19-1The Asset Market, Money, and Prices,Part 19-2Agenda• What Is Money?• Portfolio Allocation & the Demand for Assets• The Demand for Money9-3What Is Money?• Money is any asset that is widely used and accepted as payment.9-4What Is Money?• The three functions of money:¾ Medium of exchange.• Money is used to make (and finalize) transactions.¾ Unit of account. • The basic unit for measuring economic value.¾ Store of value.• Money can be used to hold wealth.29-5What Is Money?• Measuring money—the monetary aggregates:¾ Distinguishing what assets count as money from those that do not is sometimes difficult.¾ Two monetary aggregates (or measures):•M1•M29-6What Is Money?• Measuring money—M1:¾ M1 consists of:• Currency and traveler’s checks held by the public.• Demand deposits (which pay no interest).• Other checkable deposits (which may pay interest).¾ All components of M1 are used in making payments, so M1 is the closest money measure to our theoretical description of money.9-7What Is Money?• Measuring money—M2:¾ M2 consists of:•M1,• Savings deposits,• Small (< $100,000) time deposits,• Non-institutional MMMF balances, and• Money-market deposit accounts (MMDAs).9-8Table 7.1 U.S. Monetary Aggregates39-9What Is Money?• The money supply (M):¾ The money supply or money stock is the amount of money circulating in the economy.• Owned by the non-bank public.9-10What Is Money?• The money supply (M):¾ Where does money come from?• Currency and coins are issued by the government.• “Other” money is issued by the financial system.– But heavily influenced by the central bank.¾ The amount of money in circulation in the economy is controlled by the central bank.9-11What Is Money?• The money supply (M):¾ The central bank changes the money supply through open (or closed) market operations.• Open market operations are the buying and selling of financial assets by the central bank in the open market.• Closed market operations are the buying and selling of financial assets by the central bank directly from the government.9-12What Is Money?• Open market operations:¾ To increase the money supply, the central bank buys financial assets from the public with newly created money.•This is an open-market purchase.¾ To reduce the money supply, the central bank sells financial assets to the public and removes money from circulation.•This is an open-market sale.49-13What Is Money?• Closed market operations:¾ The central bank could also buy newly issued government bonds directly from the government (i.e., the Treasury).• This is the same as the government financing its expenditures directly by printing money.• This happens frequently in some countries (though is forbidden by law in the United States).9-14Portfolio Allocation & the Demand for Assets• The portfolio allocation decision:¾ How do people decide on the allocation of their wealth among various assets? ¾ Various factors to consider:• Expected returns,•Risk,• Liquidity, and• Time to maturity.9-15Portfolio Allocation & the Demand for Assets• Expected return:¾ The rate of return on an asset is its increase in value per unit of time.• Because returns not known in advance, people must estimate their expected return.¾ Other things equal, investors prefer assets with the highest expected return.9-16Portfolio Allocation & the Demand for Assets• Risk:¾ Risk is the degree of uncertainty about an asset’s return.¾ Other things equal, investors prefer assets with the lowest risk. • Because, in general, people are risk-adverse.59-17Portfolio Allocation & the Demand for Assets• Liquidity:¾ Liquidity is the ease and quickness with which an asset can be traded.¾ Other things equal, investors prefer assets with the highest liquidity. 9-18Portfolio Allocation and the Demand for Assets• Time to maturity:¾ Time to maturity is the amount of time until an asset matures and the investor is repaid principal.¾ Other things equal, investors prefer assets with the shortest maturity. •A term-risk premium exists, i.e., long-term interest rates typically exceed short-term interest rates to compensate investors for holding longer-term bonds.9-19Portfolio Allocation & the Demand for Assets• The Demand for Various Assets:¾ There are trade-offs among expected return, risk, liquidity, and time to maturity.• Assets with low risk, high liquidity, and short maturity also have low expected returns.• Risk can also be reduced by diversifying the portfolio of assets. 9-20Portfolio Allocation & the Demand for Assets• The Demand for Various Assets:¾ The amount a wealth holder wants of an asset is his or her demand for that asset.¾ The sum of asset demands equals total wealth.• Or the supply of assets.69-21The Demand for Money•The demand for money is the quantity of money people want to hold in their portfolios.¾ The demand for money depends on expected return, risk, and liquidity.• Money is the most liquid asset.• Money pays a low (or zero) return.¾ Money-holding decisions depend on how much people value liquidity versus the low return on money.9-22The Demand for Money• Macroeconomic variables that affect the aggregate demand for money:¾ The price level,¾ Real income, and¾ Interest rates.9-23The Demand for Money• The price level:¾ The higher the price level, the more money needed for transactions.¾ Nominal money demand rises proportionallyas the price level rises.9-24The Demand for Money• Real income:¾ The higher real income, the higher is spending.¾ The higher is spending, the more money needed for transactions.¾ Real money demand rises less than proportionallyas real income rises.79-25The Demand for Money• Interest rates:¾ The higher the interest rate, the higher the expected return on non-monetary assets.• And the higher the opportunity cost of holding money.¾ Nominal money demand declines as the interest rate (or return on non-monetary assets) increases.• People trade off less liquidity for a higher return. 9-26The Demand for Money• The demand for money function:Md= P * L(Y, i)¾ Mdis nominal (aggregate) demand for money,¾ P is the price level,¾ L is the demand for money function,¾ Y is real income or output, and¾ i is the nominal interest rate on non-money assets.9-27The Demand for Money• The demand for money function:¾ The nominal money demand is proportional to the price level.¾ The real demand for money is