md= P L(Y, i) (7.1)

Md is nominal money demand (aggregate)

Pis the price level L is the money demand function

Y is real income or output

i is the nominal interest rate on nonmonetary assets

8/3/2019 Macro_C07

41/75



As discussed above, nominal money demand isproportional to the price level

A rise in Y increases money demand; a rise in ireduces money demand

We exclude im from Eq. (7.1) since it doesntvary much

8/3/2019 Macro_C07

42/75



Alternative expression:

Md= P L(Y, r+ e) (7.2)

A rise in ror e reduces money demand

Alternative expression:

Md/P = L(Y, r+ e) (7.3)

8/3/2019 Macro_C07

43/75


Other factors affecting money demand

Wealth: A rise in wealth may increase moneydemand, but not by much

Risk Increased riskiness in the economy may increase

money demand

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

8/3/2019 Macro_C07

44/75


Other factors affecting money demand

Liquidity of alternative assets: Deregulation,competition, and innovation have given other

assets more liquidity, reducing the demand formoney

Payment technologies: Credit cards, ATMs, andother financial innovations reduce moneydemand

8/3/2019 Macro_C07

45/75

Summary 9

8/3/2019 Macro_C07

46/75


Elasticities of money demand

How strong are the various effects on moneydemand?

Statistical studies on the money demandfunction show results in elasticities

Elasticity: The percent change in moneydemand caused by a one percent change insome factor

8/3/2019 Macro_C07

47/75


Elasticities of money demand Income elasticity of money demand

Positive: Higher income increases money demand

Less than one: Higher income increases money

demand less than proportionately Goldfelds results: income elasticity = 2/3

Interest elasticity of money demand Small and negative: Higher interest rate on

nonmonetary assets reduces money demand slightly

Price elasticity of money demand is unitary, somoney demand is proportional to the pricelevel

8/3/2019 Macro_C07

48/75


Velocity and the quantity theory of money

Velocity (V) measures how much money turnsover each period

V= nominal GDP / nominal money stock= PY/ M (7.4)

Plot of velocities for M1 and M2 (Fig. 7.2)shows fairly stable velocity for M2, erratic

velocity for M1 beginning in early 1980s

8/3/2019 Macro_C07

49/75

Figure 7.2 Velocity of M1 and M2, 1959-2009

Source: FRED database of the Federal Reserve Bank of St. Louis, research.stlouisfed.org/fred2, series M1SL, M2SL, and GDP.

8/3/2019 Macro_C07

50/75



Plot of money growth (text Figure 7.3) showsthat instability in velocity translates into erratic

movements in money growth

8/3/2019 Macro_C07

51/75

Figure 7.3 Growth rates of M1 and M2,1960-2009

Source: FRED database of the Federal Reserve Bank of St. Louis, research.stlouisfed.org/fred2, series M1SL and M2SL.

8/3/2019 Macro_C07

52/75



Quantity theory of money: Real money demandis proportional to real income

If so,Md/ P= kY

(7.5) Assumes constant velocity, where velocity isnt

affected by income or interest rates

8/3/2019 Macro_C07

53/75


Velocity and the quantity theory of money But velocity of M1 is not constant; it rose steadily

from 1960 to 1980 and has been erratic since then

Part of the change in velocity is due to changes in

interest rates in the 1980s Financial innovations also played a role in velocitys

decline in the early 1980s

M2 velocity is closer to being a constant, but not overshort periods

8/3/2019 Macro_C07

54/75


Asset market equilibriuman aggregationassumption

Assume that all assets can be grouped into two

categories, money and nonmonetary assets Money includes currency and checking accounts

Pays interest rate im

Supply is fixed at M

Nonmonetary assets include stocks, bonds, land, etc.

Pays interest rate i= r+ e

Supply is fixed at NM

8/3/2019 Macro_C07

55/75


Asset market equilibrium occurs when quantity ofmoney supplied equals quantity of moneydemanded

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)

8/3/2019 Macro_C07

56/75


So excess demand for money (Md M)plus excess demand for nonmonetaryassets (NMd NM) equals 0

So if money supply equals money demand,nonmonetary asset supply must equalnonmonetary asset demand; then entireasset market is in equilibrium

8/3/2019 Macro_C07

57/75


The asset market equilibrium conditionM/ P= L(Y, r+ e)(7.9)

real money supply = real money demand Mis determined by the central bank e is fixed (for now)

The labor market determines the level ofemployment; using employment in the

production function determines Y Given Y, the goods market equilibrium

condition determines r

8/3/2019 Macro_C07

58/75


The asset market equilibrium condition

With all the other variables in Eq. (7.9)determined, the asset market equilibrium

condition determines the price levelP= M/ L(Y, r+ e) (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

8/3/2019 Macro_C07

59/75


The inflation rate is closely related to thegrowth rate of the money supply

Rewrite Eq. (7.10) in growth-rate terms:

P/P= M/M L(Y,r+ e

)/L(Y,r+ e

) (7.11) If the asset market is in equilibrium, the

inflation rate equals the growth rate of thenominal money supply minus the growth rateof real money demand

8/3/2019 Macro_C07

60/75


To predict inflation we must forecast both moneysupply growth and real money demand growth

In long-run equilibrium, we will have iconstant, so letslook just at growth in Y

Let LY be the elasticity of money demand with respect toincome

Then from Eq. (7.11),

= M/M LY Y/Y(7.12) Example: Y/Y= 3%, LY = 2/3, M/M= 10%, then =

8%

8/3/2019 Macro_C07

61/75


Application: money growth and inflation inthe European countries in transition

Though the countries of Eastern Europe

are becoming more market-oriented,Russia and some others have high inflationbecause of rapid money growth

8/3/2019 Macro_C07

62/75


Application: money growth and inflation in theEuropean countries in transition

Both the growth rates of money demand and moneysupply affect inflation, but (in cases of high inflation)

usually growth of nominal money supply is the mostimportant factor

For example, ifLY = 2/3 and Y/Y= 15%, L/L = 10% (=2/3 v 15%); or ifY/Y= 15%, L/L = 10%

So money demand doesnt vary much, no matter how wellor poorly an economy is doing

But nominal money supply growth differs across countriesby hundreds of percentage points, so large inflationdifferences must be due to money supply, not moneydemand

8/3/2019 Macro_C07

63/75



Fig. 7.4 shows the link between money growth

and inflation in these countries; inflation isclearly positively associated with money growth

8/3/2019 Macro_C07

64/75

Figure 7.4 The relationship betweenmoney growth and inflation

Source: Money growth rates and consumer price inflation from International FinancialStatistics,February 2003, International Monetary Fund. Figure shows European countries in transition for whichthere are complete data.

8/3/2019 Macro_C07

65/75



So why do countries allow money supplies to

grow quickly, if they know it will causeinflation?

They sometimes find that printing money is the onlyway to finance government expenditures

This is especially true for very poor countries, or

countries in political crisis

8/3/2019 Macro_C07

66/75


The expected inflation rate and thenominal interest rate

For a given real interest rate (r), expected

inflation (e

) determines the nominal interestrate (i= r+ e)

8/3/2019 Macro_C07

67/75



What factors determine expected inflation?

People could use Eq. (7.12), relating inflation to thegrowth rates of the nominal money supply and realincome

If people expect an increase in money growth, theywould then expect a commensurate increase in theinflation rate

The expected inflation rate would equal the currentinflation rate if money growth and income growth werestable

8/3/2019 Macro_C07

68/75



What factors determine expected inflation?

Expectations cant be observed directly They can be measured roughly by surveys

If real interest rates are stable, expected inflation canbe inferred from nominal interest rates

Policy actions that cause expected inflation to riseshould cause nominal interest rates to rise

8/3/2019 Macro_C07

69/75



Text Fig. 7.5 plots U.S. inflation and nominal

interest rates Inflation and nominal interest rates have tended to

move together

But the real interest rate is clearly not constant

The real interest rate was negative in the mid-1970s,

then became much higher and positive in the late-1970s to early-1980s

8/3/2019 Macro_C07

70/75

Figure 7.5 Inflation and the nominal interestrate in the United States, 19602009

Source: FRED database of the Federal Reserve Bank of St. Louis, research.stlouisfed.org/fred2, series GS1 (interest rate) and CPIAUCNS(CPI).

8/3/2019 Macro_C07

71/75


Application: measuring inflationexpectations How do we find out peoples expectations of

inflation? We could look at surveys

But a better way is to observe implicit expectationsfrom bond interest rates

The U.S. government issues nominal bonds andTreasury Inflation Protected Securities (TIPS) TIPS bonds make real interest payments by adjusting

interest and principal for inflation

Compare nominal interest rate with real interest rate(Fig. 7.6)

i 6 l d

8/3/2019 Macro_C07

72/75

Figure 7.6 Interest rates on nominal andTIPS ten-year notes, 1997-2009

Sources: Nominal interest rate: Federal Reserve Board of Governors, available at research.stlouisfed.org/fred2/series/GS10; TIPSinterest rates: constructed by authors from latest ten-year TIPS note yield, yield data available atresearch.stlouisfed.org/fred2/series/TP10J07to TP10J19.

8/3/2019 Macro_C07

73/75


Application: measuring inflation expectations

The interest rate differential: interest rate on nominalbonds minus real interest rate on TIPS bonds

The interest rate differential is a rough measure of expected

inflation TIPS bonds have lower inflation risk, so the measure of

expected inflation may be too high

TIPS bonds do not have as liquid of a market, so themeasure of expected inflation may be too low

The net effect of the two effects is likely to be small, so the

measure of expected inflation may be about right

8/3/2019 Macro_C07

74/75


Application: measuring inflationexpectations

The data show fluctuations in the expected

inflation rate based on the interest ratedifferential (Fig. 7.7)

In contrast, the rate of expected inflation measured insurveys has been fairly constant

Either bond market participants have very different

inflation expectations than forecasters, or else thedegree of inflation risk and liquidity on TIPS bondsvaried substantially from 1998 to 2009

8/3/2019 Macro_C07

75/75

Figure 7.7 Alternative measures ofexpected inflation, 1997-2009

Sources: Interest rate differential: authors calculations from data for Fig. 7.6; Survey of Professional Forecasters: Federal Reserve Bank ofPhiladelphia, available at www.philadelphiafed.org.

Macro_C07

Documents

Transcript of Macro_C07