Macroeconomics
Eleventh Edition • Global Edition
Chapter 7
The Asset Market, Money, and
Prices
© 2024 Pearson Education Ltd.
Learning Objectives
7.1 Define money, discuss its functions, and describe how it is
measured in the United States (Sec. 7.1: What Is Money?)
7.2 Discuss the factors that affect how people choose which
assets they own (Sec. 7.2: Portfolio Allocation and the
Demand for Assets)
7.3 Examine macroeconomic variables that affect the demand for
money (Sec. 7.3: The Demand for Money)
7.4 Discuss the fundamentals of asset market equilibrium (Sec.
7.4: Asset Market Equilibrium)
7.5 Discuss the relationship between money growth and inflation
(Sec. 7.5: Money Growth and Inflation)
What Is Money?
• Money: assets that are widely used and accepted as
payment
• The functions of money
– Medium of exchange
– Unit of account
– Store of value
What Is Money?
• The functions of money
– Medium of exchange
• Barter is inefficient—double coincidence of wants
• Money allows people to trade their labor for money,
then use the money to buy goods and services in
separate transactions
• Money thus permits people to trade with less cost in
time and effort
• Money allows specialization, so people don’t have to
produce their own food, clothing, and shelter
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
different unit of account (like gold, US dollars, etc.),
so they don’t have to constantly change prices
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
a short period and for small amounts, because it
earns less interest than money in the bank
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
was inefficient
– Even nonsmokers used cigarettes as money
– Characteristics of cigarettes as money: standardized
(so value was easy to ascertain), low in value (so
“change” could be made), portable, fairly sturdy
– Problem with having a commodity money like
cigarettes: cannot smoke them and use them as
money at the same time
What Is Money?
• Measuring money – the monetary aggregates
– Distinguishing what is money from what isn’t money is
sometimes difficult
• For example, money market mutual funds (MMMFs)
allow check-writing, but give a higher return than
bank checking accounts: Are they money?
• There’s no single best measure of the money stock
What Is Money?
• Measuring money
– The M1 monetary aggregate
• Currency held by the public
• Transaction accounts on which checks may be drawn
• Savings accounts
– Savings accounts added to M1 in 2021, as Fed
stopped distinguishing between savings deposits
and transactions deposits
– Result: M1 increased substantially from previous
measures
– But M1 data revised back only to May 2020, creating
break in series
What Is Money?
• Measuring money
– All components of M1 are used in making payments,
so M1 is the closest money measure to our theoretical
description of money
– In Turkey, the definition of M1 as of December 2005
• M1 = Currency in Circulation + Demand Deposits
(TRY, FX)
What Is Money?
• Measuring money
– The M2 monetary aggregate
• M2 = M1 + less money-like assets
– Additional assets in M2:
• small (< $100,000) time deposits
• non-institutional M M M F balances
• money-market deposit accounts (M M D A s)
– In Turkey, the definition of M2 as of December 2005
• M2 = M1 + Time Deposits (TRY, FX)
What Is Money?
• Measuring money
– The M3 monetary aggregate
– In Turkey, the definition of M3 as of December 2005
• M3 = M2 + Repo + Money Market Funds
– In Turkey, M3 is redefined (as of December 2010) as
• M3 = M2 + Repo + Money Market Funds + Debt
Securities Issued
U.S. – Monetary Aggregates
Amounts in billions of dollars – December 2021
M1 20,600.1
Currency 2129.1
Liquid deposits 18,471.1
M2 21,724.0
Components of M1 20,600.1
Small-denomination time deposits 93.2
Retail money-market funds 1030.7
Note: Numbers may not add to totals shown owing to rounding.
Source: Federal Reserve Statistical Release H.6, May 22, 2022. Data are not seasonally
adjusted.
© 2024 Pearson Education Ltd.
Turkey – Monetary Aggregates
© 2024 Pearson Education Ltd.
Turkey – Monetary Aggregates
November 15, 2024 November 17, 2023
(in '000) (in '000)
M1 = ₺ 6,116,178,696 ₺ 4,622,568,604
Money in circulation ₺ 606,546,779 ₺ 426,121,333
+ Checking accounts (in TL) ₺ 1,698,591,150 ₺ 1,204,182,117
+ Checking accounts (in other currencies) ₺ 3,811,040,767 ₺ 2,992,265,154
M2 = M1 ₺ 16,968,059,863 ₺ 12,946,825,102
+ Saving accounts (in TL) ₺ 9,013,523,139 ₺ 6,312,098,401
+ Saving accounts (in other currencies) ₺ 1,838,358,028 ₺ 2,012,158,097
M3 = M2 ₺ 18,715,540,884 ₺ 13,303,235,834
+ Repo ₺ 558,509,468 ₺ 174,451,473
+ Money market funds ₺ 1,139,767,551 ₺ 145,642,201
+ Asset-backed and other securities issued ₺ 49,204,002 ₺ 36,317,058
© 2024 Pearson Education Ltd.
What Is Money?
• In Touch with Data and Research: monetary aggregates
– The Federal Reserve Board of Governors compiles and
reports data on M1 and M2
– Data are released every Thursday afternoon (this is
also the case in Turkey)
– Publication of the data keeps the public informed about
how the Fed is changing the money supply
© 2024 Pearson Education Ltd.
What Is Money?
• In Touch with Data and Research: Where have all the
dollars gone?
– In 2018, U.S. currency averaged about $4800 per
person
– Some is held by businesses and the underground
economy, but most is held abroad
– Foreigners hold dollars because of inflation in their local
currency and political instability
– The data show large fluctuations in M1 when major
events occur abroad, like military conflicts
– The United States benefits from foreign holdings of its
currency, since it essentially get an interest-free loan
© 2024 Pearson Education Ltd.
What Is Money?
• The money supply
– Money supply = money stock = amount of money
available in the economy
– How does the central bank of a country increase the
money supply?
• Use newly printed money to buy financial assets from
the public—an open-market purchase
• To reduce the money supply, sell financial assets to
the public to remove money from circulation—an
open-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 country increase the
money supply?
• Could also buy newly issued government bonds
directly from the government (i.e., the Treasury)
– This is the same as the government financing its
expenditures directly by printing money
– This happens frequently in some countries (though
is forbidden by law in the United States)
– Throughout text, use the variable M to represent money
supply; this might be M1 or M2
© 2024 Pearson Education Ltd.
Portfolio Allocation / Demand for Assets
• How do people allocate their wealth among various
assets? The portfolio allocation decision
• Main factors
– Expected return
– Risk
– Liquidity
– Time to maturity
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Portfolio Allocation / Demand for Assets
• Expected return
– Rate of return = an asset’s increase in value per 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 highest expected return
(other things equal)
– Returns not known in advance, so people estimate their
expected return
© 2024 Pearson Education Ltd.
Portfolio Allocation / Demand for Assets
• Risk
– Risk is the degree of uncertainty in an asset’s return
– People do not like risk, so they prefer assets with low
risk (other things equal)
– Risk premium: the amount by which the expected
return on a risky asset exceeds the return on an
otherwise comparable safe asset
© 2024 Pearson Education Ltd.
Portfolio Allocation / Demand for Assets
• Liquidity
– Liquidity: the ease and quickness with which an asset
can be traded
– Money is very liquid
– Assets like automobiles and houses are very illiquid—
long time and large transaction costs to trade them
– Stocks and bonds are fairly liquid
– Investors prefer liquid assets (other things equal)
© 2024 Pearson Education Ltd.
Portfolio Allocation / Demand for Assets
• Time to maturity
– Time to maturity: the amount of time until a financial 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 over the
same period yields the same expected return
– Because long-term interest rates usually exceed short-term
interest rates, a risk premium exists: the compensation to an
investor for bearing the risk of holding a long-term bond
© 2024 Pearson Education Ltd.
Portfolio Allocation / Demand for Assets
• 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
risk and less liquidity
• Stocks pay dividends and can have capital gains and
losses, and are much riskier 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 for
capital gains, but is quite illiquid
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Portfolio Allocation / Demand for Assets
• Types of assets and their characteristics
– Households must consider what mix of assets they
wish to own
– The following table illustrates the large declines in the
value of stocks and housing in the financial crisis
• The value of stocks and pension funds rebounded by
2021 to a level substantially higher than it was in
2006
• The value of housing surpassed its 2006 level by
mid-2016
© 2024 Pearson Education Ltd.
Household Assets in the U.S.
Note: Numbers may not add to totals owing to rounding.
Source: Federal Reserve Financial Accounts of the United States, Statistical Release Z.1, March 10, 2022.
© 2024 Pearson Education Ltd.
Portfolio Allocation / Demand for Assets
• In touch with data and research: the housing crisis of 2007
to 2011
– People gained tremendous wealth in their houses in the
2000s
– As house prices rose, houses became increasingly
unaffordable, leading mortgage lenders to create
subprime loans for people who would not normally
qualify to buy houses
– Most subprime loans had adjustable interest rates, with
a low initial interest rate that would later rise in a
process known as mortgage reset
© 2024 Pearson Education Ltd.
Portfolio Allocation / Demand for Assets
• The housing crisis of 2007 to 2011
– As long as housing prices kept rising, both lenders and
borrowers thought the subprime loans would work out,
as the borrowers could always sell their houses to pay
off the loans
– But housing prices stopped rising as much, leading
more subprime borrowers to default, so banks began to
tighten their lending standards, reducing the demand
for housing and leading housing prices to start falling
© 2024 Pearson Education Ltd.
Portfolio Allocation / Demand for Assets
• The housing crisis of 2007 to 2011
– Many homeowners lost their homes and financial
institutions lost hundreds of billions of dollars because
of mortgage loan defaults
– Because many mortgage loans had been securitized
and were parts of mortgage-backed securities, the
increased default rate on mortgages led to a financial
crisis in Fall 2008, as many investors simultaneously
tried to sell risky assets, including mortgage-backed
securities and stocks
© 2024 Pearson Education Ltd.
Change in Home Prices From One Year
Earlier, 1976Q1–2021Q4
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Portfolio Allocation / Demand for Assets
• Asset Demands
– Trade-off among expected return, risk, liquidity, and
time to maturity
– Assets with low risk and high liquidity, like checking
accounts, have low expected returns
– Investors consider diversification: spreading out
investments in different assets to reduce risk
– The amount a wealth holder wants of an asset is their
demand for that asset
– The sum of asset demands equals total wealth
© 2024 Pearson Education Ltd.
The Demand for Money
• The demand for money is the quantity of monetary assets
people want to hold in their portfolios
– Money demand depends on expected return, risk, and
liquidity
– Money is the most liquid asset
– Money pays a low return
– People’s money-holding decisions depend on how
much they value liquidity against the low return on
money
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The Demand for Money
• Key macroeconomic variables that affect money demand
– Price level
– Real income
– Interest rates
• The money demand function
𝑀 ! = 𝑃 $ 𝐿(𝑌, 𝑖)
© 2024 Pearson Education Ltd.
The Demand for Money
• Price level
– The higher the price level, the more money you need
for transactions
– Prices are significantly higher than, say, 50 years ago,
so it takes much more money for equivalent
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 more money you
need
– Real income is a prime determinant of the number of
transactions you conduct
– So money demand rises as real income rises
– But money demand isn’t proportional to real income, since
higher-income individuals use money more efficiently, and
since a country’s financial sophistication grows as its
income rises (use of credit and more sophisticated assets)
– Result: Money demand rises less than 1-to-1 with a rise in
real income
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The Demand for Money
• Interest rates
– An increase in the interest rate or return on nonmonetary
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
– Though there are many nonmonetary assets with many
different interest rates, because they often move together
we assume that for nonmonetary assets there’s just one
nominal interest rate, 𝑖
– The real interest rate, which affects saving and investment
decisions, is 𝑟 = 𝑖 − 𝜋 !
– The nominal interest paid on money is 𝑖 "
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The Demand for Money
• The money demand function
𝑀 ! = 𝑃 $ 𝐿(𝑌, 𝑖)
where
– 𝑀 ! is nominal money demand (aggregate)
– 𝑃 is 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 is
proportional to the price level
– A rise in 𝑌 increases money demand
– A rise in 𝑖 reduces money demand
𝑑𝑀 ! 𝑑𝑀 !
> 0; <0
𝑑𝑌 𝑑𝑖
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The Demand for Money
• The money demand function
– Alternative expression:
𝑀 ! = 𝑃 $ 𝐿(𝑌, 𝑟 + 𝜋 " )
§ A rise in 𝑟 or 𝜋 " reduced money demand
– Alternative expression:
𝑀 ! /𝑃 = 𝐿(𝑌, 𝑟 + 𝜋 " )
– The left side of this equation is the demand for real
balances, or real money demand
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The Demand for Money
• Other factors affecting money demand
– Wealth: A rise in wealth may increase money demand, but
not by much
– Risk
§ Increased riskiness in the economy may increase money
demand
§ Times of erratic inflation bring increased risk to money,
so money demand declines
– Liquidity of alternative assets: Deregulation, competition,
and innovation have given other assets more liquidity,
reducing the demand for money
– Payment technologies: Credit cards, ATMs, and other
financial innovations reduce money demand
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The Demand for Money
• Application: Bitcoin and cryptocurrencies
– Cryptocurrencies, such as Bitcoin, do not exist in physical
form but only as records in a computer system
– Bitcoin uses blockchain technology to record who owns how
many bitcoins
– Cryptocurrencies allow for anonymous transactions; so are
sometimes used by tax evaders and criminals
– Blockchain works by using public records verified by others
and replicated by many computers throughout the system;
the technology has many possible business applications
– Shortcomings of cryptocurrencies include high transactions
costs and lack of stable value, plus some questions about
security
© 2024 Pearson Education Ltd.
The Demand for Money
Causes money
An increase in demand to Reason
Price level, 𝑃 Rise A doubling of the price level doubles the
proportionally number of dollars needed for
transactions.
Real income, 𝑌 Rise less than Higher real income implies more
proportionally transactions and thus a greater demand for
liquidity.
Real interest rate, 𝑟 Fall Higher real interest rate means a higher
return on alternative assets and thus a
switch away from money.
Expected inflation, 𝜋 ! Fall Higher expected inflation means a lower
real return on money and thus a switch
away from money.
Nominal interest rate on Fall Higher return on nonmonetary assets
nonmonetary assets, 𝑖 makes people less willing to hold money
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The Demand for Money
Causes money
An increase in demand to Reason
Nominal interest rate on Rise Higher return on money makes people
money, 𝑖 " more willing to hold money.
Wealth Rise Part of an increase in wealth may be held
in the form of money.
Risk Rise, if risk of Higher risk of alternative asset makes
alternative asset money more attractive.
increases
Blank Fall, if risk of Higher risk of money makes it less
money increases attractive.
Liquidity of alternative Fall Higher liquidity of alternative assets makes
assets these assets more attractive.
Efficiency of payments Fall People can operate with less money.
technologies
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The Demand for Money
• Elasticities of money demand
– How strong are the various effects on money demand?
– Statistical studies on the money demand function show
results in elasticities
– Elasticity: The percent change in money demand
caused by a one percent change in some 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
§ Goldfeld’s 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, so money
demand is proportional to the price level
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The Demand for Money
• Velocity and the quantity theory of money
– Velocity (𝑉) measures how much money “turns over”
each period
𝑃𝑌
𝑉=
𝑀
where
§ 𝑃𝑌 is nominal GDP
§ 𝑀 is nominal money stock
© 2024 Pearson Education Ltd.
The Demand for Money
• Velocity and the quantity theory of money
– Quantity theory of money: Real money demand is
proportional to real income
§ If so (assuming 𝑀 ! = 𝑀, that is, nominal money
demand equals the actual money stock),
𝑃𝑌 𝑀 1 𝑀!
𝑉= ⇒ = 𝑌⇒ = 𝑘𝑌
𝑀 𝑃 𝑉 𝑃
𝑀!
⇒ = 𝐿 𝑌, 𝑟 + 𝜋 " = 𝑘𝑌
𝑃
§ Assumes constant velocity (= 1/𝑘), where velocity
isn’t affected by income or interest rates
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Asset Market Equilibrium
• Asset market equilibrium—an aggregation assumption
– Assume that all assets can be grouped into two
categories, money and nonmonetary assets
§ Money includes currency and checking accounts
– Pays interest rate 𝑖 #
– Supply is fixed at 𝑀
§ Nonmonetary assets include stocks, bonds, land,
etc.
– Pays interest rate 𝑖 = 𝑟 + 𝜋𝑒
– Supply is fixed at 𝑁𝑀
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Asset Market Equilibrium
• Asset market equilibrium occurs when quantity of money
supplied equals quantity of money demanded
– Total nominal wealth of an individual = 𝑚 ! + 𝑛𝑚 !
– Aggregate nominal wealth = 𝑀 ! + 𝑁𝑀 !
(from adding up individual wealth)
– Aggregate nominal wealth = 𝑀 + 𝑁𝑀
(supply of assets)
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Asset Market Equilibrium
• Subtracting the second equation from the first gives
𝑀 ! − 𝑀 + 𝑁𝑀 ! − 𝑁𝑀 = 0
• Excess demand for money (𝑀 ! − 𝑀) plus excess demand
for nonmonetary assets (𝑁𝑀 ! − 𝑁𝑀) equals 0
• So if money supply equals money demand, nonmonetary
asset supply must equal nonmonetary asset demand; then
entire asset market is in equilibrium
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Asset Market Equilibrium
• The asset market equilibrium condition
𝑀
= 𝐿(𝑌, 𝑟 + 𝜋 " )
𝑃
real money supply = real money demand
– 𝑀 is determined by the central bank
– 𝜋 " is fixed (for now)
– The labor market determines the level of employment;
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 determined, the asset
market equilibrium condition determines the price level
𝑀
𝑃=
𝐿(𝑌, 𝑟 + 𝜋 " )
§ 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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Asset Market Equilibrium – Summary
• Labor market ⇒ level of employment, 𝑁
⇒ Using 𝑁 in the production function ⇒ 𝑌
• Goods market (equilibrium condition) ⇒ determines 𝑟
(given 𝑌)
• Asset market (equilibrium condition) ⇒ determines (given
𝑀 and fixed 𝜋 " )
𝑀
𝑃=
𝐿(𝑌, 𝑟 + 𝜋 " )
© 2024 Pearson Education Ltd.
Money Growth and Inflation
• The inflation rate is closely related to the growth rate of the
money supply
– Rewrite asset market equilibrium condition in growth-
rate terms:
𝑀 ∆𝑃 ∆𝑀 ∆𝐿(𝑌, 𝑟 + 𝜋 " )
𝑃= "
⇒ = −
𝐿(𝑌, 𝑟 + 𝜋 ) 𝑃 𝑀 𝐿(𝑌, 𝑟 + 𝜋 " )
– 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
– So, rate of inflation is closely related to the rate of
growth of the nominal money supply
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Money Growth and Inflation
• To predict inflation, we must forecast both money supply
growth and real money demand growth
– In long-run equilibrium, we will have 𝑖 constant, so we
look just at growth in 𝑌
– Let 𝜂$ be the elasticity of money demand with respect
to income ⟹ 𝜂$ = (∆𝐿/𝐿)/(∆𝑌/𝑌)
– Substituting 𝜋 for ∆𝑃/𝑃
∆𝑃 ∆𝑀 ∆𝐿 𝑌, 𝑟 + 𝜋 " ∆𝑀 ∆𝑌
= − "
⟹𝜋= − 𝜂$
𝑃 𝑀 𝐿 𝑌, 𝑟 + 𝜋 𝑀 𝑌
– So, if Δ𝑌/𝑌 = 3%, 𝜂$ = 2/3 and Δ𝑀/𝑀 = 10%, then
𝜋 = 8%
© 2024 Pearson Education Ltd.
Money Growth and Inflation
• Application: money growth and inflation in the European
countries in transition
• Though the countries of Eastern Europe are becoming
more market-oriented, Russia and some others have high
inflation because of rapid money growth
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Money Growth and Inflation
• Application: money growth and inflation in the European
countries in transition
– 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
§ For example, if 𝜂) = 2/3 and Δ𝑌/𝑌 = 15%, Δ𝐿/𝐿 = 10%
(= 2/3 1 15%); or if ∆𝑌 ⁄𝑌 = −15%, ∆𝐿⁄𝐿 = −10%
§ So money demand does not vary much (or varies less
than income), no matter how well or poorly an economy
is doing
§ But nominal money supply growth differs across
countries by hundreds of percentage points, so large
inflation differences must be due to money supply, not
money demand
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Money Growth and Inflation
• Application: money
growth and inflation in
the European countries
in transition during the
period 1995-2001
• The figure shows the
link between money
growth and inflation in
these countries; inflation
is clearly positively
associated with money
growth
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Money Growth and Inflation
• Application: money growth and inflation in the European
countries in transition
– So why do countries allow money supplies to grow
quickly, if they know it will cause inflation?
§ They sometimes find that printing money is the only
way 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 inflation rate and the nominal interest rate
– Expectations cannot be observed directly, except
perhaps through surveys
– If money growth is not expected to change much and if
factors affecting money demand are stable, inflation
may not change much, so the expected inflation rate
would be approximately equal to the actual inflation
rate
– If the real interest rate is stable, then the nominal
interest rate will move one for one with inflation
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