Chapter 7 and the First Part of Chapter 14 Together the Asset Market, Money, and Prices

Chapter 7 and the first part of Chapter 14 together– The Asset Market, Money, and Prices

Money: assets that are widely used and accepted as payment (a medium of exchange)
Money = currency + demand deposits

The cost of holding money is the interest income forgone
%∆P is inflation
Over half the US currency is held abroad – most likely due to its stability and its good store of value
Money/Asset demand: quantity of assets that people choose to hold in their portfolios
Money/Asset supply: quantity of assets that areavailable
Asset market is in equilibrium when money supplied = money demanded

3 Functions of Money:

Medium of Exchange
Definition: device for making transactions
Allows us to specialize
Results in a more efficient use of scarce economic resources
Unit of Account
Basic unit for measuring economic value
This simplifies the comparison among different goods
Store of Value
Money is a way of holding wealth
Any asset can be a store of value and money is typically not considered as a good store of value (i.e., we assume a zero nominal return on money and thus, the actual return on money is negative the rate of inflation). Bonds and Stocks and other non-monetary assets (e.g., real estate) are usually thought of being a ‘better’ store of value than money.
Money’s usefulness as a medium of exchanges is why people choose to use it as a store of value (vs. stocks, bonds, etc.) even though the return is less

Monetary Aggregates

M1 includes
Currency
Checkable deposits
Traveller’s cheques
M2 includes M1 +:
Savings Deposits
Money market mutual funds and deposit accounts
Small denomination time deposits
M3 includes M2 +:
Large denomination time deposits
MMMFs held by institutions
Deposits of American dollars held abroad
Discuss the Chuderewicz research regarding forecasting with real M3.

Money Supply Notes –(most of this is in Chapter 14 of your textbook)

Define money as below:

1) M = C + D where C = currency (cash) and D = demand deposits (checking accounts)

The Fed has pretty darn good control over what is referred to as the monetary base (MB) (also referred to as high powered money since changes in MB due to open market operations result in high powered effects, via the money multiplier, on the money supply). Define MB as follows with C = currency as before, R equals total reserves, a combination of required reserves (RR) and excess reserves (ER).

2) MB = C + R

Divide 1) by 2)

3) M/MB = (C + D)/(C + R)

Now a “trick” – divide the numerator and denominator of the RHS (right hand side) of 3) by D

4) M/MB = (C /D+ D/D)/(C/D + R/D)

Let’s do a few things to 4) – a) get MB on RHS, b) D/D = 1, and c) R = RR + ER

5) M = [(C /D+ 1)/(C/D + RR/D + ER/D)] MB

The term in brackets is referred to as the money multiplier, which is a little different than what you saw in principles. Equation 5) implies that the money multiplier is influenced by household behavior via C/D, which is determined by us. C/D is simply the currency to deposit ratio. For example, if you typically carry $100 in cash and you have $1000 in a demand deposit, then your C/D is 0.1. Think about what happened to C/D during Y2K.

Equation 5) also implies that bank behavior influences the money multiplier via ER/D. Even though banks tend to get rid of excess reserves (ER) since they earn zero interest, sometimes they hold on to them. What do you think banks were doing during Y2K? Probably holding a lot of ER to meet the liquidity needs of their customers (they anticipated significant withdrawals)!

The last player that has influence over the money multiplier is the Fed themselves via RR/D which is simply the reserve requirement ratio (this is what you were supposed to learn in principles). Note that if we let C/D and ER/D equal zero, the money multiplier collapses to 1/(RR/D) which is the ‘simple’ money multiplier that you may or may not have learned about in principles.

Specifics on the money multiplier: If C/D, ER/D, or RR/D go up, then the multiplier falls. This is important, because if MB remains constant, the money supply will fall along with the multiplier. We will now use an example that is a simplified version of what happened during the great depression.

Graphical Analysis, connecting the reserve market to the money market.

Initial Conditions

Let C/D = .2 , RR/D = .1 and ER/D = 0

Money Multiplier = (.2 +1)/ (.2 + .1 + 0) = 4

What does this mean?

A couple things: first, suppose the MB is $ 100 billion ; M = $ 400 billion

Second, a 10 billion dollar open market purchase will result in a $40 billion increase in the money supply (remember high powered money!) See the two graphs below.

The Great Depression – an Example

The Fed is blamed by some for causing the great depression or at the very least, failing to respond appropriately as in they should of conducted more open market purchases! Of course hindsight is 20/20.

What will a bank run do to C/D ratios?

So C/D rose dramatically as people were trying to get their cash – remember, there was no FDIC insurance back then.

ER/D also rose for two reasons – one, banks were keeping ER to meet the liquidity needs of their customers and two, had no one to lend to – banks are reluctant to make loans in such a dismal environment (i.e., the default risk of the borrower is naturally high in such a dismal environment).

Ironically, RR/D went up as well. The Fed was young, less than 20 years in existence and felt that raising the required reserve ratio would make banks more sound as well as giving the public more confidence so that they would not run on banks – in hindsight, raising the required reserve ratio was a mistake!

All three components of money multiplier rose during the great depression – impact on money multiplier?

Recall Money Multiplier equals:

[(C /D+ 1)/(C/D + RR/D + ER/D)]

Initially, let C/D = .2 , RR/D = .1 , and ER/D = 0

With numbers:

[(.2+ 1)/(.2 + .1 + 0)] = 4

Now account for changes in C/D, RR/D, ER/D

Let C/D up to .5, RR/D up to .2, ER/D up to .3

[(.5+ 1)/(.5 + .2 + .3] = 1.5

NEW Multiplier = 1.5

With numbers – before the great depression

M = ( 4 ) MB

If MB = $ 100 billion ; M = $ 400 billion

Now great depression hits and the multiplier falls to 1.5

MB still at $100 billion – M = 150 billion

Now the Fed isn’t blind – they buy $ 100 billion in Gov Securities, increasing MB by $100 billion – Money Supply up to $300 billion (1.5 times $200 billion) – still a 25% drop from where it was initially.

So the Fed pumped up the Monetary Base via open market purchases – but it was not enough to offset the dramatic fall in the money multiplier – they should have been easier!!

The lesson here is that the Fed has incomplete control over the money supply and in order to have better control, they better try to figure out what determines C/D and ER/D ratios. In normal times, these are pretty stable so that ‘normally,’ the Fed has pretty good control over the money supply (M1).

Portfolio Allocation and the demand for assets

Tell Texas Tech story!

We will make the following simplification as the book does – we separate the many assets in to monetary (money) and non-monetary assets (everything else).

There are three main determinants of asset pricing with each asset having somewhat unique characteristics.

1) Expected return: The higher the expected return of the asset, all else constant, the higher the price of the asset. We assume money (C+D) earns a nominal return of zero and a real return equal to the ‘negative’ of the inflation rate.[1] Non-monetary assets have an expected return of inm. Note, that with QE2, the Fed is purposely lowering the expected return on bonds so that people buy other non-monetary assets like stocks! We have discussed this many times before!

Asset price = f (Rete) :

{stated as “the asset price is a positive (+) function (f) of it’s expected return (Rete), all else constant}

2) Liquidity: Liquidity is an attractive quality in any asset and a highly liquid asset has three qualities:

1) it is easy (low cost) to convert the asset into money where money is defined as transactions money

2) it can be converted to money quickly

3) the amount that it is converted to is representative of its fundamental value (i.e., I can sell my house very quickly and easily for $5, but that doesn’t mean it is liquid!).

Typically, the more liquid the asset, the lower the return. Take money, typically considered to be the most liquid asset of all.

Liquidity is especially attractive in a highly uncertain environment. We will ‘say’ more about his in a moment.

Asset price = f (Liq) :

{stated as “the asset price is a positive (+) function (f) of it’s liquidity (Liq), all else constant}

3) Risk:The more risky the asset, the more uncertain as to the assets’ return. Risk arises for a variety of reasons and we assume that all else equal, investors prefer assets with less risk (i.e., on average, investors are risk averse). We also note that risk and expected return are related – typically, the higher the risk, the higher the expected return (investors require a higher expected return to take on the higher risk).

Asset price = f (Risk) :

{stated as “the asset price is a negative (-) function (f) of it’s Risk, all else constant}

APPLICATION – examining the behavior of these three main characteristics at the height of the financial crisis – i.e., the fall of 2008. – click Here and zoom in on what was happening during the fall of 2008.

So during this time, the demand for money rose dramatically, since money is more liquid (liquidity is highly desirable in a crisis!), ii is less risky, and the expected nominal return of zero is a lot better than a negative one (money under the mattress is better than losing it in the stock market).

MONEY DEMAND –

The other half of the money market - money demand

There are quite a few determinants of money demand

First –inm , the (opportunity) cost of holding money is the interest foregone by holding a non-monetary asset that we typically call a bond (inm). The higher the interest rate, the higher the cost of holding money so the less money you will hold. This idea gives us a negatively sloped money demand as shown below.

Second – real income (denoted Y) – if your real income goes up you will conduct more transactions and in order to conduct more transactions, you need to hold more money. Graphically, an increase in real income (economic growth) shifts the money demand curve to the right (i.e., you desire to hold more money at any given interest rate)

Third – Prices – if prices go up, you need more money to conduct the same number (amount) of transactions. In fact, we assume that nominal money demand is proportional to the price level. For example, if prices rise by 4% then nominal money demand will rise by 4%. Since we deal with real money supply and real money demand, we can derive a general form of real money demand as follows (the text does this on pages 253 and 254)

1) Md = P x L(Y, i) -

L is a function to be determined – but we know a few things from above - Md is positively related to P and Y and negative related to i (note i = inm).

Noting that i = r+ πe and using the proportionality assumption, we can re-write 1) as

2) Md/P = L(Y, r+πe)

A more specific money demand function is in order – this one is from a numerical problem from the back of chapter 7

3) Md/P = 500 +.2Y – 1000(r+πe)

Note that 3) is consistent with real money demand being a positive function of real income (GDP) and negatively related to the nominal interest rate.

THE INTERCEPT IN THE REAL MONEY DEMAND EQUATION – VERY IMPORTANT!

Beyond the three determinants of money demand, there are others – and given the recent financial crisis, these other determinant have played a critical role

Fourth determinant of real money demand – the liquidity of non-monetary assets – if the liquidity of non-monetary assets falls, all else constant, money demand will increase since money is the most liquid asset on the earth and liquidity is a desirable quality. The result is a rightward shift in the money demand function – even though real income (Y) and i = r+πe did not change.

Fifth determinantof real money demand – risk on non- monetary assets – if the risk on non-monetary assets rises, all else constant, then money becomes more attractive since we assume that people are risk averse, all else constant.

Given the financial crisis, especially during the fall of 2008, we can characterize the situation with simple graph of the money market.

Now, what should the Fed do?? If they do nothing, then real rates will rise which is exactly what we DON’T NEED given the financial panic. In addition, the Fed gained authority to pay interest on reserves (both required and excess) in October, 2008. We know from our money supply discussions and especially money supply problem #1, that the real money supply will shift to the left, exacerbating the increase in interest rates due to the two portfolio shocks to money demand. In summary, the Fed was facing an increase in money demand and a decrease in money supply during the fall of 2008, both of which will increase the real rate – to offset this, the Fed needs to conduct massive amounts of open market purchases. Click Here to see if they did (look at the data during the fall of 2008)!

How does the story change given the new economy during the mid to late 1990s?

Other Determinants of Money Demand –

So far, we have that nominal money demand is a function of positive function of P, Y and risknm and a negative function of i( = r + πe) and liqnm.

In principles and elsewhere, you probably have the nominal interest rate on the vertical axis, since the opportunity cost of holding non-interest bearing money is in fact the nominal interest rate. But since we have been working with real interest rates throughout the semester and desire to continue to do so, we place r on the vertical axis and hold inflationary expectations (πe) constant so in effect, inflationary expectations becomes a shift variable.

Example: if we set πe = 0, then i = r. (i.e., r = i – πe). Now if πe rises to 2% and we assume that r stays the same, then i must rise by 2% as well – that is, the cost of holding money has gone up, at the same real interest rate. The influence is that the money demand function will shift to the left (i.e., money demand is negatively related to πe, all else constant). See graphic below.

Final Determinants of Money Demand

Wealth – an increase in wealth will cause people to hold more money, since higher wealth typically means more transactions. We need to remind ourselves that wealth is a stock variable where income (y) is a flow variable.

Interest rate on money - If banks all of a sudden start paying interest on m, denoted im, then all else constant, people will hold more money.

Efficiency of Payment Systems – years ago, this determinant of money demand was very relevant. Now, we can pretty much ignore this determinant but through the years, the increase in the efficiency of payment systems has resulted in people holding less money, since it is easy to transfer money in savings to money in checking, in fact, many banks do this automatically if you overdraw.

Identifying the shocks to real money demand is a very big deal when it comes to monetary policy, If money demand increases because of a nominal shock such as the risk of non-monetary assets rising, then the Fed should not only accommodate the shock, they should conduct enough open market purchases so that the real rate falls and thus, we might be able to offset the negative shock. Conversely, if the shock to money demand is real, that is, money demand is increasing due to higher output, then the Fed should worry about overheating and thus ‘allow’ real rates to rise to prevent inflation from accelerating. All told, it is critical for the Fed to identify the shocks since the appropriate policy response depends critically on the source of the shock.

The quantity theory of money and the equation of exchange

Another way to view supply and demand for money is through the equation of exchange:

MV = PY

Where M is the nominal money balances, V is the velocity of money (the number of times a dollar bill turns over in a years time), P is the general price level, and Y is real output (GDP).

Example – island economy with one good, bicycles. In 2010, there were 50 bicycles produced at a price of $100 per bicycle. So nominal GDP (P times Y) is $5000. We also have a nominal money supply equal to $1000. What is V? V = 5, which means, each dollar exchanges hands (turns over) 5 times per year.

MV = PY = $1000 x 5 = $100 x 50

If we take the percent change of the equation of exchange, also known as the quantity theory of money, we have:

%∆M + %∆V = %∆P + %∆Y

The equation above is extremely useful. Consider the following: Let us assume that V is constant so that the %∆V = 0. If we go to the right hand side, what is the %∆ in P called? What is the %∆ in Y called? Do we have any notion as to the optimal values of these two important macroeconomic variables? Hint, the cruise ship example.

So let us write out the equation with the above information:

%∆M + 0 = 2% + 3%

Which implies that the Fed should allow the nominal money supply to grow at 5%. In fact, this equation is often associated with Milton Friedman, who was a classical economist and among many other famous quotes once said that:

“Inflation is always and everywhere a monetary phenomenon”

Let us apply this statement to the equation of exchange