Chapter 7

The Asset Market,

Money, and Prices

Macroeconomics, 10th Edition

Copyright © 2021 by Pearson. All Rights Reserved.
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 Chapter Outline
7.1 What Is Money?
Define money, discuss its functions, and describe how it is measured in the United States
7.2 Portfolio Allocation and the Demand for Assets
Discuss the factors that affect how people choose which assets they own
7.3 The Demand for Money
Examine macroeconomic variables that affect the demand for money
7.4 Asset Market Equilibrium
Discuss the fundamentals of asset market equilibrium
7.5 Money Growth and Inflation
Discuss the relationship between money growth and inflation

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 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
Medium of exchange
Barter is inefficient—double coincidence of wants
Money allows people to trade their labour 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

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 What is 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, so they don’t
have to constantly change prices

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

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 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
Measuring money
The M1 monetary aggregate
• Currency and traveler’s checks held by the public
• Transaction accounts on which checks may be drawn
All components of M1 are used in making payments, so M1 is the closest money
measure to our theoretical description of money

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 What is Money?
Measuring money
The M2 monetary aggregate
• M2 = M1 + less money like assets
Additional assets in M2:
• savings deposits
• Small (<$100,000) time deposits
• non-institutional MMMF balances
• money-market deposit accounts (MMDAs)
The M2 monetary aggregate
• Savings deposits include passbook savings accounts
• Time deposits bear interest and have a fixed term (substantial penalty for early
withdrawal)
• MMMFs invest in very short-term securities and allow limited checkwriting
• MMDAs are offered by banks as a competitor to MMMFs

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 What is Money?
U.S. Monetary Aggregates (April 2018)

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 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
• 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

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 Portfolio Allocation and the 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
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

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 Portfolio Allocation and the 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
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)

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 Portfolio Allocation and the 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

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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
Households must consider what mix of assets they wish to own
Table shows the mix in 2006, 2009, and 2017
The 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 2017 to a level substantially
higher than it was in 2006
• The value of housing surpassed its 2006 level by mid-2016

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 Portfolio Allocation and the Demand for Assets
Household Assets, 2006, 2009, and 2017

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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
People’s money-holding decisions depend on how much they value liquidity against
the low return on money
Key macroeconomic variables that affect money demand
Price level
Real income
Interest rates
Price level
The higher the price level, the more money you need for transactions
Prices are 10 times as high today as 65 years ago, 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 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 − πe
The nominal interest paid on money is im

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 The Demand for Money
The money demand function
M d = P × L(Y, i)
• 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
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 im from Eq since it doesn’t vary much

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 The Demand for Money
The money demand function
Alternative expression: M d = P × L(Y, r + πe )
• A rise in r or πe reduces money demand
Alternative expression:

The left side of Eq. is the demand for real balances, or real money demand
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
Macroeconomic Determinants of the Demand for Money

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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
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
V=nominal GDP / nominal money stock = PY/M
Plot of velocities for M1 and M2 (Fig.) shows fairly stable velocity for M2, erratic
velocity for M1 beginning in early 1980s

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 The Demand for Money
Velocity and the quantity theory of money
Plot of money growth (Fig.) shows that instability in velocity translates into erratic
movements in money growth

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 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,

• Assumes constant velocity, where velocity isn’t affected 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
• Part of the change in velocity is due to changes in interest rates in the 1980s
• Financial innovations also played a role in velocity’s decline in the early 1980s
M2 velocity is closer to being a constant, but not over short periods

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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 im
– 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
md + nmd = total nominal wealth of an individual
M d + NM d = aggregate nominal wealth (from adding up individual wealth)
M + NM = aggregate nominal wealth (supply of assets)
Subtracting gives
(M d − M) + (NM d − NM) = 0
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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 Asset Market Equilibrium
The asset market equilibrium condition

real money supply = real money demand

M is determined by the central bank
πe is fixed (for now)
The labour market determines the level of employment; using employment in the
production function determines Y
Given Y, the goods market equilibrium condition determines r
With all the other variables in Eq. determined, the asset market equilibrium condition
determines the price level

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 Eq. in growth-rate terms:

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
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 𝜂𝑌 be the elasticity of money demand with respect to income
Then;

Example: ΔY/Y = 3%, ηY = 2/3, ΔM/M = 10%, then π = 8%

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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
Figure plots U.S. inflation and nominal interest rates
• Inflation and nominal interest rates have tended to move together
• But the real interest rate is clearly not constant
• The real interest rate was negative in the mid-1970s, then became much higher
and positive in the late 1970s to early 1980s
• The real interest rate turned negative again following the financial crisis of 2008

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 Money Growth and Inflation
Figure: Inflation and the nominal interest rate in the United States, 1960–2018

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