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The Asset Market,
Money, and Prices
Chapter 7
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Chapter Outline
What Is Money?
Portfolio Allocation and the Demand forAssets
The Demand for Money
Asset Market Equilibrium
Money Growth and Inflation
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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
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What Is Money?
The functions of 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
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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 differentunit of account, so they dont 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 ashort period and for small amounts, because it earnsless interest than money in the bank
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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
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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
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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
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What Is Money?
Measuring money
The M2 monetary aggregate
M2 = M1 + less moneylike assets
Additional assets in M2: savings deposits
small (< $100,000) time deposits
noninstitutional MMMF balances
money-market deposit accounts (MMDAs)
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Table 7.1 U.S. Monetary Aggregates (June2009)
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What Is Money?
Measuring money
The M2 monetary aggregate
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
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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
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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
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What Is Money?
The money supply
Money supply = money stock = amount ofmoney available in the economy
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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
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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)
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What Is Money?
The money supply
Throughout text, use the variable Mtorepresent money supply; this might be M1 or
M2
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Portfolio Allocation and the Demand forAssets
How do people allocate their wealth amongvarious assets? The portfolio allocation decision
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Portfolio Allocation and the Demand forAssets
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
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Portfolio Allocation and the Demand forAssets
Risk
Risk is the degree of uncertainty in an assetsreturn
People dont like risk, so they prefer assetswith low risk (other things equal)
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Portfolio Allocation and the Demand forAssets
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)
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Portfolio Allocation and the Demand forAssets
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
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Portfolio Allocation and the Demand forAssets
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
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Portfolio Allocation and the Demand forAssets
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
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Portfolio Allocation and the Demand forAssets
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
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Table 7.2 Household Assets, 2006 and 2009
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Portfolio Allocation and the Demand forAssets
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
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Portfolio Allocation and the Demand forAssets
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)
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Figure 7.1 Increase in home prices from oneyear earlier, 1976-2009
Source: Federal Housing Finance Agency, www.fhfa.gov.
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Portfolio Allocation and the Demand forAssets
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
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Portfolio Allocation and the Demand forAssets
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
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The Demand for Money
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
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The Demand for Money
Key macroeconomic variables that affectmoney demand
Price level
Real income Interest rates
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The Demand for Money
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
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The Demand for Money
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
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The Demand for Money
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
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The Demand for Money
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
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The Demand for Money
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
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The Demand for Money
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
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The Demand for Money
The money demand function
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
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The Demand for Money
The money demand function
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)
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The Demand for Money
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
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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 formoney
Payment technologies: Credit cards, ATMs, andother financial innovations reduce moneydemand
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Summary 9
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The Demand for Money
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
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The Demand for Money
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
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The Demand for Money
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
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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.
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The Demand for Money
Velocity and the quantity theory of money
Plot of money growth (text Figure 7.3) showsthat instability in velocity translates into erratic
movements in money growth
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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.
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The Demand for Money
Velocity and the quantity theory of money
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
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The Demand for Money
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
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Asset Market Equilibrium
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
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Asset Market Equilibrium
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)
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Asset Market Equilibrium
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
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Asset Market Equilibrium
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
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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 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
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Money Growth and Inflation
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
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Money Growth and Inflation
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%
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Money Growth and Inflation
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
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Money Growth and Inflation
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
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Money Growth and Inflation
Application: money growth and inflation inthe European countries in transition
Fig. 7.4 shows the link between money growth
and inflation in these countries; inflation isclearly positively associated with money growth
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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.
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Money Growth and Inflation
Application: money growth and inflation inthe European countries in transition
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
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Money Growth and Inflation
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)
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Money Growth and Inflation
The expected inflation rate and thenominal interest rate
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
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Money Growth and Inflation
The expected inflation rate and thenominal interest rate
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
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Money Growth and Inflation
The expected inflation rate and thenominal interest rate
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
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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).
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Money Growth and Inflation
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
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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.
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Money Growth and Inflation
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
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Money Growth and Inflation
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
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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.