CHAPTER THREE

REAL ESTATE PRICING: MONEY VS ASSET

MARKET
1) What is Money?
2) What are the types of money?
3) What are the characteristics of money?
4) What is monetary policy?
Money Defined…
Money is the stock of assets that can be
readily used to make transactions.
The money came into existence to overcome
the drawbacks of the barter system. Earlier,
people use to exchange goods and services as
a form of commerce.
This often led to many disadvantages, one of
which was the double coincidence of wants.
To solve this problem, a standard medium of
exchange, money, was introduced.
The first types of money were commodities.
Money…
 A medium of exchange that is centralized, generally
accepted, recognized, and facilitates transactions of
goods & services, is known as money.
 Money is a medium of exchange for various goods
and services in an economy.
 The money system varies with the governments and
countries.
 Different countries have different currencies.
 The central authority is responsible for monitoring
the monetary system.
 There are many forms of money, & cryptocurrency
is the newest addition to the forms of money & can
be internationally exchanged.
Functions of Money: money is what it does

◦ Money as a medium of exchange - a generally

accepted means of payment;
◦ Money as a unit of account - a widely recognized
measure of value;
◦ Money as a store of value - a transfer of
purchasing power from present to future;
◦ Money as a means of payment – serve as payment
for any business transactions.
Types of Money
 Types of Money: paper, commodity &
electronic
◦ Fiat money
 has no intrinsic value

 Example: the paper currency we use

◦ Commodity money
 has intrinsic value

 Examples: gold, coins

How do you characterize
Money?
01
Portable
Uniform
04

02 Durable Limited 05

03 Divisible Acceptable 06
Characteristics of Money
Characteristics of Money
 Fungible currency: A currency must be fungible which
means that the units used as a currency must be equal in
quality and shall be interchangeable. A non-fungible form of
currency is not considered reliable for transactions.
 Durable: A good currency is durable enough to be used more
than just one time. It should not be perishable. A perishable
good or article should not be used as a currency because it
cannot be used multiple times and also cannot be stored for
future transactions. Therefore, to conserve the future-oriented
use-value of the money, a currency must be durable.
 Easily recognizable: The users of the money must be
ascertained of its authenticity. In other words, the currency
must be universally recognized. An unrecognized currency or
money leads to disagreement with the exchange terms. A
recognized currency ensures trust in the money system as
well as its acceptance.
Characteristics of Money…
 Stability: A currency must be stable in terms of value. In
simple terms, money should have a constant or increasing
value. Money cannot be unstable whose value keeps
drastically changing. An unstable currency can give room
to the risk of a sudden drop in value which can hamper
the acceptance and authenticity of the money system.
 Portable: A currency must be portable and can be
conveniently transported from one place to another. The
money must be divisible into various quantities making
its use better. Money if not portable can lead to an
exceeded cost of transportation of the currency itself.
Therefore, money should be able to be divided into
further smaller units to facilitate smooth transactions of
various quantities of goods. Secondly, it should be easily
transferable and portable.
Monetary Aggregates
Monetary aggregates are the measures of
money stock in a country. Central banks
measure money aggregates and present them
in the form of end-of-month national
currency stock series.
Central banks use monetary aggregates to
create monetary policies, given their ability
to measure a nation’s financial stability and
economic health.
Money Aggregates and Their Effects
A country’s economic health and financial
stability is assessed using data on monetary
aggregates. As a result, for decades, they’ve
been used by central banks in establishing
monetary policies.
 Nevertheless, in the past few decades,
economists were able to prove the disconnect
between fluctuation in money supply metrics,
such as unemployment, GDP, and inflation.
 The central bank’s monetary policy guides the
release of money into the economy by the
Federal Reserve.
The Impact of Money Aggregates
 Studying monetary aggregates can generate
substantial information on the financial stability and
overall health of a country. For example, monetary
aggregates that grow too rapidly may cause fear of a
high rate of inflation.
 If there is a greater amount of money in circulation
than what is needed to pay for the same amount of
goods and services, prices are likely to rise. If a
high rate of inflation occurs, central banking groups
may be forced to raise interest rates or stop the
growth in the money supply.
 The amount of money the Federal Reserve releases
into the economy is a preferable indication of
a nation's economic health.
The Impact of Money Aggregates…
 For decades, monetary aggregates were essential
for understanding a nation's economy and were
key in establishing central banking policies in
general. The past few decades have revealed that
there is less of a connection between fluctuations
in the money supply and significant metrics such
as inflation, gross domestic product (GDP), and
unemployment.
 The amount of money the Federal
Reserve releases into the economy is a clear
indicator of the central bank's monetary policy.
When compared to GDP growth, M2 is still a
useful indicator of potential inflation.
Monetary Aggregates…
Thethree broad monetary aggregates are
M1+ M2 + M3
M1 monetary aggregate
◦ Currency and coins
◦ Checkable deposits
◦ Traveler’s checks
M2 monetary aggregate=M1 + less money
like assets
◦ M1+Savings accounts
◦ Small Time deposits [<$100K]
◦ Money Market Mutual Funds
Monetary Aggregates…
M3 monetary aggregate = M2 + less
money like assets
◦ + Repurchase agreements
◦ + Money market fund (MMF) shares/units
◦ + Debt securities up to 2 years
◦ Large denomination (> $100,000) time deposits
But, the most common measures for studying
the effects of money on the economy are M1
and M2
Monetary Aggregates…
In the U.S., monetary aggregates are
conventionally labeled as M0, M1, M2,
and M3. The categories come with
different definitions, as follows:
Monetary Aggregates…
Monetary Aggregates…
Monetary Policy
 An stabilization policy that deals with the supply of
money, credit and interest rate in an economy.
 Can be set of general policy guideline which is related
to the supply and demand for credits, economic
business cycle or the economy as a whole.
 Broadly there are expansional and contractionary
monetary policy.
 During economic expansion and recession the
contractionary and expansionary monetary policy is
applied respectively.
 Expansionary monetary policy implies increase in
money supply and decrease in interest rate [ bank rate
or fund rate] but contractionary monetary policy
reduces money supply and increases interest rate.
Objectives of Monetary Policy
Stabilize
price level
Growth with Stabilize
stability 01 Foreign
Exchange

0022
07
OMP Protect the
Credit

03
06

availability outflow of gold

05 04

Meet business Control

needs business
cycle
Monetary Policy Instruments
There are two types of monetary policy
instruments.
◦ Indirect monetary policy
◦ Direct monetary policy
Indirectmonetary policies
These are measures to regulate the overall
level of credit in the economy through
commercial banks.
Here there are 3 basic instruments:
A. Reserve requirements
B. The discount rate
C. Open-market operations
Direct Monetary Policy Instruments…
There are two principal motives of open
market operations.
a) To influence the reserves of commercial
banks in order to control their power of
credit creation.
b) To affect the market rates of interest, so as
to control the commercial bank credit.
To control inflationary pressures CB sells
government security and the converse to
control deflationary pressures.
Indirect Monetary Policy Instruments…
2. Direct monetary Policies
A. Fixed interest rate policy
◦ Here, the CB directly fixes the interest rate
applicable to deposits & lending by
commercial banks.
B. Credit ceiling/control
◦ Here, the CB imposes credit ceiling on:
 Government borrowing from CB
 Commercial bank lending
Money Supply (MS) & Money Creation
1.100% Reserve Banking
Let say there is no bank, thus MS= CC, because
, D=0
Let’s introduce banks
First, suppose the bank accept deposits but do
not make loans.
Here, the purpose of banks is to provide a safe
place for depositors to keep their money.
The deposits that banks have received but have
not let out are called reserves.
 Money Supply (MS) & its Creation …
 Here, banks leave the
ABC
money there until the
depositors make a
withdrawal or writes a Assets Liabilities
check against the balance.
 This system is called Reserves 1000 Deposits 1000
100% reserve banking-
banks hold all the deposit
as reserve.
 Example: Suppose the
house holds deposit 1000
birr in ABC bank. Then
the balance sheet will be
Money Supply (MS) & its Creation…
Here, there is no loan
Presumably that the bank charges depositors a
small amount of fee to cover its costs.
Thus what is the money supply in this
economy? It remains1000.
Thus money supply remains the same when
there is no bank and when there is bank which
do not lend.
If banks hold 100% of the deposits in reserve
the banking system does not affect the
money supply.
Money Supply (MS & its Creation…
 But, we know a bank borrows from people willing to
deposit cash with it in return for a claim on bank in
the form of a bank deposit.
 Banks can make a profit by acquiring interest-earning
assets in the form of bank loans.
A bank doesn’t hold all of its assets as loans a portion
is held as cash in order to repay deposits on demand &
thus avoid insolvency.
A bank is financial intermediary.
 The margin b/n interest payments on deposits & the
interest received on loans is sufficient to cover
operating expenses & provide profit.
Money Supply (MS & its Creation…
2. Fractional-Reserve Banking
Now imagine that banks start to use some of
their deposits to make loans. For example,
to families, who are buying houses or to firms
that are investing in new plants and
equipment.
The advantage of banks is to charge interest
on the loans.
They keep some reserves in their hand to
give for depositors whenever they want to
withdraw.
This is known as fractional reserve
banking system under which banks keep
only a fraction of their deposits in reserve.
Demand for Money
Operationally, demand for money describes
how much money people want to hold [in
their hand, pocket, home] in the form of
cash.
On the basis of actors, demand for money is
categorized in to two:
A. Individuals demand for money
B. Aggregate demand for money
Let us see each of them in the following
sections.
Individuals Demand for Money
 Three factors influence individuals demand for
money are:
 Expected return
 Risk
 Liquidity
 Expected Return
The interest rate measures the opportunity
cost of holding money rather than interest-
bearing bonds.
A rise in the interest rate raises the cost of
holding money & causes money demand to
fall.
Individuals Demand for Money…
 Risk: is the degree of uncertainty in an asset's return
 People don't like risk, so prefer assets with low risk (other
things equal)
 Example: money involves high risk but asset assumes low risk
 Risk
 Holding money is risky
 An unexpected increase in the prices of goods and
services could reduce the value of money in terms
of the commodities consumed.
 Any change in the riskiness of money causes an
equal change in the riskiness of bonds.
 Liquidity
 Liquidity: is the ease and quickness with which an asset can
be traded
 Example: Money is the very liquid but assets are less liquid
Individuals Demand for Money…
 The main benefit of holding money comes from its
liquidity.
 HHs & firms hold money b/se it is the easiest way of financing
their everyday purchases.
A rise in the average value of transactions carried out by
a household or firm causes its demand for money to
rise.
 Ability to convert an asset to a medium of exchange
without loss of value
 Factors that affect liquidity include:
 Time constraints
 Withdrawal restrictions
 Minimum deposits
 Market conditions
 When liquidity decreases, savers demand compensation
(interest)
Aggregate Demand for Money
Aggregate money demand
The total demand for money by all
households and firms in the economy.
It is determined by three main factors:
Interest rate
It reduces the demand for money.
Price level
It raises the demand for money.
Real national income
It raises the demand for money.
Portfolio Allocation & Demand for Assets
Portfolio Allocation refers to the
distribution of wealth of people into
money and asset forms.
Demand for assets defines how much asset
people want to hold in the form of real assets
[ e.g. land, house] out of their total wealth
rather than monetary alternatives.
Let us see the them briefly as follows.
Portfolio Allocation & Demand for Assets…
Asset demand
Trade-off among expected return,
risk, & liquidity factors determines
Assets with low risk & high liquidity, like
checking accounts, have low expected
returns
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
Liquidity
Liquidity is a complex concept. Stated
simply, liquidity is the ease of trading a
security.
One source of illiquidity is exogenous
transaction costs such as brokerage fees,
order-processing costs, or transaction taxes.
Every time a security is traded, the buyer
and/or seller incurs a transaction cost; in
addition, the buyer anticipates further costs
upon a future sale, and so on, throughout
the life of the security.
Liquidity…
 Another source of illiquidity is demand pressure
and inventory risk. Demand pressure arises
because not all agents are present in the market at
all times, which means that if an agent needs to
sell a security quickly, then the natural buyers
may not be immediately available. As a result,
the seller may sell to a market maker who buys in
anticipation of being able to later lay off the
position. The market maker, being exposed to the
risk of price changes while he holds the asset in
inventory, must be compensated for this risk – a
compensation that imposes a cost on the seller.
Liquidity…
 Another source of illiquidity is the difficulty of locating a
counter-party who is willing to trade a particular security,
or a large quantity of a given security. Further, once a
counterparty is located, the agents must negotiate the
price in a less than perfectly competitive environment
since alternative trading partners are not immediately
available. This search friction is particularly relevant in
over-the-counter (OTC) markets in which there is no
central marketplace. A searching trader incurs financing
costs or opportunity costs as long as his trade is delayed,
and, further, he may need to give price concessions in the
negotiation with the counterparty that he eventually finds.
Alternatively, he may trade quickly with a dealer and bear
illiquidity cost. In general, a trader faces a tradeoff
between search and quick trading at a discount.
Liquidity…
 These costs of illiquidity should affect securities
prices if investors require compensation for
bearing them. In addition, because liquidity
varies over time, risk-averse investors may
require a compensation for being exposed to
liquidity risk. These effects of liquidity on asset
prices are important. Investors need to know
them in designing their investment strategies.
And if liquidity costs and risks affect the required
return by investors, they affect corporations’ cost
of capital and, hence, the allocation of the
economy’s real resources.
Figure : The Liquidity Continuum
 Items to the left are more liquid or more easily used to
purchase something of value.

 The farther to the right on liquidity continuum, the less

liquid the item is and vise versa.
 Currency is more liquid and real estate is more difficult asset
to convert to money.
What are assets markets?
An asset is an economic resource which can
be owned or controlled to return a profit, or a
future benefit. In financial trading, the term
asset relates to what is being exchanged on
markets, such as stocks, bonds, currencies
or commodities.
What are the 4 types of assets?
Assets can be broadly categorized into
current (or short-term) assets, fixed
assets, financial investments, and
intangible assets.
Thank You!