FIU ECO 3202 - Chapter 7 The Asset Market, Money, and Prices

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Chapter 7Chapter OutlineWhat Is Money?Slide 4Slide 5Slide 6Measuring MoneySlide 8Table 7.1 U.S. Monetary Aggregates (May 2006)Slide 10Money SupplyPortfolio Allocation and the Demand for AssetsPortfolio Allocation and the Demand for AssetsQuestion?The Demand for MoneySlide 16Slide 17Slide 18Slide 19Slide 20Slide 21Slide 22Questions?Slide 24Summary 9Slide 26Slide 27Slide 28Figure 7.1 Velocity of M1 and M2, 1959-2005Slide 30Slide 31Application of MV=PYAsset Market EquilibriumSlide 34Slide 35Slide 36Application of asset market equilibriumSlide 38Money Growth and InflationSlide 40Slide 41© 2008 Pearson Addison-Wesley. All rights reservedThe Asset Market, Money, and PricesChapter 7© 2008 Pearson Addison-Wesley. All rights reserved7-2Chapter Outline•What is Money?–Functions, measurement of money and money supply•Portfolio Allocation and the Demand for Assets•The Demand for Money•Asset Market Equilibrium•Money Growth and Inflation© 2008 Pearson Addison-Wesley. All rights reserved7-3What Is Money?•Money: assets that are widely used and accepted as payment•The functions of money–Medium of exchange–Unit of account–Store of value© 2008 Pearson Addison-Wesley. All rights reserved7-4What Is Money?•The functions of money–Medium of exchange•Barter is inefficient—double coincidence of wants•Money allows people to trade their labor for money, then use the money to buy goods and services in separate transactions•Money thus permits people to trade with less cost in time and effort•Money allows specialization, so people don’t have to produce their own food, clothing, and shelter© 2008 Pearson Addison-Wesley. All rights reserved7-5What Is Money?•The functions of money–Unit of account•Money is basic unit for measuring economic value•Simplifies comparisons of prices, wages, and incomes•The unit-of-account function is closely linked with the medium-of-exchange function•Countries with very high inflation may use a different unit of account, so they don’t have to constantly change prices© 2008 Pearson Addison-Wesley. All rights reserved7-6What Is Money?•The functions of money–Store of value•Money can be used to hold wealth•Most people use money only as a store of value for a short period and for small amounts, because it earns less interest than money in the bank© 2008 Pearson Addison-Wesley. All rights reserved7-7Measuring Money–The M1 monetary aggregate (more liquid)•Currency and traveler’s checks held by the public•Demand deposits (which pay no interest)•Other checkable deposits (which may pay interest, e.g. ATS)–All components of M1 are used in making payments, so M1 is the closest money measure to our theoretical description of money© 2008 Pearson Addison-Wesley. All rights reserved7-8Measuring Money–The M2 monetary aggregate (less liquid)•M2 = M1 + less moneylike assets–Additional assets in M2:•savings deposits•small (< $100,000) time deposits (CDs)•Non-institutional MMMF balances (non-FDIC insured)•money-market deposit accounts (MMDAs)–Higher min. balance, less checks(3), less withdraws(6), compared to savings account.–What about other quasi-money, or money-equivalent?© 2008 Pearson Addison-Wesley. All rights reserved7-9Table 7.1 U.S. Monetary Aggregates (May 2006)© 2008 Pearson Addison-Wesley. All rights reserved7-10Measuring Money•Box 7.2: where have all the dollars gone?–In 2006, U.S. currency averaged about $2500 per person, but surveys show people only hold about $100–Some is held by businesses and the underground economy, but most is held abroad–Foreigners hold over 1/4 of M1, because of inflation in their local currency and political instability (good for the U.S.)© 2008 Pearson Addison-Wesley. All rights reserved7-11Money Supply–Money supply = money stock = amount of money available in the economy –How does the central bank of a country increase or decrease the money supply?•Use newly printed money to buy financial assets from the public—an open-market purchase (not directly print money for government purchases, which is forbidden in the US.)•To reduce the money supply, sell financial assets to the public to remove money from circulation—an open-market sale•Open-market purchases and sales are called open-market operations© 2008 Pearson Addison-Wesley. All rights reserved7-12Portfolio Allocation and the Demand for Assets –How do people allocate their wealth among various assets? The portfolio allocation decision (or Asset Demand)–Cash, stocks, bonds, derivatives…•Return(expected rate of return)•Risk (uncertainty)•Liquidity (ease to be traded)•Time to maturity© 2008 Pearson Addison-Wesley. All rights reserved7-13Portfolio Allocation and the Demand for Assets•Time to maturity–Time to maturity: the amount of time until an asset matures and the investor is repaid the principal–Expectations theory of the term structure of interest rates•Term structure is based on investors’ expectation of interest rates•In equilibrium, holding different types of bonds over the same period yields the same expected return–Because long-term interest rates usually exceed short-term interest rates, a risk premium exists: the compensation to an investor for bearing the risk of holding a long-term bond© 2008 Pearson Addison-Wesley. All rights reserved7-14Question?•The interest rate on long-term bonds is somewhat higher than suggested by the expectations theory becauseA) the expectations theory doesn't account for taxes. B) a risk premium exists. C) an inflation premium must be added to long-term bonds. D) the Fed can only control short-term interest rates.© 2008 Pearson Addison-Wesley. All rights reserved7-15The Demand for Money•The demand for money is the quantity of monetary assets people want to hold in their portfolios–Money demand depends on expected return, risk, and liquidity–Money is the most liquid asset–Money pays a low return–People’s money-holding decisions depend on how much they value liquidity against the low return on money© 2008 Pearson Addison-Wesley. All rights reserved7-16The Demand for Money•Key macroeconomic variables that affect money demand –Price level–Real income–Interest rates© 2008 Pearson Addison-Wesley. All rights reserved7-17The Demand for Money•Price level–The higher the price level, the more money you need for transactions–Prices are 10 times as high today as in 1935, so it takes 10 times as much


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