Class 6 – Slides

This slide deck is an edited version of the publisher’s slides for Chapter 7
Macroeconomics
Ninth Canadian Edition

Chapter 7
The Asset Market, Money, and Prices

Copyright © 2022 Pearson Canada Inc. 7–2

Main Questions

What is money?

How people decide to allocate their wealth among the various assets?

What are the determinants of demand for and supply of money?

How money and the price level are related?

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
Asset Markets

The asset market is the entire set of markets in which people buy and sell
real and financial assets, for example, gold, houses, stocks, and bonds.

Money is an asset widely used and accepted as payment.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
The Functions of Money
A medium of exchange—money is a device for making transactions at less cost in time and
effort.

A unit of account—money is the basic unit for measuring economic value.

A store of value—money is a way of holding wealth.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
The Monetary Aggregates (1 of 2)

Monetary aggregates are different measures of the money stock.

M1+ consists primarily of currency and balances held in chequing

accounts.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
The Monetary Aggregates (2 of 2)

M2 is M1+ plus personal and non-personal non-chequable deposits.

M3 is M2 plus non-personal term deposits held by businesses and

foreign currency deposit of Canadian residents.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
The Money Supply (1 of 3)

The money supply is the amount of money available in an economy.

The money supply is partly determined by the central bank.

Assume that the Bank of Canada sets the money supply—in practice it is done indirectly.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
The Money Supply (2 of 3)

One way to influence the money supply is open-market operations—

open market purchases and sales of government bonds to the public.

A purchase of government bonds from the public increases the money

supply.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
The Money Supply (3 of 3)

Another way to influence the money supply is to purchase

and sell government bonds directly to the government.

In effect this means the government is financing its

expenditures by printing money. It induces inflation.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
 Digression: Transmission
Mechanism

Source: Bank of Canada 15

 Digression: Transmission
Mechanism

Source: Bank of Canada 16

 Digression:
Monetary Policy Transmission Mechanism
A Canadian Case Study

17
Objective ?
• Discuss in class

18
Macroeconomic Variables (Summary)

• 3 Month T-bill yields • Exchange Rate

• Overnight Rate • Monetary Conditions Index
• Bank of Canada Rate • Real GDP
• 10-year Government of • Unemployment Rate
Canada Bond Yields
• Inflation Rate
• 30-year Government of
Canada Bond Yields • Current Account
• Prime Rate • Yield Curve
• Money Supply - M1 • S&P/TSX (TSE 300)
• Money Supply - M2

19
 Money Supply - M1
100,000.00

90,000.00

80,000.00

70,000.00
Dollars (millions)

60,000.00

50,000.00

40,000.00

30,000.00

20,000.00

10,000.00

-
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Source: Bank of Canada 20

 Money Supply - M1
Yearly Percentage Change
18.00%

16.00%

14.00%

12.00%

10.00%
% Change

8.00%

6.00%

4.00%

2.00%

0.00%
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

-2.00%

Year

Source: Bank of Canada 21

 Money Supply - M2
450,000

400,000

350,000
Dollars (millions)

300,000

250,000

200,000

150,000

100,000
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Source: Bank of Canada 22

 Money Supply - M2
Yearly Percentage Change
16.00%

14.00%

12.00%

10.00%
% Change

8.00%

6.00%

4.00%

2.00%

0.00%
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

-2.00%

Year

Source: Bank of Canada 23

 Overnight Money Market Financing
20.00%

18.00%

16.00%

14.00%

12.00%

10.00%
Rate

8.00%

6.00%

4.00%

2.00%

0.00%
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Source: Bank of Canada 24

 Bank of Canada Rate

20.00%

18.00%

16.00%

14.00%

12.00%
Rate

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Source: Bank of Canada 25

 3 Month Treasury Bill Yields
20.00%

18.00%

16.00%

14.00%

12.00%

10.00%
Yield

8.00%

6.00%

4.00%

2.00%

0.00%
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Source: Bank of Canada 26

 Prime Rate
25.00%

20.00%

15.00%
Rate

10.00%

5.00%

0.00%
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Source: Bank of Canada 27

 10 Year Government of Canada Bond Yields
16.00%

14.00%

12.00%

10.00%
Yield

8.00%

6.00%

4.00%

2.00%
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Source: Bank of Canada 28

 Long Term Government of Canada Bond Yields
18.00%

16.00%

14.00%

12.00%

10.00%
Yield

8.00%

6.00%

4.00%

2.00%

0.00%
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Source: Bank of Canada 29

 Exchange Rate
CAD/USD Spot Rate (CAD)
1.5500

1.5000

1.4500

1.4000

1.3500
Rate - (Cdn$)

1.3000

1.2500

1.2000

1.1500

1.1000
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Source: Bank of Canada 30

 Current Account Surplus/Deficit
All Countries
$10,000

$5,000

$-
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

-$5,000
Dollars (millions)

-$10,000

-$15,000

-$20,000

-$25,000

-$30,000

Year

Source: Statistics Canada 31

 Real GDP - Expenditure Based
at 1992 Prices - Seasonally Adjusted

$900,000

$850,000

$800,000

$750,000

$700,000
Dollars (millions)

$650,000

$600,000

$550,000

$500,000

$450,000

$400,000
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Source: Statistics Canada 32

 Real GDP - II
Yearly Percentage Change
7.00%

6.00%

5.00%

4.00%

3.00%
Percentage Change

2.00%

1.00%

0.00%
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

-1.00%

-2.00%

-3.00%

-4.00%

Year

Source: Statistics Canada 33

 Unemployment Rate - 15 Yrs. and Over
13.00%

12.00%

11.00%

10.00%

9.00%
Rate

8.00%

7.00%

6.00%

5.00%
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Source: Statistics Canada 34

 Inflation - Percentage Change in Consumer
Price Index - All Items
14.00%

12.00%

10.00%

8.00%
Rate

6.00%

4.00%

2.00%

0.00%
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Source: Statistics Canada 35

 TSX Composite Index

7,000.00

6,000.00

5,000.00

4,000.00
Level

3,000.00

2,000.00

1,000.00
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Year

Source: Bank of Canada 36

 TSX Composite Index
Yearly Percentage Change
50.00%

40.00%

30.00%

20.00%
Percent Change

10.00%

0.00%
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

-10.00%

-20.00%

-30.00%

Year

Source: Bank of Canada 37

 Monetary Conditions Index
20.00

15.00

10.00
Index Level

5.00

0.00
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

-5.00

-10.00

Year

Source: Bank of Canada 38

 Yield Curve: 1982 - 1984

17.00%

15.00%

1982
1984
13.00%

1983
Yield

11.00%

9.00%

7.00%

5.00%
0 2 4 6 8 10 12 14 16

Term To Maturity (yrs)

Source: Bank of Canada 39

 Yield Curve: 1985 - 1987
12.00%

1985
11.00%

10.00% 1987

1986
9.00%
Yield

8.00%

7.00%

6.00%

5.00%
0 2 4 6 8 10 12 14 16

Term To Maturity (yrs)

Source: Bank of Canada 40

 Yield Curve: 1988 - 1990
14.00%

13.00%

12.00%

1990
11.00%

1988
10.00%
Yield

1989
9.00%

8.00%

7.00%

6.00%
0 2 4 6 8 10 12 14 16

Term To Maturity - (yrs)

Source: Bank of Canada 41

 Yield Curve: 1991 - 1993
11.00%

10.00%

1991
9.00%

1992
8.00%

1993
7.00%
Yield

6.00%

5.00%

4.00%

3.00%
0 2 4 6 8 10 12 14 16

Term to Maturity (yrs)

Source: Bank of Canada 42

 Yield Curve: 1994 - 1996

10.00%

9.00%
1994

1995
8.00%

1996
7.00%
Yield

6.00%

5.00%

4.00%

3.00%

2.00%
0 2 4 6 8 10 12 14 16

Term To Maturity (yrs)

Source: Bank of Canada 43

 Yield Curve: 1997 - 1999
7.00%

1997
6.00%
1999
1998
5.00%

4.00%
Yield

3.00%

2.00%

1.00%

0.00%
0 2 4 6 8 10 12 14 16

Term To Maturity (yrs)

Source: Bank of Canada 44

Monetary Policy Transmission Mechanism
Some More Detail

45
 Sources

• Statistics Canada - CANSIM Time Series Database: www.statcan.ca

• Bank of Canada: www.bank-banque-canada.ca

• International Monetary Fund:www.imf.org

• Government of Canada – Ministry of Finance: www.fin.gc.ca

46
The 2007-2008 Financial Crisis

What did the How did the banks

What happened?
government do? respond?

Copyright © 2022 Pearson Canada Inc. 7–47

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
Excess Reserves of Depository Institutions to 2020

Copyright © 2022 Pearson Canada Inc. 7–49

Chinese economy falls into deflation as recovery stumbles | FT, Aug 9, 2023

Copyright © 2022 Pearson Canada Inc. 7–50

Why China is flirting with deflation as the west battles rising prices | FT, July 13, 2023

Copyright © 2022 Pearson Canada Inc. 7–51

Portfolio Allocation and the Demand for
Assets
A portfolio is a set of assets that a holder of wealth chooses to
own.

The portfolio allocation decision is based on expected return,

risk, and liquidity of an asset.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
Asset Demands

There is a trade-off among the four characteristics that make an asset

desirable: a high expected return, low risk, liquidity and term to maturity.

The amount of each particular asset that a holder of wealth desires to

include in her portfolio is called her demand for assets.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
Types of Assets

Money—highly liquid, inflation risk, short term to maturity

Bonds—differing default risk, term to maturity and liquidity

Stocks—dividends not guaranteed, substantial price fluctuations, most shares in large corporations is liquid, no maturity

Real Estate—very illiquid, provides shelter services, no maturity

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
The Demand for Money (1 of 2)

The demand for money is the quantity of monetary assets that

people choose to hold in their portfolios.

Money is the most liquid asset but pays a low return (zero
nominal return).

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
The Demand for Money (2 of 2)
The demand for money will depend on the expected return, risk and liquidity of
money relative to other assets.

The macroeconomic variables that have the greatest effects on money demand
are the price level, real income, and interest rates.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
The Money Demand Function (1 of 4)

M  P  L(Y , i )
d

Md is the aggregate demand for money

P is the price level
Y is real income or output
i is the interest rate earned by nonmonetary assets
L is a function relating Md to Y and i

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
 The Money Demand Function (2 of 4)

M  P  L(Y , r   )
d e

r is the expected real interest rate

πe is the expected rate of inflation, it is assumed to be
fixed

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
 The Money Demand Function (4 of 4)
• Real money demand or demand for real balances

d
M
 L(Y , r   )
e

P
• The function L that relates real money demand to
output and interest rates is called the real money
demand function.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
 • Money demand increases as •Source: Abel et al,
Other Factors a result of Macroeconomics, Ch. 7, 9th
Affecting • Higher wealth Canadian Edition, Pearson
Canada, 2022
Money Demand • Higher riskiness of
alternative assets
• Lower liquidity of
alternative assets
• Higher efficiency of
payment technologies
Elasticities of Money Demand (1 of 2)

The income elasticity of money demand is the percentage change in

money demand resulting from a 1% increase in real income.

The interest elasticity of money demand is the percentage change in

money demand resulting from a 1% increase in the interest rate.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
Elasticities of Money Demand (2 of 2)
The empirical evidence is that the income elasticity of money demand
is positive but less than one (about 0.5).

The empirical studies find a small negative value (about −0.3) for the
interest rate elasticity of money demand.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
Velocity and the Quantity Theory of Money
• Velocity (V) is nominal GDP (P times Y) divided by the
nominal money stock (M).

PY
V
M

• The quantity theory of money asserts that real

money demand is proportional to real income.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
The Quantity Theory of Money
d
M
 kY
P
where k is a constant.
• The real money demand function L(Y,r + πe) takes the
simple form kY.
• This is a strong assumption that velocity is a
constant, 1/k, and does not depend on Y and r + π e.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
Asset Market Equilibrium Assumption
We assume that all assets may be grouped into monetary and nonmonetary
assets.

Asset market equilibrium reduces to the condition that the quantity of

money supplied equals the quantity of money demanded.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
Asset Market Equilibrium (1 of 3)
• The sum of all individual demands equals the
economy’s total nominal wealth

M d  NM d  aggregate nominal wealth

Md is the aggregate demand for money

NMd is the aggregate demand for nonmonetary assets

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
Asset Market Equilibrium (2 of 3)
• Aggregate nominal wealth

M  NM  aggregate nominal wealth

M is the fixed nominal supply of money

NM is the fixed nominal supply of nonmonetary assets

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
Asset Market Equilibrium (3 of 3)
• Thus, the equilibrium condition is

( M  M )  ( NM  NM )  0
d d

• If (Md − M) = 0, then (NMd − NM) = 0.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
 • As long as the amount of •Source: Abel et al,
Asset Market money supplied and Macroeconomics, Ch. 7, 9th
Equilibrium demanded are equal, the Canadian Edition, Pearson
entire asset market will be in Canada, 2022
Condition (1 of equilibrium.
3)
 Asset Market Equilibrium
Condition (2 of 3)
• The asset market equilibrium condition is

M
 L(Y , r   )
e

M
P
L(Y , r   )
e

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
 • P is determined by the asset •Source: Abel et al,
Asset Market market equilibrium Macroeconomics, Ch. 7, 9th
Equilibrium condition. Canadian Edition, Pearson
Canada, 2022
Condition (3 of • M is determined by the
central bank.
3) • Y and r are determined by
equilibrium conditions in
labour and goods markets.
Money Growth and Inflation (1 of 3)
• The rate of inflation equals the growth rate of the
nominal money supply minus the growth rate of real
money demand.

P M L(Y , r   e )
 
P M L(Y , r   )
e

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
Money Growth and Inflation (2 of 3)
We show that the rate of inflation is closely related to the rate of
growth of nominal money supply.

In long-run equilibrium with a constant growth rate of money, the

nominal interest rate will also be constant.

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
Money Growth and Inflation (3 of 3)
• Thus, the rate of inflation in a full-employment
economy also depends on the percentage change in
real income (ΔY/Y) and the income elasticity of money
demand (ηY)

M Y
  Y
M Y

Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
 • In practice, the expected •Source: Abel et al,
The Expected inflation rate is fixed and the Macroeconomics, Ch. 7, 9th
Inflation Rate current inflation rate often Canadian Edition, Pearson
approximates the expected Canada, 2022
(1 of 2) inflation rate, as long as
people do not expect
changes in M or Y.
 • Policy actions (such as rapid •Source: Abel et al,
The Expected expansion of money supply) Macroeconomics, Ch. 7, 9th
Inflation Rate that cause people to fear Canadian Edition, Pearson
future increases in inflation Canada, 2022
(2 of 2) should cause the nominal
interest rate to rise, all else
being equal.
Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
Source: Abel et al, Macroeconomics, Ch. 7, 9th Canadian Edition, Pearson Canada, 2022
Source: Bank of Canada, April 2022
https://www.bankofcanada.ca/2022/04/canadian-survey-of-consumer-expectations-first-quarter-of-2022/