Chapter 7. The Asset Market, Money, and Prices i. What is Money Money refers to specifically to assets that are widely used and accepted as payment. Example: Currency Checkable deposits Checks Money order a. The Function of Money There are three functions : 1) Medium of exchange- Money permits to trade at less cost in time and effort! 2) Unit of account: Money is the basic unit for measuring economics. 3) Store of Value: money is a way of storing wealth. II. Measuring Money: The Monetary Aggregate Money is measured in three ways: a. The M1 Monetary Aggregate. This is the narrowest definition of money. It consist of: Currency Traveler’s checks Demand Deposits Other checkable deposits (such as NOW and ATS) M1 is perhaps the closest counter part of the theoretical definition of money because all its components are actively used and widely accepted for making payments. b. The M2 Monetary Aggregate. It consist of: M1 Savings deposits, including MM Small-denomination time deposits MMMFs (non-institutional) c. The M3 Monetary Aggregate. It consist of: M1 and M2 Large denomination time deposits MMMF (institutional) Repurchasing agreements (an agreement by a bank to borrow from a non-bank by selling securities) Eurodollars held by domestic institutions Some of these assets can not be used as currency, but can easily be converted.
III.
The Money Supply
The money supply is the amount of money available in the economy. It is determined by the central bank (FED). If the FED wants to increase MS, all it needs to do is increase the currency in the market.
One way to do so is for the FED to uses newly minted currency to buy financial assets ( bonds) from the public. Now the public holds less assets and more currency. To reduce MS the FED needs to sell financial assets and pay with currency. Open-market operations are the purchase or sell of assets by the central bank, used to affect the money supply. IV. Portfolio Allocation and the Demand for Assets Portfolio allocation decision is the decision about which assets and how much of each to hold. • Expected Return: the higher the expected return the higher consumption the agent can enjoy! • Risk: agents are risk-averse, hence to hold a risky asset, it must have a higher expected return • Liquidity: the easier is to exchange the asset for goods, services or other assets, the more attractive is the asset. Money is highly liquid! V.
The Demand for Money
The demand for money is the quantity of monetary assets that people choose to hold in their portfolios. The Demand of money will depend on the expected return, risk and liquidity of money and other assets. I. The Price Level Higher prices increase people’s need for liquidity and thus raised the demand for money. The less money is needed for transactions the demand for money is smaller. Ceteris paribus, the nominal demand for money is proportional to the price level II. Real Income An increase in income raises the demand for money. This is because higher income means more transactions and greater need for liquidity. An increase in income is not means a proportional increase in demand for money. Reasons: The more money you make the less likely you are to hold all of it in an extremely liquid account. A nation’s financial sophistication tends to increase as national income grows. III. Interest Rate The higher the interest rate on money, the more people will demand; however, the higher the interest rate paid on alternative assets to money, the more people will want to switch from money to those alternative assets. VI.
Other Factors Affecting Money Demand
a.
Wealth
When wealth increase, part of the extra wealth will be hold on money, increasing the total demand for money.
Ceteris paribus, a holder of wealth has little incentive to keep extra wealth in money rather than investment. b. Risk Money usually is not risky. However, if the risks of alternative assets increase too much, the demand for money will increase. In period of high inflation uncertainty may be high, making it risky to hold money. This would reduce the demand for money. c. Liquidity of Alternative Assets The more quickly and easily alternative assets can be converted into cash, the less need there is to hold money. As more alternative assets become more liquid, the demand for money will decline. d. Payment Technologies Money demanded is also affected by technology available for making and receiving payments. Think credit card and debit card. VII.
Velocity and the Quantity theory of Money
The Velocity measures how often the money stock “turns over” each period. If velocity rises, each dollar of the money stock is being used in a greater dollar volume of transaction in each period. The quantity theory of money asserts that real money demand is proportional to real income,
