978-0132992282 Chapter 7 Lecture Note

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c. Money thus permits people to trade with less cost in time and effort

2. Unit of account

a. Money is the basic unit for measuring economic value

3. Store of value

a. Money can be used to hold wealth

b. Most people use money only as a store of value for a short period and for small amounts,

because it earns less interest than money in the bank

4. In touch with data and research: money in a prisoner-of-war camp

a. Radford article on the use of cigarettes as money

b. Cigarette use as money developed because barter was inefficient

c. Even nonsmokers used cigarettes as money

d. Characteristics of cigarettes as money: standardized (so value was easy to ascertain), low

1. Distinguishing what is money from what isn’t money is sometimes difficult

a. For example, MMMFs allow check writing, but give a higher return than bank checking

2. The M1 monetary aggregate

a. Consists of currency and traveler’s checks held by the public, and transaction accounts

3. The M2 monetary aggregate

a. M2  M1  less money like assets

b. Additional assets in M2 include savings deposits, small (< $100,000) time deposits,

noninstitutional MMMF balances, money-market deposit accounts (MMDAs)

4. Table 7.1 shows recent data

Analytical Problem 1 looks at portfolio changes and how they affect M1 and M2

1. In 2012, U.S. currency averaged about $3300 per person, but surveys show people only hold

about $100

2. Some is held by businesses and the underground economy, but most is held abroad

3. Foreigners hold dollars because of inflation in their local currency and political instability

4. Since currency is 1/2 of M1 and over half of currency is held abroad, foreigners hold over

1/4 of M1

a. The data show large fluctuations in M1 when major events occur abroad, like military

5. The United States benefits from foreign holdings of our currency, since we essentially get an

interest-free loan

1. Money supply  money stock  amount of money available in the economy

2. How does the central bank of a country increase the money supply?

a. Use newly printed money to buy financial assets from the public—an open-market

purchase

b. To reduce the money supply, sell financial assets to the public to remove money from

circulation—an open-market sale

3. Throughout text, use the variable M to represent money supply; this might be M1, M2, or

some other aggregate

1. Rate of return  an asset’s increase in value per unit of time

a. Bank account: Rate of return  interest rate

2. Investors want assets with the highest expected return (other things equal)

3. Returns aren’t always known in advance (for example, stock prices fluctuate unexpectedly),

so people must estimate their expected return

1. Risk is the degree of uncertainty in an asset’s return

2. People don’t like risk, so prefer assets with low risk (other things equal)

3. The risk premium is the amount by which the expected return on a risky asset exceeds the

return on an otherwise comparable safe asset

Theoretical Application

Their separate work in developing financial theory brought the 1990 Nobel Prize in Economics

1. Liquidity is the ease and quickness with which an asset can be traded

2. Money is very liquid

3. Assets like automobiles and houses are very illiquid—it may take a long time and large

transaction costs to trade them

4. Stocks and bonds are fairly liquid, some more so than others

5. Investors prefer liquid assets (other things equal)

D. Time to maturity

1. Time to maturity: the amount of time until a financial security matures and the investor is

repaid the principal

2. Expectations theory of the term structure of interest rates: the idea that investors compare

returns on bonds with differing times to maturity; in equilibrium, holding different types of

3. Because long-term interest rates usually exceed short-term interest rates, a risk premium

exists: the compensation to an investor for bearing the risk of holding a long-term bond

1. People hold many different assets, including money, bonds, stocks, houses, and consumer

durable goods

2. Money has a low return, but low risk and high liquidity

3. Bonds have a higher return than money, but have more risk and less liquidity

4. Stocks pay dividends and can have capital gains and losses, and are much more risky than

money

5. Ownership of a small business is very risky and not liquid at all, but may pay a very high

return

6. Housing provides housing services and the potential for capital gains, but is quite illiquid

7. Households must consider what mix of assets they wish to own; Table 7.2 shows the mix in

2006, 2009, and 2012. The table illustrates the large declines in the value of stocks, pension

funds, and housing in the financial crisis and shows how the value of stocks and pension

1. People gained tremendous wealth in their houses in the 2000s

2. As house prices rose, houses became increasingly unaffordable, leading mortgage lenders to

create subprime loans for people who wouldn’t normally qualify to buy houses

3. Most subprime loans had adjustable interest rates, with a low initial interest rate that would

later rise in a process known as mortgage reset

4. As long as housing prices kept rising, both lenders and borrowers thought the subprime loans

would work out, as the borrowers could always sell their houses to pay off the loans

5. But housing prices stopped rising as much, leading more subprime borrowers to default, so

banks began to tighten their lending standards, reducing the demand for housing and leading

6. Many homeowners lost their homes and financial institutions lost hundreds of billions of

dollars because of mortgage loan defaults

7. Because many mortgage loans had been securitized and were parts of mortgage-backed

securities, the increased default rate on mortgages led to a financial crisis in Fall 2008, as

many investors simultaneously tried to sell risky assets, including mortgage-backed

securities and stocks

G. Asset demands

1. Trade-off among expected return, risk, liquidity, and time to maturity

2. Assets with low risk and high liquidity, like checking accounts, have low expected returns

3. Investors consider diversification: spreading out investments in different assets to reduce risk

4. The amount a wealth holder wants of an asset is his or her demand for that asset

5. The sum of asset demands equals total wealth

III. The Demand for Money (Sec. 7.3)

1. Money demand depends on expected return, risk, and liquidity

2. Money is the most liquid asset

3. Money pays a low return

4. People’s money-holding decisions depend on how much they value liquidity against the low

return on money

1. Price level

a. The higher the price level, the more money you need for transactions

2. Real income

a. The more transactions you conduct, the more money you need

b. Real income is a prime determinant of the number of transactions you conduct

c. So money demand rises as real income rises

3. Interest rates

a. An increase in the interest rate or return on nonmonetary assets decreases the demand for

money

b. An increase in the interest rate on money increases money demand

1. Md  P  L(Y, i) (7.1)

a. Md is nominal money demand (aggregate)

2. As discussed above, nominal money demand is proportional to the price level

3. A rise in Y increases money demand; a rise in i reduces money demand

4. We exclude im from Eq. (7.1) since it doesn’t vary much

5. Alternative expression:

Md  P  L(Y, r  e) (7.2)

6. Alternative expression:

Md/P  L(Y, r  e) (7.3)

7. The left side of Eq. (7.3) is the demand for real balances, or real money demand

D. Other factors affecting money demand

1. Wealth: A rise in wealth may increase money demand, but not by much

2. Risk

a. Increased riskiness in the economy may increase money demand

3. Liquidity of alternative assets: Deregulation, competition, and innovation have given other

assets more liquidity, reducing the demand for money

4. Payment technologies: Credit cards, ATMs, and other financial innovations reduce money

demand

1. How strong are the various effects on money demand?

2. Statistical studies on the money demand function show results in elasticities

3. Elasticity: The percent change in money demand caused by a one percent change in some

factor

4. Income elasticity of money demand

a. Positive: Higher income increases money demand

5. Interest elasticity of money demand

Small and negative: Higher interest rate on nonmonetary assets reduces money demand

6. Price elasticity of money demand is unitary, so money demand is proportional to the price

level

1. Velocity (V) measures how much money “turns over” each period

2. V  nominal GDP/nominal money stock  PY/M(7.4)

Numerical Problem 1 is an empirical exercise calculating velocity from a money-demand

3. Plot of velocities for M1 and M2 (text Figure 7.2) shows fairly stable velocity for M2, erratic

velocity for M1 beginning in early 1980s

4. Plot of money growth (text Figure 7.3) shows that instability in velocity translates into erratic

movements in money growth

the 1980s.

5. Quantity theory of money: Real money demand is proportional to real income

a. If so,

Md/P  kY (7.5)

b. Assumes constant velocity, where velocity isn’t affected by income or interest rates

c. But velocity of M1 is not constant; it rose steadily from 1960 to 1980 and has been erratic

1. Assume that all assets can be grouped into two categories, money and nonmonetary assets

a. Money includes currency and checking accounts

2. Asset market equilibrium occurs when quantity of money supplied equals quantity of money

demanded

a. md  nmd  total nominal wealth of an individual

b. Md  NMd  aggregate nominal wealth (from adding up individual wealth) (7.6)

1. M/P  L(Y, r  e) (7.9) real money supply  real money demand

a. M is determined by the central bank

2. With all the other variables in Eq. (7.9) determined, the asset market equilibrium condition

determines the price level

a. P  M/L(Y, r  e) (7.10)

b. The price level is the ratio of nominal money supply to real money demand

1. Rewrite Eq. (7.10) in growth-rate terms:

P/P  M/M  L(Y, r e )/L(Y, r  e ) (7.11)

2. If the asset market is in equilibrium, the inflation rate equals the growth rate of the nominal

money supply minus the growth rate of real money demand

3. To predict inflation we must forecast both money supply growth and real money demand

growth

a. In long-run equilibrium, we will have i constant, so let’s look just at growth in Y

b. Let Y be the elasticity of money demand with respect to income

1. Though the countries of Eastern Europe are becoming more market-oriented, Russia and

some others have high inflation because of rapid money growth

2. Both the growth rates of money demand and money supply affect inflation, but (in cases of

high inflation) usually growth of nominal money supply is the most important factor

15%, real money demand would grow 10% ( 2/3  15%); or if income fell 15%, real

money demand would fall 10%

3. Text Figure 7.4 shows the link between money growth and inflation in these countries;

inflation is clearly positively associated with money growth

4. So why do countries allow money supplies to grow quickly, if they know it will cause

inflation?

a. They sometimes find that printing money is the only way to finance government

expenditures

1. For a given real interest rate (r), expected inflation (e) determines the nominal interest rate

(i  r  e)

2. What factors determine expected inflation?

a. People could use Eq. (7.12), relating inflation to the growth rates of the nominal money

supply and real income

(1) If people expect an increase in money growth, they would then expect a

commensurate increase in the inflation rate

3. Text Figure 7.5 plots U.S. inflation and nominal interest rates

a. Inflation and nominal interest rates have tended to move together

b. But the real interest rate is clearly not constant

c. The real interest rate was negative in the mid-1970s, then became much higher and

1. How do we find out people’s expectations of inflation?

a. We could look at surveys

2. The U.S. government issues nominal bonds and Treasury Inflation-Protected Securities

(TIPS)

3. The interest rate differential: interest rate on nominal bonds minus real interest rate on TIPS

bonds

a. The interest rate differential is a rough measure of expected inflation

b. TIPS bonds have lower inflation risk, so the measure of expected inflation may be too

4. The data show fluctuations in the expected inflation rate based on the interest rate differential

(text Figure 7.7)