Intermediate Macroeconomic

Econ 2102/2220B

Lecture 5

Fall, 2014

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 Outline

What is Money?
Portfolio Allocation and the Demand for Assets
Money Demand (and Supply)
Asset Market Equilibrium
Money Growth and Inflation

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 What Is Money?

Bill Gates has a lot of money.

He makes a lot of money.
Money: assets that are widely used and accepted as
payment
The functions of money
- Medium of exchange
- Unit of account
- Store of value

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 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 in separate
transactions
Money thus permits people to trade with less cost in time
and effort
Money allows specialization, so people dont have to
produce their own food, clothing, and shelter

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 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, so they dont have to constantly change prices

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 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

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Concepts of Money

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 M1 and M2

The M1 monetary aggregate

- Currency and travellers 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 making payments, so
M1 is the closest money measure to our theoretical
description of money
The M2 monetary aggregate
- M2 = M1+ less moneylike assets

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 The money supply

Money supply = money stock = amount of money available

in the economy
Money supply in the U.S.
Money supply in Hong Kong
Use the variable M to represent money supply

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Portfolio Allocation and the Demand for Assets

We want to understand money demand.

As we have seen, money is an asset.
Could it be possible for people to hold all their wealth in the
form of money?
How do people allocate their wealth among various
assets?
The portfolio allocation decision

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 Expected return

Rate of return = an assets 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

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 Risk

Risk is the degree of uncertainty in an assets return

People dont like risk (why?), so they prefer assets with low
risk (other things equal)

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 Liquidity

Liquidity: the ease and quickness with which an asset can

be traded.
Bid-Ask Spread: The amount by which the ask price
exceeds the bid. This is essentially the difference in price
between the highest price that a buyer is willing to pay for
an asset and the lowest price for which a seller is willing to
sell it. If the bid price is $20 and the ask price is $21 then
the "bid-ask spread" is $1.
Money is very liquid. Stocks and bonds are fairly liquid.
Assets like automobiles and houses are very illiquid long
time and large transaction costs to trade them.
Investors prefer liquid assets (other things equal)

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Portfolio Allocation and the 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 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 for
capital gains, but is quite illiquid

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Portfolio Allocation and the 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 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 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
- Peoples 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

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 The Demand for Money

Price level
- The higher the price level, the more money you need for
transactions
- Prices are 10 times as high today as in 1935, so it takes 10
times as much 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 isnt proportional to real income, since
higher-income individuals use money more efficiently, and
since a countrys 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 theres just one
nominal interest rate, i

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 Interest Rates

Real vs. nominal interest rates

- Interest rate: a rate of return promised by a borrower to a
lender
- Real interest rate: rate at which the real value of an asset
increases over time
- Nominal interest rate: rate at which the nominal value of an
asset increases over time
- i =+r
The expected real interest rate

r = i e

- If = e , real interest rate = expected real interest rate

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 The Demand for Money

The money demand function

M d = P L(Y , i) (1)

M d 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
- We exclude i m from (1) since it doesnt vary much

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 The money demand function

Alternative expression:

M d = P L(Y , r + e ) (2)

- A rise in r or e reduces money demand

Alternative expression:

M d /P = L(Y , r + e ) (3)

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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

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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 for money
- Payment technologies: Credit cards, ATMs, and other
financial innovations reduce money demand

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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
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, so money
demand is proportional to the price level

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 Asset Market Equilibrium

Asset market equilibriuman 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 m
- 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 of money

supplied equals quantity of money demanded
- md + nmd = total nominal wealth of an individual
-
M d + NM d = aggregate nominal wealth (4)
(from adding up individual wealth)
-
M + NM = aggregate nominal wealth (5)
(supply of assets)
- Subtracting (5) from (4) gives

(M d M) + (NM d NM) = 0 (6)

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 Asset Market Equilibrium

So excess demand for money (M d M) plus excess

demand for nonmonetary assets (NM d 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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 The asset market equilibrium condition

M/P = L(Y , r + e ) (7)

real money supply = real money demand

M is determined by the central bank

e is fixed (for now)

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 The asset market equilibrium condition

With all the other variables in (7) determined, the asset

market equilibrium condition determines the price level

P = M/L(Y , r + e ) (8)

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 the growth rate of the

money supply
- Rewrite (8) in growth-rate terms:

P/P = M/M L(Y , r + e )/L(Y , r + e ) (9)

- 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

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 Money Growth and Inflation in the long run

In long-run equilibrium, we will have i constant, so lets

look just at growth in Y
In the long run, e = , no surprise.
Let Y be the elasticity of money demand with respect to
income
Then from (9),

= M/M Y Y /Y (10)

Example:

Y /Y = 3%, Y = 2/3, M/M = 10%, then = 8%

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 Expected Inflation Rate

In the short run, could deviate from e

Expectations cant be observed directly
They can be measured roughly by surveys
If real interest rates are stable, expected inflation can be
inferred from nominal interest rates
Policy actions that cause expected inflation to rise should
cause nominal interest rates to rise

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 Inflation and money growth

A Shift in the Money Growth Rate

Suppose that the monetary authority raises the money
growth rate from to 0 in year T .
Real GDP, Y , is fixed.

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Inflation and money growth

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 A Shift in the Money Growth Rate

The red line shows that the nominal quantity of money, Mt ,

grows at the constant rate before year T . After year T ,
Mt grows along the brown line at the higher rate .
The blue line shows that the price level, Pt , grows at the
same rate as money, , before year T .
After year T , Pt grows along the green line at the same
rate as money, The price level, Pt , jumps upward during
year T . This jump reduces real money balances, Mt /Pt ,
from the level prevailing before year T to that prevailing
after year T .

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