Money
Moneyistheeconomictermforassets thatarewidelyusedand
acceptedasameansofpayment.
Theformsofmoneyhavebeenverydifferent:fromshellstogoldto
cigarettes!
Mostpricesaremeasuredinunitsofmoney
Understandingtheroleofmoneyisimportanttounderstandinflation.
Manyeconomistsbelievethatmoneyhasalsoimpactonreal variables.
Moneyhasthemostliquid buthasalow return.
Liquidity
Theeaseandquicknesswithwhichanassetcanbeconvertibleintoa
meansofpayment withlittlelossinvalues
FunctionsofMoney
(i) Mediumofexchange orMeansofpayment:Moneypermitsto
tradeatlesscostintimeandeffort!
Barterisinefficient becauseitisdifficultandtimeconsumingtofind
[Link]
unnecessary.
Otherbenefitsofmoney:allowspecialization andincrease
productivity.
(ii)Unitofaccount:Moneyisabasicunitformeasuringeconomic
value.
Giventhatgoodsandservicesaremostlyexchangedformoney,itis
naturaltoexpresseconomicvalueintermsofmoney.
FunctionsofMoney
Incountrieswithvolatileinflation,moneyisapoorunitofaccount
[Link]
accountsshouldbeused(dollarsorgold),eveniftransactionsuse
localcurrency.
Centralbankdiscardslocalcurrencyafteryearsofhyperinflation
whichatonepointreached500,000,000,000%
FunctionsofMoney
(iii)Storeofvalue:moneyisawayofstoringwealth.
Othertypesofassetsmaypayhigher returns,butarenot amedium
ofexchange.
Money
*Moneyisastock variable.
Stock variable:somethingmeasuredatagivenpointintime
Examples:wealth,amountofcapital,governmentdebt,thenumber
ofunemployedpeople,savings
Flow variable:somethingmeasuredperunitoftime
Examples:GDP,income,expenditure,saving,amountofinvestment,
budgetdeficit,thenumberofpeoplelosingtheirjobs
Thevalueofstock variablechangesovertimeasthevalueofflow
[Link],wealthcanonlychangeovertimeas
yousaveordissave.
MeasuresofMoney
Therearetwomainofficialmeasuresofmoneystockcalledmonetary
aggregates:M1 isthenarrowestdefinitionofmoney.
TwoBroadMeasuresoftheMoneyStock:
Symbol
Assets included
M1
Currency (coins and bills in the hands of the public)
+ Demand deposits (e.g., checking accounts) at banks
(non-interesting-bearing bank deposits on or against which agents can write checks)
+ Other checkable deposits (interest-earning checking accounts)
+ Travelers checks
M2
Everything in M1
+ Small time deposits (Certificate deposits less than $100,000)
+ Saving-type deposits (deposits at banks and other thrift institutions)
+ MMMFs (money market mutual funds)
+ Money market deposit accounts (MMDAs)
PortfolioAllocationandDemandforAssets
Tounderstandhowagentsdeterminetheamountofmoneythey
choosetohold,wefindananswerforthequestion:howdoagents
allocatetheirwealthamongmanydifferentassetsthatareavailable?
Portfolioallocationdecision
Agentsdecisionaboutwhichassetsandhowmuchofeachasset
tohold
Agentsdecisiononhowtodistributewealthamongmanytypesof
assets
Portfolio
Thesetofassetsthatanagent aholderofwealth choosesto
own
CharacteristicsofAssets
Fundamentally,onlyfour maincharacteristicsofassetsmatterforthe
portfolioallocationdecision:expected return,risk,liquidity,andtime
tomaturity.
Expected return:Therateofreturn istherateofincrease initsvalue
[Link],thehigher anassets
expectedreturn(aftersubtractingtaxesandfeessuchasbrokers
commissions),themore desirabletheassetisandthemore ofitan
agentwillwanttoown.
CharacteristicsofAssets
Risk:Anassethashigh riskifthereisasignificantchancethatthe
actual returnreceivedwillbeverydifferentfromtheexpected return.
Becausemostagentsareriskaverse,theyholerisky assetsonlyifthe
expectedreturnishigher thanthatinrelativelysafe assets,suchas
[Link].
Riskpremium
Theamountbywhichtheexpectedreturnonariskyassetexceeds
thereturnonacomparablesafeasset
CharacteristicsofAssets
Liquidity:Liquiditymakestransactionseasier andcheaper andalso
providesflexibilitytotheholderofwealth:aliquidassetcaneasilybe
disposed ofifthereisanemergencyneedforfundsorifunexpectedly
[Link],everythingelsebeing
equal,themore liquid anassetis,themore attractiveitwillbeto
agents.
Time to Maturity:theamountoftimeuntilafinancialsecurity
maturesandtheinvestorisrepaidhisorherprincipal.
CharacteristicsofAssets
Typically,thereisatradeoff amongfourcharacteristicsthatmakean
assetdesirable:ahighexpectedreturn,safety(lowrisk),liquidity,and
timetomaturity.
Forexample,asafe andliquidassetwithashort timetomaturity,
suchasacheckingaccount,islikelytohavealow expectedreturn.
DemandforMoney
Demandformoney
Quantityofmonetaryassets,suchascashandcheckingaccounts,
.
thatpeoplechoosetoholdintheirportfolio;
Inpractice,two characteristicsofmoneyareparticularlyimportant:
First,moneyisthemostliquid asset,whichisaprimarybenefitof
holdingmoney.
Second,moneypaysalow return (currencypaysazero nominal
return).
Thelowreturnearnedbymoney,relativetootherassets,isamajor
cost ofholdingmoney.
Peoplesdemandformoneyisdeterminedbyhowtheytradeofftheir
desireforliquidityagainstthecostofalowerreturn.
DemandforMoney
Assumption:Agentsonlyhavethechoicebetweentwofinancial
assets,money (transaction liquidity role)andnonmonetary assets
bond(investment):
Wealth=M(money)+B(bonds)
Q:Inwhatproportionsshouldpeopleholdbothmoneyandbonds?
A:Theanswerwilldependmainlyontwovariables:
Leveloftransactions:Thehigher theleveloftransactions,thelarger
thedemandformoney.
Interest rate onbonds(i):Thehigher theinterestrate,thelower the
demandformoney;[Link]
bonds.
DerivingDemandforMoney
4.1 :
where =theaggregatedemandformoneyinnominalterms
(demandforM1);
=theoverallricelevel(CPIorGDPdeflator);
=realincomeoroutput(realGDP);
,thenominalinterestrateearnedbynonmonetaryassets;
=afunctionrelatingmoneydemandtorealincomeandthe
nominalinterestrate.
MeaningofEq(4.1):Themoneydemanddependsontheoveralllevel
oftransactions intheeconomyandontheinterest rate.
ThreeMacroeconomicVariablesandMoneyDemand
(i)Pricelevel
Thehigher thegeneralpricelevel,themore moneypeopleneedto
conducttransactionsandthusthemore moneypeoplewanttohold.
Thus,everythingelsebeingequal,thenominaldemandformoneyis
proportional tothepricelevel.
Thedemandformoneyisproportional tothepricelevel(P):
by 10%
by 10%.
(ii)Nominalincome $
orRealincome
Theoverallleveloftransactionsintheeconomyislikelytobe
roughly proportional tonominalincome(incomemeasuredin
dollars).
ThreeMacroeconomicVariablesandMoneyDemand
Thedemandformoneyincreasesinproportion tonominalincome
$ . Ifnominalincomedoubles,thenthedemandformoneyalso
[Link] demand formoney.
Becausehigher realincomemakesmoreandlargertransactionsanda
greaterneedforliquidity,theamountofmoneydemandedshould
[Link]
neednot beproportional toanincreaseinrealincome.
ThreeMacroeconomicVariablesandMoneyDemand
(iii)Nominalinterestrate orRealinterestrate
Thedemandformoneynegatively dependsontheinterest rate.
Anincrease intheinterestrateonnonmonetaryassetsdecreases the
[Link] ,thequantityofmoneyis
adecreasing (ornegative)functionoftheinterest rate.
Thetheoryofliquiditypreference byKeynespositsthattheinterest
rate isonedeterminantofhowmuchmoneypeoplechoosetohold
becausetheinterestrateistheopportunity cost ofholdingmoney.
Figure 4.1:TheDemandforMoney
curveshowstherelationb/wthedemand formoney andthe
interest rate foragivenlevelofnominal income ($Y).
DemandforMoneyCurve
Thecurveisdownward sloping:
Thelower theinterestrate(theloweri),thehigher theamountsof
moneypeoplewanttohold(thehigherM).
Wheninterestratesonbondsarelow (high),theopportunitycostof
holdingmoneyislow (high),sothequantitydemandedofmoneywill
behigh (low).
Foragiveninterestrate,anincrease innominalincome
increases thedemandformoney:Anincrease innominalincome
shiftsthedemandformoneytotheright,from to
.
MoneyDemandFunction
4.2 :
,
4.2 showsthatforanygivenexpectedrateofinflation
,
increases thenominalinterest
anincrease intherealinterestrate
rate andsoreduces thedemandformoney.
Similarly,foranygivenrealinterestrate ,anincrease inthe
expectedrateofinflation
increases thenominalinterestrate
andsoreduces thedemandformoney.
Rememberthat thenominalinterestrate movesoneforone with
changesinexpectedinflation
.
RealMoneyBalances
Sincethedemandfornominalmoneyisproportional tothe
aggregate(oroverall)pricelevel ,wecandividebothsidesof
nominalmoneydemandequationby :
4.3
RealMoneyBalances
4.3 givestheliquidity demand function orthedemandforreal
[Link]
4.3 isthedemand for
real balances (therealpurchasing power ofmoneyortheamountof
moneydemandedintermsofthegoodsitcanbuy).
Therighthandsideof
4.3 istheliquidity demand function.
Thedemandforrealmoneybalancesisdecomposedintoa
transaction demandformoney(capturedby )andaportfolio
demandformoney(capturedby and ).
OtherFactorsAffectingMoneyDemand
Changesinvariablesotherthantheinterest rate causethedemand
curvetoshift.
Wealth:anincrease inwealthcausesmoneydemandtorise
becausepart
ofanincreaseinwealthmaybeheldintheformofmoney.
Risk:anincrease inriskofalternativeassetscausesmoneydemand
torise sincehigher riskofalternativeassetsmakesmoneymore
[Link],anincrease inriskofmoneycauses
moneydemandtofall becausehigher riskofmoneymakesitless
attractive.
OtherFactorsAffectingMoneyDemand
Forexample,inaperiodoferraticinflation,peopletrytoswitch
moneytoinflationhedges(assetswhoserealreturnsarelesslikelyto
beaffectedbyerraticinflation)suchasgold,realestate,and
consumerdurablegoods.
Liquidity ofalternativeassets:anincrease inliquidityofalternative
assetscausesmoneydemandtofall sincehigher liquidityof
alternativeassetsmakestheseassetsmore attractive.
OtherFactorsAffectingMoneyDemand
Efficiency ofpaymenttechnology:anincrease inpayment
technologycausesdemandmoneytofall sincepeoplecanoperate
withless money.
Expected inflation:anincrease inexpectedinflationcausesmoney
demandtofall sincehigher expectedinflationmeansahigher return
onalternativeassetsandthusswitchawayfrommoney.