Chp. 7: The Asset Market, Money and Prices

1
Chp. 7 The Asset Market, Money and Prices

• Focus
• Equilibrium in the asset market
• Demand and Supply of Money
• Quantity Theory of Money

2

• Money is an asset which is widely used and
  accepted as payment.
• Three roles of money
• Medium of Exchange
• Unit of Account
• Store of Value

3

• Supply of money refers to the amount of money
  available in an economy.
• Methods to influence money supply
• Open market operations Purchase and sale of
  government bonds by the Central Bank is called.
• Seniorage Printing of new currency.

4

• Portfolio Allocation Decision Allocation of
  wealth among different assets, physical or
  financial.
• Demand for money arises from the portfolio
  allocation decision.
• Portfolio allocation decision depends on 1)
  Expected Return, 2) Risk, and 3) Liquidity of
  assets.

5

• The money demand function relates the demand for
  real balance (M/P) to output and interest rates
• Md/P L(Y, i) L(Y, r ?e)
• where i net nominal rate of interest
• ?e expected inflation rate

6

• Income Elasticity of Money Demand Percentage
  change in money demand for one percent increase
  in real income.
• Interest Elasticity of Money Demand Percentage
  change in money demand for one percent increase
  in the interest rate.
• Velocity of Money (V) The ratio of nominal GDP
  (PY) to the nominal stock of money (M).

7

• Quantity Theory of Money Real money demand is
  proportional to real income. It assumes that V is
  constant.
• Md/P kY
• Where k is a constant.
• Under the assumption that there are only two
  types of assets (Money and some other asset),
  assets market attains equilibrium when demand for
  money equals supply of money.

8

• The equilibrium condition is given by
• M/P L(Y, r ?e)
• Relationship between money growth and inflation
• ?P/P ?M/M - ?L(Y, r ?e)/L(Y, r ?e) or,
• ? ?M/M ?_Y?Y/Y
• Where ?_K Income Elasticity of Money Demand