The Asset Market

Wong Wei Kang

Do not circulate without permission
 Outline
•  What Is Money?
•  Portfolio Allocation & the Demand for Assets
•  The Demand for Money
•  Asset Market Equilibrium
•  Money Growth and Inflation
•  The Fisher Effect
 Money
•  Assets that are widely used and accepted as payment
•  The functions of money
–  Medium of exchange
•  Barter and the double coincidence of wants
•  Lower transaction costs

–  Unit of account
•  Basic unit for measuring economic value

–  Store of value
•  Used to hold wealth → Bonds and stocks offer higher expected
returns but are less liquid
 Some Definitions
•  Liquidity
•  The relative ease and speed with which an asset
can be converted into a medium of exchange
•  Fiat money
•  has no intrinsic value

•  E.g., the paper currency we use

•  Commodity money
•  has intrinsic value

•  E.g., gold coins, cigarettes in P.O.W. camps

 Figure 25.1HO U.S. Money Supply (July 2015)

•  U.S. currency holdings are unusually high by world standards;

people in other countries sometimes hold and use U.S. dollars.
Figure 7.3 Growth rates of M1, M2 and nominal GDP, 1960-2015Q1
Different measures of money tell a very different story about the
course of monetary policy in the 1990s
 The Money Supply
•  The amount of money available in the economy
–  M to represent money supply; M1 or M2
•  The central bank changes the money supply (Ms)
through open-market operations [Figure 8.5B]
–  Open market purchases: use newly printed money to buy
financial assets from the public → ↑ Ms
–  Open market sale: sells financial assets to the public →
↓ Ms
–  Can also buy newly issued government bonds directly
from the government → Finance expenditures directly by
printing money → Inflation
 Portfolio Allocation and Asset Demand
•  How do people allocate their wealth among various assets?
Tradeoff among…
–  Expected return
–  Risk
–  Liquidity
•  Asset demand
–  The amount a wealth holder wants of an asset
–  The sum of asset demands = total wealth because all wealth must be
held as some type of asset
•  Money demand
–  The quantity of monetary assets that people want to hold in their
portfolios
The Money Demand Function
+ −
(M P ) = L (Y , i )
d

(M/P )d = real money demand, depends

§  positively on Y
higher Y ⇒ more spending and transactions
⇒ so, need more money
§  negatively on i
i is the opportunity cost of holding money
(L is used for the real money demand function
because money is the most liquid asset)
The Money Demand Function
(M P ) = L (i ,Y )
d

e
= L (r + π ,Y )
When people are deciding whether to hold money or
bonds, they don’t know what inflation will turn out to be
Hence, the nominal interest rate relevant for money
demand is r + πe
Henceforth, unless stated otherwise, i = nominal interest
rate on nonmonetary assets and this is the money demand
function we will use.
 Real vs. Nominal Interest Rates
•  Real: the growth rate of purchasing power, r
•  Nominal: the growth rate of money, i
•  Inflation rate: the growth rate of “prices”, π

1+ i
1+ r =
1+ π
1+ r + π + rπ = 1+ i
i−π
r=
1+ π
r ≈ i − π or i ≈ r+π
 The Elasticity of Money Demand
•  Elasticity of Y with respect to X
–  The %Δ in Y caused by a one %Δ in X = (ΔY/Y)/(ΔX/X)
•  Income elasticity of money demand
–  ↑ Y → ↑ Md
–  ↑ Y→ Financial innovation (e.g., use of credit card) & use
money more efficiently → ↑ Md less than 1-to-1
–  Stephen Goldfeld: around 2/3
•  Interest elasticity of money demand
–  ↑ r on non-monetary assets → ↓ Md
–  Around -0.1 to -0.2
 Asset Market Equilibrium
•  Assume that all assets can be grouped into two
categories, money and nonmonetary assets
–  Money includes currency and checking accounts
•  Pays interest rate im
–  Unless stated explicitly otherwise, we assume that im=0 (i.e.,
money pays no interest)
•  Supply is fixed at M
–  Nonmonetary assets include stocks, bonds, land, etc.
•  Pays interest rate i = r + πe
•  Supply is fixed at NM
 Asset Market Equilibrium
•  Supply = Demand for each type of asset
•  If the money market is in equilibrium
–  Total wealth is held either as monetary or non-monetary assets
–  The non-money market must also be in equilibrium
–  Asset market is in equilibrium (Walras Law)

•  Asset Market Equilibrium ↔ Money Market

Equilibrium
Md/P = Ms/P
 Equilibrium in Money Market ↔
Equilibrium in Non-money Market
An individual has a fixed amount of wealth that he allocates
between monetary and nonmonetary assets → Demand for Assets
md + nmd = total nominal wealth of an individual

Summing across all wealth holders → Aggregate Demand for Assets

Md + NMd = Aggregate nominal wealth (1)

Money and nonmonetary assets are the only assets in the economy
M + NM = Aggregate nominal wealth (2)
 Equilibrium in Money Market ↔
Equilibrium in Non-money Market
(1) – (2): (Md – M) + (NMd – NM) = 0

Excess demand for money (Md – M)

+ Excess demand for nonmonetary assets (NMd – NM) = 0

Md = M → NMd = NM

Equilibrium in Money market → Equilibrium in Non-money

market → Asset market Equilibrium
 Asset Market Equilibrium
↔ Money Market Equilibrium

M e
= L (r + π , Y )
P
The supply of real
money balances Real money
demand
 Real Money supply
r s
The nominal interest (M P )
money supply is rate
exogenously fixed
by the central bank
while prices are
assumed to be fixed
in the short run:

S M/P
⎛M ⎞ ⎛M ⎞ M P real money
⎜⎜ ⎟⎟ = ⎜⎜ ⎟⎟
⎝P ⎠ ⎝P ⎠ balances
 Real Money demand
r
s
interest (M P )
rate
Demand for real
money balances:

d
⎛M ⎞
⎜⎜ ⎟⎟ = L (r + π e , Y )
⎝P ⎠ L (Y, i )

M/P
M P real money
balances
 Equilibrium
r
s
In the short run, interest (M P )
the real interest rate
rate r adjusts to
equate the supply
and demand for
r1
money:
L (Y, i )
M P = L (r + π e , Y )
M/P
M P real money
balances
What Determines What in the Long Run?

M e
= L (r + π , Y )
P
Variable How Determined (in the Long Run)?
M Exogenous (the Fed – Open Market Oper.)
r Adjusts to make Sd = Id (Goods Market)
Y Y = F ( K , L ) (Labor Market)
P Adjusts to make M = L (i ,Y ) (Asset Market)
P
 How P Responds to ΔM?
M e
= L (r + π , Y )
P

•  For given values of r, Y, and πe,

a change in M causes P to change by the same
percentage
Money and the Price Level in the United States
 Money and Inflation
•  Asset market equilibrium → rate of inflation = growth rate of
nominal money supply - growth rate of real money demand
M
P=
L(Y , r + π e )
ΔP ΔM ΔL(Y , r + π e )
= −
P M L(Y , r + π e )
ΔM ΔY Δi
π= − ηY − ηi
M Y i
•  In countries with high inflation, the growth of nominal money
supply tends to be much more important than the growth of real
money demand
 Money Growth & Inflation
ΔM ΔY Δi
π= − ηY − ηi
M Y i
•  Inflation rate = Growth rate of the nominal money supply
− Adjustment for the growth rate of real money demand
arising from growth in real output Y
− Adjustment for the growth rate of real money demand
arising from growth in nominal interest rate i
•  Milton Friedman
–  Inflation is always and everywhere a monetary
phenomenon (Figure 7.4)
Figure M5.1 U.S. inflation and money growth
High money growth leads to high infla3on
 Figure M5.2 U.S. inflation and money growth, 1960–2012
14%

M2 growth rate
12%
% change from 12 mos. earlier

10%

8%

6%

4%

2% inflation
rate
0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 U.S. inflation and money growth, 1960–2012
Inflation and money growth
14%
have the same long-run trends
12%
% change from 12 mos. earlier

10%

8%

6%

4%

2%

0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Figure 7.4 The relationship between money growth and
inflation for European countries in transition
Figure M5.2 International data on inflation and money growth
 Hyperinflation
•  def: π ≥ 50% per month
•  The costs of hyperinflation are HUGE
•  Money ceases to function as a store of value, and may not serve its other
functions (unit of account, medium of exchange)
•  People may conduct transactions with barter or a stable foreign currency
•  Hyperinflation is also caused by excessive money supply growth
•  Thus, the solution to hyperinflation is simple: stop printing money.
–  So why do countries allow money supplies to grow quickly, if they know it will
cause inflation?
•  They sometimes find that printing money is the only way to finance
government expenditures
•  Especially true for very poor countries, or countries in political crisis
–  This often involves painful fiscal reform (↓ G to reduce budget deficit)
 A few examples of hyperinflation
CPI Infla2on M2 Growth
country period
% per year % per year
Israel 1983-85 338% 305%
Brazil 1987-94 1,256 1,451
Bolivia 1983-86 1,818 1,727
Ukraine 1992-94 2,089 1,029
Argen3na 1988-90 2,671 1,583
Dem. Republic
1990-96 3,039 2,373
of Congo / Zaire
Angola 1995-96 4,145 4,106
Peru 1988-90 5,050 3,517
Zimbabwe 2005-07 5,316 9,914
 The Fisher Effect
•  With constant real interest rate, the nominal interest
rate changes one-for-one with changes in the
expected inflation rate
•  In other words, with r = constant, Δ i = Δ πe
–  Unless people expect large changes in the growth rates of
M or Y, πe ≈ π
–  Expect i to comove with π, i.e., Δ i ≈ Δ π
–  The comovement won’t be perfect because r will most
likely not remain constant
Figure 7.5 Inflation and the nominal interest rate in the U.S.
 Focus: Nominal Interest Rates and Inflation across
Latin America in the Early 1990s
Figure 1 Nominal Interest Rates and Inflation: Latin America,
1992–1993
Figure M5.4 Inflation and nominal interest rates across countries
 Appendix:
The Derivation of
Growth Rate Formula
 Growth Rate Formula
•  Let y = x1x2
•  Taking natural log, ln y = ln x1+ ln x2

dy dx1 dx2
•  Differentiating, = +
y x1 x2
Δy Δx1 Δx2
•  Thus, if y = x1x2, then ≅ +
y x1 x2
 Growth Rate Formula
x1
•  Similarly, let y =
x2

•  Taking natural log, ln y = ln x1 – ln x2

dy dx1 dx2
•  Differentiating, = −
y x1 x2
Δy Δx1 Δx2
•  Thus, if y = x1/x2, then ≅ −
y x1 x2
•  Similarly, let y = f (x1, x2)
•  Taking natural log, ln y = ln f (x1, x2)

dy 1 ⎡ ∂y ∂y ⎤
•  Differentiating, = ⎢ dx1 + dx2 ⎥
y y ⎣ ∂x1 ∂x2 ⎦
dy ∂y x1 dx1 ∂y x2 dx2
= +
y ∂x1 y x1 ∂x2 y x2
•  Thus, dy dx1 dx2
= η y,x + η y,x
y 1
x1 2
x2
•  Summarizing, if y = f (x1, x2)

•  Then Δy Δx 1
Δx 2
≅ η y,x + η y,x
y 1
x1 2
x2
•  where
Δy Δx1
η y,x1 = = Elasticity of y with respect to x1
y x1
Δy Δx2
η y,x2 = = Elasticity of y with respect to x2
y x2