Chapter 7

THE ASSET MARKET, MONEY AND PRICES.

Introduction.

  • Let's talk about money. So far we have managed to talk about the economy without talking about money. That's a good indication that in economics money, per se, is not that important.
  • The real economy (unemployment, real output...) usually goes its own separate way from the financial sector (stock and bonds market, finance) but of course they are related and we have to talk about the later sector too.
  • This chapter should be seen as an introduction to a “Money and Banking” course and for our purposes it will be the groundwork for the future discussion of monetary policy.

7.1 What is Money?

  • First of all we have to clarify a general confusion between money as income ("making a lot of money") and money as wealth ("having a lot of money").
  • Money is a flow and a stock at the same time and that can be occasionally misleading.
  • In all of our discussions here we will refer to money as a stock variable.
  • Secondly, we have to stress that we refer to as money other assets besides bills and coins.
  • In Economics we call money -regardless of what it looks like- anything that serves as:

-Medium of exchange (used to pay for goods and services. Better than barter)

-Unit of account (a yardstick to measure the value of things, to put a price tag)

-Store of value (a way of accumulating wealth)

  • In the financial world, the liquidity of different assets is a critical attribute. Liquidity is the speed at which we can transform an asset into the medium of exchange of the economy.

(naturally, the dollar is the most liquid asset of all because it is the medium of exchange)

  • How Do We Measure Money?
  • Should we consider money only what is a medium of exchange (e.g.: bills and coins)?

Problem: Many assets are so liquid that are used as -and can be confused with- money.

  • Our bank balances can be used to purchase goods and services simply by putting our signature on a piece of paper (a check) or by sweeping a piece of plastic through a small terminal (a debit card.) By the way, credit cards are not money.
  • Since banks lend to other people the money that we deposit in them, we say that banks create money, and so we have to consider as money our bank balances.
  • To clarify matters we will follow the official definitions and classifications of money: the Federal Reserve's Monetary Aggregates.

(See Table 7.1)

-The different types of money are classified from the most liquid to the least liquid.

-Like Russian dolls, each definition encompasses the previous one.

-Whenever the Fed compares the total amount of money printed by the Treasury Department with the actual amount of cash circulating in the US they find a huge difference. Where is the missing money? In the underground economy and overseas.

7.3 Demand for Money.

  • If I ask "how much money do you want to hold?" you are going to say: "as much as possible, thank you", but that will be the wrong question to ask.
  • If I ask "how much of your total wealth do you want to keep in cash in your pocket?" the answer will probably different.
  • Money as a form of wealth has some unique characteristics:

- It is the most liquid of all assets, so you will always need some cash in order to pay for goods and services. The higher the average price level, the larger your money holdings.

-Holding money in your pocket does not bring you any financial return. Cash collects no interest rate, it has a significant opportunity cost.

-Your cash holdings (for purchasing purposes) tend to be proportional to your real income, so as your wealth increases your demand for money (cash) also does.

  • Since we are talking about macroeconomics we have to put these concepts in terms of a country and write:

The sign on top of each variable represents the direction of the change in Md when there is an increase in each of the listed variables.

where:Md = money demand

P= price level

Y= real income = GDP

r + = real interest rate + inflation = i = nominal interest rate

  • We will get back to this in chapter 9 wherewe will talk about how the interaction between money supply and money demand determines interest rates.

7.4 Money and Prices.

  • We are going to see later on that inflation is a purely monetary phenomenon:

-It is originated by an excessive money supply and does not affect the real sector of the economy (unemployment, output) in the long-run.

-In the short-run it can be very devastating as inflation undermines the financial sector of the economy by making money useless for transaction purposes and as a store of value.

  • We relate money to prices through the quantitative equation of money. At any given moment it must be true that:

M. v = P. Y

where:M= money supply

v= velocity of money

P= price level

Y= real income = GDP

  • That is: the amount of money balances that we require to buy and sell all the goods and services that we produce in a given year (P. Y) must be equal to the amount of money available (M), times the number of times it exchanges hands (v) during that year.
  • Since output (Y) is somehow fixed in the short-run, velocity (v) has proven to be stable across time, only money supply (M) and prices (P) are flexible.

-In that way, if M it must be that P in order to keep the identity true.

-Of course, velocity does change across time (see Figure 7.1) but as we choose a wider definition of money (M2) we observe it is very stable.

  • How do we know that this equation holds true?

-We can study how money growth and inflation move together, proving that inflation is a purely monetary phenomenon.

(See Figure 7.2)

-We can study how inflation rates and nominal interest rates move together, making true another one of our basic identities and showing how inflation can destroy the financial sector of an economy.

(See Figure 7.3)