110-1The Asset Market, Money, and Prices,Part 210-2Agenda• Asset Market Equilibrium• Money Growth and Inflation10-3Asset Market Equilibrium• Asset market equilibrium:¾ Assume that all assets can be grouped into two categories, money and non-monetary assets.• Money (M) includes currency and checking accounts– Pays interest rate im(which we will assume is zero).– Supply is fixed at M.• Non-monetary assets (NM) include stocks, bonds, etc.– Pays interest rate i = r + πe– Supply is fixed at NM.10-4Asset Market Equilibrium• Asset market equilibrium:¾ The nominal demand for assets:•Let md+ nmdbe an individual’s nominal demand for assets, and•Let Md+ NMdis the aggregate nominal demand for assets.– Which is also aggregate nominal wealth.210-5Asset Market Equilibrium• Asset market equilibrium:¾ The nominal supply of assets:•Let M + NM be the aggregate nominal supply of assets.– Which is also aggregate nominal wealth.¾ Equilibrium in the asset market requires:(Md– M) + (NMd– NM) = 010-6Asset Market Equilibrium• Asset market equilibrium:¾ Equilibrium in the asset market requires:(Md– M) + (NMd– NM) = 0• The excess demand for money (Md– M) plus the excess demand for nonmonetary assets (NMd– NM) must equal 0.10-7Asset Market Equilibrium• Asset market equilibrium:¾ If money supply equals money demand, (Md= M), then non-monetary asset supply MUST equal non-monetary asset demand, (NMd= NM).¾ Consequently, when the money market is in equilibrium, the entire asset market is in equilibrium.10-8Asset Market Equilibrium• Asset market equilibrium:M / P = L(Y, r + πe)¾ Real money supply = Real money demand• M is determined by the central bank,•πeis fixed (for now),• The labor market determines N; given N the production function determines Y, and•Given Y, goods market equilibrium determines r.310-9Asset Market Equilibrium• Asset market equilibrium:¾ Because all of the other variables are pre-determined, the asset market equilibrium condition determines the price level.P = M / L(Y, r + πe)• The price level is the ratio of nominal money supply to real money demand.10-10Money Growth and Inflation• Determining inflation:¾ Start with the price equation:P = M / L(Y, r + πe)¾ Rewrite in growth rate terms:ΔP/P = ΔM/M – ΔL(Y,r + πe)/L(Y,r + πe)10-11Money Growth and Inflation• Determining inflation:ΔP/P = ΔM/M – ΔL(Y,r + πe)/L(Y,r + πe)¾ 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.• Thus, the inflation rate is closely related to the growth rate of the money supply.10-12Money Growth and Inflation• Determining inflation:¾ Inflation depends on both money supply growth and real money demand growth.• In long-run equilibrium, i will be constant.– So money demand depends on real output.•Let ηYbe the elasticity of money demand with respect to income. Thenπ= ΔM/M –ηYΔY/Y410-13Money Growth and Inflation• Determining inflation:π= ΔM/M –ηYΔY/Y¾ Both money demand growth and money supply growth affect inflation.¾ In cases of high inflation, nominal money supply growth is usually the more important factor.10-14Money Growth and Inflation• Determining inflation:π= ΔM/M –ηYΔY/Y¾ Money demand does not vary dramatically, no matter how well or poorly an economy is doing.• For example, suppose that ηY= 2/3.–If ΔY/Y = 15%, then ΔL/L = 10%.–If ΔY/Y = –15%, then ΔL/L = –10%.10-15Money Growth and Inflation• Determining inflation:π= ΔM/M –ηYΔY/Y¾ Nominal money supply growth has differed across countries by hundreds of percentage points. ¾ So large inflation differences must be due to money supply, not money demand.10-16Money Growth and Inflation∆M/Mπ510-17Money Growth and Inflation: Application• The European transition economies:¾ Though the countries of Eastern Europe are becoming more market-oriented, Russia and some others have very high inflation because of rapid money growth.10-18The relationship between money growth, inflation10-19Money Growth and Inflation: Application• The European transition economies:¾ Why do countries allow money supplies to grow quickly if they know it will cause inflation?• Sometimes printing money is the only way to finance government expenditures.– This is especially true for very poor countries or countries in political crisis.10-20Money Growth and Inflation• Expected inflation & nominal interest rates:¾ For a given real interest rate (r), expected inflation (πe) determines the nominal interest rate (i = r + πe).610-21Money Growth and Inflation• Expected inflation & nominal interest rates:¾ What factors determine expected inflation?• People could use the inflation equation.– If people expect an increase in money growth, then they would expect a commensurate increase in the inflation rate.– The expected inflation rate would equal the current inflation rate if money growth and income growth were stable.10-22Money Growth and Inflation• Expected inflation & nominal interest rates:¾ What factors determine expected inflation?• However, expectations can’t be observed directly.• But if real interest rates are stable, then expected inflation can be inferred from nominal interest rates.10-23Inflation and the nominal interest rate10-24Money Growth and Inflation• Expected inflation and nominal interest rates:¾ Observations:• Inflation and nominal interest rates tend to move together.• So real interest rates are clearly not constant.– The real interest rate was negative in the mid-1970s, then became much higher and positive in the late-1970s to early-1980s710-25Money Growth and Inflation: Application• Measuring inflation expectations:¾ Two ways to measure inflation expectations.• Derive implicit expectations from bond interest rates. • Surveys of inflation expectations.10-26Money Growth and Inflation: Application• Measuring inflation expectations:¾ The U.S. government issues two types of bonds.• Nominal bonds, and • Treasury Inflation Indexed Securities (TIIS).– TIIS bonds make real interest payments by adjusting interest payments and principal for inflation.10-27Interest rates on nominal and TIIS 10-year notes10-28Money Growth and Inflation: Application• Measuring inflation expectations:¾ The interest rate differential—the interest rate on nominal bonds minus real interest rate on TIIS