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Ch The Asset Market, Money and PricesAsset market - the entire set of markets in which people buy and sell real and financial assets, including, for example, gold, houses, stocks, and bonds.A type of asset that has long been believed to have special macroeconomic significance is money. Money is the ...

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Ch.7 The Asset Market, Money and Prices Asset market - the entire set of markets in which people buy and sell real and financial assets, including, for example, gold, houses, stocks, and bonds. A type of asset that has long been believed to have special macroeconomic significance is money. Money is the set of assets that are widely used and accepted as payment, such as currency and checking accounts. Money functions as a medium of exchange, a unit of account, and a store of value. 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. Having a medium of exchange also raises productivity by allowing people to specialize in economic activities at which they are most skilled. As a unit of account, money is the basic unit for measuring economic value. The medium-of-exchange and unit-of-account functions of money are closely linked. However, the medium of exchange and the unit of account aren't always the same. In countries with high and erratic inflation, for example, fluctuating currency value makes money a poor unit of account because prices must be changed frequently. In such cases, economic values are commonly stated in terms of a more stable unit of account, such as dollars or ounces of gold, even though transactions may continue to be carried out in the local currency. As a store of value, money is a way of holding wealth. 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. The central bank's official measures of money are called the monetary aggregates. M1 is made up primarily of currency and checking accounts and M2 includes a broader set of monetary assets. How can FED increase money supply? One way is 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. 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. The central bank can also increase the money supply by buying newly issued government bonds directly from the government itself.

Portfolio Allocation and the Demand for 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.  A portfolio allocation decision is made by a holder of wealth when determining how much of each asset to hold.  The major assets that people hold are money, bonds, stocks, houses, and consumer durable goods.  The rate of return to an asset is the rate of increase in its value per unit of time.  Only four characteristics of assets matter for the portfolio allocation decision: expected return, risk, liquidity, and time to maturity.  Everything else being equal, the higher an asset's expected return, the more desirable the asset is and the more of its holders of wealth will want to own.  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. 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 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. Thus, everything else being equal, the more liquid an asset is, the more attractive it will be to holders of wealth.  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.  The idea that investors compare the returns on bonds with differing times to maturity to see which is expected to give them the highest return underlies the expectations theory of the term structure of interest rates. The expected rate of return on an N-year bond should equal the average of the expected rates of return on one-year bonds during the current year and the N-1 succeeding years.  Term premium - an interest rate on long-term bonds that is somewhat higher than the expectations theory would suggest. Example: If we add the term premium to the expectations theory, we have a more complete theory of how interest rates vary with time to maturity. For example, suppose the interest rate on a one-year bond today is 5% per year, the interest rate on a one-year bond one year from now is expected to be 6% per year, and the term premium on a two-year bond is 0.75% per year. Then, in equilibrium, the interest rate on a two-year bond should equal the average interest rate on the one-year bonds, which equals (5% + 6%)/2 == 5.5°/o, plus the term premium, 0.75%, or 6.25%.

Types of Assets and Their Characteristics All types of money usually have a low expected rate of return compared with other assets. Money also usually does not have much risk, although there is always some risk that inflation will be higher than expected, so that the real return to holding money might turn out to be lower than expected. But money is very liquid compared with the other assets; indeed, its liquidity is generally the defining characteristic of what we call money. Because of its liquidity, money's time to maturity is generally very short. However, some assets included in M2, such as small-time deposits, may have a longer time to maturity and are not very liquid. Bonds are financial securities that are sometimes called fixed-income securities because they promise to pay bondholders specific amounts on specific dates. People often choose to own bonds issued by the U.S. government because these bonds have very little risk of default. Bonds issued by corporations are similar, but there is always some chance that a corporation will go bankrupt and fail to pay the interest or repay the principal it owes to its bondholders. Thus , bonds offer a higher expected return than money, but the return is riskier. Many bonds, especially those sold by the U.S. government, are very liquid, as an investor can easily sell his or her bond quickly and with low transactions costs. However, some corporate bonds are not very liquid, especially in bad economic times, and it may be difficult to sell them without a high cost. Bonds are issued in a variety of times to maturity, generally ranging from 3 months to 30 years. Stocks represent ownership in a company. Most stocks pay periodic dividends to the shareholders, but the dividend payments are not guaranteed. When the economy is weak and the company is not doing well, it may even stop paying dividends altogether for a time. Prices of stocks rise and fall every day, so the overall return to a shareholder consists of the dividends received plus any capital gain resulting from an increase in the value of the stock less any capital loss resulting from a decrease in the value of the stock. Because dividends and, especially, stock prices can change unpredictably, stocks are subject to a substantial amount of risk. Stocks in large companies are sold in very liquid markets, but when you buy or sell a stock there is a delay of several days for the transaction to clear and payment to be made. Most stocks do not have maturity dates, so the time to maturity is infinite. For most homeowners, housing is their largest asset. The returns to owning a house come in two forms: (1) the benefits to the household in terms of shelter net of maintenance costs and property taxes, and (2) the change in the value of the house (or the land it sits on) over time. Households also hold some of their assets in the form of consumer durable goods, such as automobiles and furniture. As in the case of housing, durable goods provide services (such as transportation) over a period of time but may also require maintenance expenditures and can depreciate over time. There is some risk to the value of consumer durables, and it may be difficult and costly to sell them, as the market for used consumer durables is not as well developed as the market for stocks and bonds. Thus, consumer durables are not very liquid, and, like housing, have no specified time to maturity.

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. 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 Money demand is the total amount of money that people choose to hold in their portfolios. The principal macroeconomic variables that affect money demand are the price level, real income, and interest rates. Higher prices or incomes increase people's need for liquidity and thus raise the demand for money. Thus, everything else being equal, the nominal demand for money is proportional to the price level. Interest rates affect money demand through the expected return channel: The higher the interest rate on money, the more money people will demand; however, the higher the interest rate paid on alternative assets to money, the more people will want to switch from money to those alternative assets. Higher real income increases the number of transactions and thus raises real money demand. In practice, two features of money are particularly important. First, money is the most liquid asset. Second, money pays a low return. The low return earned by money, relative to other assets, is the major cost of holding money. The Money Demand Function We express the effects of the price level, real income, and interest rates on money demand as Md = P x L(Y, i) or Md = P x L(Y, r + πe) Where: Md = the aggregate demand for money, in nominal terms P = the price level

Y = real income or output

r = expected real interest rate

i = the nominal interest rate earned by alternative, nonmonetary assets L = a function relating money demand to real income and the nominal interest rate πe = expected rate of inflation The expression Md/P is called real money demand or, sometimes, the demand for real balances. Real money demand is the amount of money demanded in terms of the goods it can buy. The function L that relates real money demand to output and interest rates is called the money demand function. Md/P = L(Y, r + πe)

Other Factors Affecting Money Demand Additional factors influencing money demand include wealth, risk, liquidity of alternative assets, and payment technologies. Summary table 9 contains a comprehensive list of variables that affect the demand for money.

Liquidity of Alternative Assets The more quickly and easily alternative assets can be converted into cash, the less need there is to hold money. As alternative assets become more liquid, the demand for money declines. Payment Technologies Money demand also is affected by the technologies available for making and receiving payments. For example, the introduction of credit cards allowed people to make transactions without money.

 The income elasticity of money demand is the percentage change in money demand resulting from a 1% increase in real income.  The interest elasticity of money demand is the percentage change in money demand resulting from a 1 °lo increase in the 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

The quantity theory of money is an early theory of money demand based on the assumption that velocity is constant, so that money demand is proportional to income. (here k is a constant)

Md/P = Ky  Historically, M2 velocity has been more stable than M1 velocity, although even M2 velocity isn't constant. To derive velocity under the quantity theory, we must assume that nominal money demand, Md, equals the actual money stock, M. Under this assumption, we verify that V = 1/k Asset Market Equilibrium: An Aggregation Assumption The asset market is in equilibrium when the quantity of each asset that holders of wealth demand equals the (fixed) available supply of that asset. We assume that all assets may be grouped into two categories: money and nonmonetary assets. Money includes assets that can be used in payment, such as currency and checking accounts. All money is assumed to have the same risk and liquidity and to pay the same nominal interest rate, i m. The fixed nominal supply of money is M. Nonmonetary assets include all assets other than money, such as stocks, bonds, land, and so on. All nonmonetary assets are assumed to have the same risk and liquidity and to pay a nominal interest rate of i = r + πe, where r is the expected real interest rate and πe is the expected rate of inflation. The fixed nominal supply of nonmonetary assets is NM. If md is the nominal amount of money and nm d is the nominal amount of nonmonetary assets that person wants to hold, the sum of person's desired money holdings and his desired holdings of nonmonetary assets must be his total wealth, or md + nmd = person's total nominal wealth

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. In long-run equilibrium with a constant nominal interest rate, the growth rate of real money demand equals the income elasticity of money demand, ny, times the growth rate of real income or output, Δ Y/Y....