Chapter 7
The Asset Market, Money, and Prices
◼ Learning Objectives
I. Goals of Chapter 7
A. Define money, discuss its functions, and describe how it is measured in the United States (Sec.
7.1)
B. Discuss the factors that affect how people choose which assets they own (Sec. 7.2)
II. Notes to Eighth Edition Users
A. We modified the section on “The Expected Inflation Rate and the Nominal Interest Rate” and
Chapter 7 The Asset Market, Money, and Prices 143
◼ Teaching Notes
I. What Is Money? (Sec. 7.1)
A. Money: assets that are widely used and accepted as payment
B. The functions of money
1. Medium of exchange
a. Barter is inefficient—it requires a double coincidence of wants
b. Money allows people to trade their labor for money and then use the money to buy goods
Theoretical Application
There have been a number of attempts to supply detailed microfoundations theory for money. An
2. Unit of account
a. Money is the basic unit for measuring economic value
3. Store of value
Theoretical Application
Money’s usefulness as a store of value declines the higher the inflation rate. In hyperinflations
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
144 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition
Policy Application
C. Measuring money—the monetary aggregates
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
accounts: Are they money?
Analytical Problem 1 looks at portfolio changes and how they affect M1 and M2
D. In touch with data and research: where have all the dollars gone?
1. In 2015, U.S. currency averaged about $4000 per person
2. Some is held by businesses and the underground economy, but 30% or more is held abroad
E. The money supply
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
Chapter 7 The Asset Market, Money, and Prices 145
II. Portfolio Allocation and the Demand for Assets (Sec. 7.2)
How do people allocate their wealth among various assets? The portfolio allocation decision
A. Expected return
1. Rate of return = an asset’s increase in value per unit of time
B. Risk
1. Risk is the degree of uncertainty in an asset’s return
Theoretical Application
Their separate work in developing financial theory brought the 1990 Nobel Prize in Economics
to Harry Markowitz, Merton Miller, and William Sharpe. Their main contributions were to
C. Liquidity
1. Liquidity is the ease and quickness with which an asset can be traded
D. Time to maturity
1. Time to maturity: the amount of time until a financial security matures and the investor is
repaid the principal
E. Types of assets and their characteristics
146 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition
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
the value of housing had almost returned to its 2006 level
F. In touch with data and research: the housing crisis of 2007–2011
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
G. Asset demands
1. Trade-off among expected return, risk, liquidity, and time to maturity
2. Assets with low risk and high liquidity, such as checking accounts, have low expected
Data Application
Was the housing crisis caused by insiders trying to capitalize on foolish homeowners or a failure by
bank regulators? According to Christopher L. Foote, Kristopher S. Gerardi, and Paul S. Willen, in
their paper “Why Did So Many People Make So Many Ex Post Bad Decisions? The Causes of the
Chapter 7 The Asset Market, Money, and Prices 147
III. The Demand for Money (Sec. 7.3)
A. The demand for money is the quantity of monetary assets people want to hold in their portfolios
B. Key macroeconomic variables that affect money demand
1. Price level
c. Nominal money demand is thus proportional to the price level
2. Real income
a. The more transactions you conduct, the more money you need
3. Interest rates
a. An increase in the interest rate or return on nonmonetary assets decreases the demand for
money
C. The money demand function
1. Md = P L(Y, i) (7.1)
a. Md is nominal money demand (aggregate)
b. P is the price level
148 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition
D. Other factors affecting money demand
1. Wealth: A rise in wealth may increase money demand, but not by much
E. Elasticities of 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
F. Velocity and the quantity theory of money
1. Velocity (V) measures how much money “turns over” each period
2. V = nominal GDP/nominal money stock = PY/M (7.4)
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
5. Quantity theory of money: Real money demand is proportional to real income
a. If so,
Chapter 7 The Asset Market, Money, and Prices 149
c. But velocity of M1 is not constant; it rose steadily from 1960 to 1980 and has been erratic
since then
(1) Part of the change in velocity is due to changes in interest rates in the 1980s
Data Application
Using the idea that M2 velocity is stable, economists at the Federal Reserve Board developed an
inflation model based on M2 growth. The model suggested that the price level would adjust to an
Policy Application
The Federal Reserve’s job of conducting monetary policy is made more complicated by sweep
IV. Asset Market Equilibrium (Sec. 7.4)
A. Asset market equilibrium—an aggregation assumption
1. Assume that all assets can be grouped into two categories, money and nonmonetary assets
a. Money includes currency and checking accounts
(2) Supply is fixed at NM
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)
nonmonetary asset demand; then the entire asset market is in equilibrium
B. The asset market equilibrium condition
1. M/P = L(Y, r +
e) (7.9) real money supply = real money demand
a. M is determined by the central bank
150 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition
Numerical Problem 2 is an exercise in calculating the equilibrium interest rate.
2. With all the other variables in Eq. (7.9) determined, the asset market equilibrium condition
For exercises dealing with price level determination, see Numerical Problems 3 and 5 and
Analytical Problem 4.
V. Money Growth and Inflation (Sec. 7.5)
A. The inflation rate is closely related to the growth rate of the money supply
1. Rewrite Eq. (7.10) in growth-rate terms:
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
Numerical Problem 4 gives practice in using elasticities to predict inflation.
B. Application: money growth and inflation in the European countries in transition
1. Though the countries of Eastern Europe are becoming more market-oriented, Russia and
Theoretical Application
You might wonder why we don’t show a diagram of money demand and money supply on the
horizontal axis and the real interest rate on the vertical axis at this point in the textbook. The
Chapter 7 The Asset Market, Money, and Prices 151
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
a. For example, if the income elasticity of money demand were 2/3 and real output grew
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?
Data Application
For a review of the causes of inflation in the short run and long run in countries throughout the
world, see Larry Ball’s article, “What Causes Inflation?” Federal Reserve Bank of Philadelphia
Business Review, March/April 1993, pp. 3–12.
C. The inflation rate and the nominal interest rate
1. Expectations can’t be observed directly, except perhaps through surveys
inflation
Analytical Problem 3 shows how expected inflation depends on the money supply.
Data Application
There are many surveys of economists’ forecasts for inflation. The most well known monthly
survey is Blue Chip Economic Indicators. Two surveys that are available free of charge are the
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
152 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition
Data Application
A careful attempt to measure the world real interest rate was undertaken by Robert J. Barro and
D. Application: measuring inflation expectations
1. How do we find out people’s expectations of inflation?
2. The U.S. government issues nominal bonds and Treasury Inflation-Protected Securities
3. The break-even inflation rate: interest rate on nominal bonds minus real interest rate on TIPS
bonds
4. The data show fluctuations in the break-even inflation rate (text Figure 7.7)
a. In contrast, the rate of expected inflation measured in surveys has been fairly constant
Chapter 7 The Asset Market, Money, and Prices 153
◼ Additional Issues for Classroom Discussion
1. How Has Technology Changed Money?
Ask your students how they think improved technology has changed the role of money in the economy.
2. How Will Money’s Role Change in the Future?
Imagine an age in which the balance in your checking account is invested immediately and automatically
in the stock or bond market, earning substantially more interest than is typical today. Suppose all payments
become electronic, so we never need to touch a dollar bill. What role would money play in such a
payments system?
These questions have been discussed for the past 20 years, and while we’re getting closer to such a system,
3. Should You Buy Indexed Bonds?
Given a choice between buying nominal bonds and indexed bonds, what would you choose? Ask your
students to list the pros and cons of buying indexed bonds.
154 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition
◼ Answers to Textbook Problems
Review Questions
1. Money is the economist’s term for assets that can be used in making payments, such as cash and
2. The three functions of money are (1) the medium of exchange function, which contributes to a better-
and (3) the store of value function, by which money is a way of holding wealth that has high liquidity
and little risk.
3. The size of the nation’s money supply is determined by its central bank; in the United States, the
central bank is the Federal Reserve System. If all money is in the form of currency, the money supply
5. The expectations theory of the term structure of interest rates originates in the idea that investors
compare bonds with different times to maturity and choose the ones that yield the highest return. In
6. The macroeconomic variables that have the greatest impact on money demand are the price level, real
income, and the nominal interest rate on other assets. The higher the price level, the higher the
7. Velocity is a measure of how often money “turns over” in a period. It is equal to nominal GDP
divided by the nominal money supply. The quantity theory of money assumes that velocity is
Chapter 7 The Asset Market, Money, and Prices 155
8. Equilibrium in the asset market is described by the condition that real money supply equals real
9. In equilibrium, the price level is proportional to the nominal money supply; in particular it equals the
10. Factors that could increase the public’s expected rate of inflation include a rise in money growth or a
decline in income growth. With no effect on the real interest rate, the increase in the expected
156 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition
Numerical Problems
1. For a two-year bond, according to the expectations theory, the interest rate would be the average of
the two one-year bonds, which is (6% + 4%)/2 = 5%. Adding the risk premium of 0.5% gives an
interest rate on the two-year bond of 5.5%.
2. (a) Real money demand is
(b) Real money demand is unchanged, because neither Y nor i has changed.
Nominal money demand is
(c) It is useful to use the last expression for velocity,
V = Y/(Md/P) = Y/(500 + 0.2Y − 1000i).
(1) Effect of increase in real income:
When i = 0.10,
(2) Effect of increase in the nominal interest rate:
Chapter 7 The Asset Market, Money, and Prices 157
3. (a) Md = $100,000 − $50,000 − [$5000 (i − im) 100]. (Multiplying by 100 is necessary since i and
im are in decimals, not percent.) Simplifying this expression, we get
Md = $50,000 − $500,000(i − im).
4. (a) From the equation MV = PY, we get M/P = Y/V. At equilibrium, Md = M, so Md/P = Y/V =
10,000/5 = 2000. Md = P (Md/P) = 2 2000 = 4000.
5. (a) P/P = −
Y Y/Y = − 0.5 6% = −3%. The price level will be 3% lower.
6. (a)
e = M/M = 10%. i = r +
e = 15%. M/P = L = 0.01 150/0.15 = 10. P = 300/10 = 30.
7. (a) With a constant real interest rate and zero expected inflation, inflation is given by the equation
= M/M −
Y Y/Y. To get inflation equal to zero, the central bank should set money growth so
158 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition
So velocity should rise 1.5% over the next year.
Analytical Problems
1. (a) People would probably take money out of checking accounts and put it into money market
mutual funds and money market deposit accounts. Money market mutual funds and money
market deposit accounts are included in M2 but are not part of M1. The result is a decrease in
M1, but no change in M2. M2 does not increase because M1 is part of M2, so the decrease in M1
2. The general rise in velocity from 1959 to 1980 is most likely due to changes in income, in interest
rates, and in financial institutions. Higher income led to a less than proportional rise in real money
3. (a) New cigarettes mean an increase in the money supply. With higher nominal money supply and
no change in real money demand, the equilibrium price level must rise.
4. (a) A temporary increase in government purchases reduces national saving, causing the real interest
rate to rise for a fixed level of income. If the real interest rate is higher, then real money demand
Chapter 7 The Asset Market, Money, and Prices 159
(c) When labor supply rises, full-employment output increases. Also, with higher output, saving will
increase, so the real interest rate will decline. Both higher output and a lower real interest rate
Working with Macroeconomic Data
1. Answers vary, depending on recent data.
2. In the 1960s and early 1970s, M1 growth was more closely related to inflation. In the 1980s, M2 growth was
3.
a. Interest rates move in the same direction as inflation. That is not surprising because if real interest rates do