Chapter 7. Chapter Outline. Asset Market Equilibrium. Money and Other Assets. The Functions of Money. What is Money?

Transcription

1 Chapter Outline Chapter 7 The Asset arket, oney, an Prices oney an acroeconomics What Is oney? The Supply of oney Portfolio Allocation an the Deman for oney Asset arket Equilibrium oney Growth an Inflation Asset arket Equilibrium Our moel requires equilibrium in labor, goos, an asset markets This chapter concerns asset markets, especially the money market oney an Other Assets By asset market, we mean all of the markets in which people buy an sell real an financial assets (gol, real estate, stocks, bons) Our focus is on money, because money growth seems to affect both business cycle fluctuations an inflation rates In focusing on money, we will simplify our theory by lumping other assets together I often refer to all non-money assets bons What is oney? In economics, money has a somewhat ifferent meaning than in everyay usage oney has multiple functions, but the efining characteristic is that it is wiely use an accepte as a means of payment in settling transactions oney is NOT the same thing as income or wealth A person who earns a lot (of income), or a person who owns a lot (has much wealth), oesn t necessarily have lots of money The Functions of oney eium of Exchange oney facilitates exchange when bilateral barter woul be ifficult. Unit of Account We measure values in ollars-worth Store of Value I can carry spening power from one time perio to the next if I hol money 1

2 The Form of oney The form money takes can vary it can be paper, gol, or rocks. While the conceptual efinition is rather simple, in practice efining money may be ifficult (next slie). The onetary Aggregates 1: Coin an currency (hel by the non-bank public) an checking account balances, also travelers checks outstaning, an (some) other checkable eposits. 2: Consists of 1 plus savings eposits (paying interest, not irectly checkable), iniviual-hel money market mutual funs an money market eposit accounts (paying interest, limite checkability), small enomination time eposits (certificates of eposit). 3: No longer reporte Table 7.1 U.S. onetary Aggregates (ay 2006) Is a Creit Car oney? No, a creit car is not, in an of itself, money. Technically, when you use a creit car to buy a goo, the immeiate consequence is that two loans are create: You owe money to the bank who issue your creit car The bank owes a payment to the merchant who sol you the goo When, these loans are pai, they are ultimately pai via eman eposit transfers, i.e., with money. The oney Supply The money supply refers to the amount of money available in an economy (for example, 1) The money supply is a stock variable Open arket Operations If the central bank prints currency an uses it to purchase a government bon hel by a member of the public, the money supply increases (because a member of the public has exchange a non-money asset for money). Conversely, central bank sales of bons (openmarket sales) reuce the supply of money. Central bank purchases an sales of bons are terme open market operations. 2

3 Controlling the oney Supply Because a central bank can make open market purchases an sales of government securities, it has control over the money supply This control is imperfect, because some ecisions mae by banks an househols affect exactly how open market operations ultimately affect the money supply In theory, we regar the money supply as a variable that can be set by the central bank as it wishes oney Deman The money supply is set by the central bank in our theory We must also consier money eman, which has to o with the willingness of the public to hol money The ecision about how much money to hol is a part of a larger problem of portfolio allocation; the problem of eciing how one s wealth is to be apportione across all many ifferent types of assets Portfolio Allocation Iniviuals have wealth, an wealth can be hel in ifferent forms Assets iffer accoring to: Expecte Return Risk Liquiity In choosing how to allocate wealth to ifferent assets, iniviuals must make trae-offs to obtain a esire portfolio in terms of return, liquiity, an risk Asset Deman an oney Deman The term asset eman refers to the amount of an asset that an iniviual wishes to hol in her portfolio (given total wealth). We are particularly intereste in the eman for money (cash an eman eposits) For our macro moel, we consier money eman to be esire holings of money, aing up over all iniviuals an private firms (excluing banks). So we now have efine both money eman an money supply perhaps there is an equilibrium conition coming (eventually)? What Determines Deman for oney? The oney Deman Function Since money is that asset that is use for making transactions, the amount that one hols epens on the nee to make transactions, as well as the costs of holing money. Determinants of money eman inclue: Price level: When prices are higher, one nees higher nominal money balances to support a given level of real transactions. Real income: ore income generally results in a nee for more transactions. Interest rates: The ifference in the interest rates on nonmoney assets (i) an money (i m ). oel ignores real-worl multiplicity of interest rates 3

4 oney Deman Function: Alternative Forms Other Factors Affecting oney Deman Some things not inclue in the L function explicitly: Wealth Risk of alternative assets Liquiity of alternative assets Payment technologies Summary Table 9 Asset arket Equilibrium At a moment of time, assume that quantities (the supplies of various assets are fixe. The asset market is in equilibrium when the quantity of each asset emane equals the fixe quantity available. Here, we will assume that there are just two kins of assets, money an non-money ( or bons ). The nonmoney asset pays a nominal interest rate i. So asset market equilibrium occurs when: = an N = N oney arket Equilibrium ost importantly for us is the requirement that the money market be in equilibrium = oney, the Price Level, an Inflation Changes in the stock of money are closely relate to changes in the average price level an the rate of inflation In the next few slies, we briefly consier why this is so 4

5 The Velocity of oney On average, how often oes a ollar (in the money supply) turn over in final goos transactions in a year? The answer is given by the velocity of money, the ratio of nominal GDP to the money supply: PY V = The Quantity Theory of oney The Quantity Theory of oney assumes that the money eman function takes this special form: P = ky Further, assuming that the quantity of money emane is equal to the quantity of money supplie, this equation becomes: ky P = or 1 PY = k The Quantity Theory an the Price Level But this equation (again shown below), implies that for a given value of Y, that P is simply proportional to ky P = The Quantity Theory an Inflation The equation also implies that, for a given Y, the growth rate of the price level will equal the growth rate of the money supply This provies us with a simple theory of inflation The exact equality of the money growth rate an the inflation rate epens on the special form of the money eman function an the assumption that output was fixe, but in the more general case, our moel will always imply that money growth an inflation are closely relate The more general case is covere in section 7.5, but I will skip that section. Figure 7.1 Velocity of 1 an 2, The Relationship between oney Growth an Inflation 5

6 Equilibrium in all Sectors We have now escribe equilibrium conitions for three markets: Labor Output Assets (oney) This completes our initial simple moel of the macroeconomy! So what o we o with it? The En 6