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 proportiona

l to the price level• 3. A rise in Y increases money demand; a rise in i reduces mo

ney 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 a

ffected 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 fi

nancial 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 demandedM + NM = aggregate nominal wealth (supply of assets)

(7.7)• So the excess demand for money (Md – M) plus the exc

ess 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 infl

ation 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 inflatio

n 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