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Asset market money and prices


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Title: Asset market money and prices

Asset market money and prices
Study of asset market and our final target
  • By asset market we mean the entire set of markets
    in which people buy and sell real and financial
  • Money is one of the most significant asset that
    plays a very crucial role in macroeconomic
  • Therefore, money will be the focus of our
    analysis of asset market.
  • We have already established goods market and
    labor market equilibriums.
  • In this class we shall establish money market
  • Then combining the goods market, labor market and
    money market equilibriums we shall try to find
    the general equilibrium conditions for the
  • The general equilibrium conditions will be
    discussed in our class on IS-LM framework.

What is money?
  • Money is something that has three properties
  • It serves as a medium of exchange
  • It can be used as a unit of account
  • It stores value
  • In most of the cases only money functions as a
    medium of exchange and only money serves as a
    unit of account. However, other assets may also
    store value like money. For example real estate,
    stock, bond.

Measuring money monetary aggregates
  • Money is defined as those assets that are widely
    used and accepted in payment.
  • Therefore, we need to define clearly the
    distinction between assets that should be counted
    as money and those that should not.
  • Assets vary according to their liquid nature.
    Therefore, it is very difficult to have a single
    measure of money.
  • For this reason, a number of different measures
    are used to quantify money stock. These are
    called monetary aggregates.

Monetary aggregates
  • In many countries the most widely used monetary
    aggregates are M1 and M2.
  • In general M1 is called narrow money and M2 is
    called broad money.
  • In Bangladesh M1 is defined as the sum of
  • Bangladesh Bank notes and coins
  • Government notes and coins
  • Currency in tills of DMBs
  • Demand deposits with DMBs (excluding demand
    deposits of banks and government)
  • Deposits with Bangladesh Bank other than DMBs
  • M2 is defined as the sum of
  • M1 and
  • Time deposits with DMBs (excluding demand
    deposits of banks and government)

Money supply
  • Money supply is the amount of money available in
    an economy.
  • The central bank of Bangladesh, Bangladesh Bank,
    controls the money supply.
  • Open market purchase and open market sale are two
    most popular ways through which the central bank
    controls money supply.
  • Open market sale and open market purchase
    together is called open market operations.
  • M1 indicates the supply of narrow money and M2
    indicates the supply of broad money.
  • There is another way of increasing or decreasing
  • By simply printing money the central bank can
    increase money supply.
  • Printing money is called Seiniorage.

Portfolio allocation and demand for assets
  • People decide about how to allocate their wealth
    on various assets. Money is one of those assets.
  • The set of assets that a consumer holds is called
    the portfolio of that consumer.
  • The decision about which assets and how much of
    each asset to hold is called portfolio
    allocation decision.
  • Fundamentally, only three characteristics of
    assets matter for the portfolio allocation
  • Expected return
  • Risk and
  • Liquidity

Expected return
  • The rate of return to an asset is the rate of
    increase in its value per unit of time.
  • For example the rate of return to a bank account
    is the interest rate on the account.
  • Higher return portfolio enables the consumer to
    consume more.
  • However, the rate of return is not always known.
  • For example when we buy a stock we do not know
    what its price will be after one year.
  • Holders of assets , in such cases, depend on
    expected rate of return.

  • An asset or portfolio of assets has high risk if
    there is a significant chance that the actual
    return received will be very different from
    expected returns.
  • Example if we buy a stock financial fundamentals
    of which are not sound then there is high risk
    that our expected return will not be realized.
  • Generally what is the nature of people? Do we
    like to take risk?
  • People will hold risky assets when the expected
    return from that asset is much higher than a safe
  • For example we bought a lot of risky stocks
    instead of putting money into fixed deposit

  • The liquidity of an asset is the ease and
    quickness with which it can be exchanged for
    goods and services or other assets.
  • Example Your mobile phone is illiquid whereas
    money in the form of cash is the highest extent
    of liquidity.
  • Note
  • There is a trade-off among these three
  • For example your savings bank account is safe
    and liquid, but has low return. On the other
    hand, your stock market investment is risky and
    not very liquid, but may give you high return.

Demand for money
  • The demand for money is the quantity of monetary
    assets, such as cash, that people choose to hold
    in their portfolios.
  • Like any other assets, demand for money depends
    on the expected return, risk and liquidity.
  • Cost of holding very liquid money is that its
    return is zero.
  • Therefore people wish to hold cash or highly
    liquid money for transaction purpose or to avoid
  • The macroeconomic variables that have the
    greatest effects on demand for money are-
  • The price level
  • Real income and
  • Interest rate

  • Price Level
  • The higher the general level of prices, the more
    Taka people need to conduct transactions and thus
    more Taka people will want to hold. Higher price
    level increase demand for money, by raising the
    need for liquidity. Therefore, the demand for
    money is proportional to the price level.
  • Real income
  • Higher real income induces people towards more
    transaction, and more transaction means more need
    of liquidity. Unlike price level, real income may
    not be proportional to money demand.
  • Interest rate
  • Interest rate indicates the return from money. We
    get expected return by deducting expected
    inflation from interest rate. If risk and
    liquidity held constant, the demand for money
    depends on the expected returns from both money
    and non-monetary assets. An increase in the
    expected return from money increases demand for
    money. On the other hand, an increase in the
    expected return from non-monetary assets will
    decrease demand for money.

Money demand function

Other factors affecting money demand
  • Wealth part of extra wealth acquired may be kept
    as money and thus demand for money rises.
  • Risk money usually pays a fixed nominal interest
    rate (zero for holding cash, fixed rate for
    holding money in the savings accounts etc.).
    However, if risks of non-monetary assets, such as
    stock, increases, people might want to hold more
  • Liquidity of non-monetary assets if increases
    demand for money will reduce.
  • Payment technologies if improved will reduce
    demand for money.

Summary of factors affecting money demand
An increase in Causes money demand to Reason
P Rise proportionally ?
Y Rise less than proportionally ?
Real interest rate (r) Fall ?
Fall ?
Nominal interest rate on money Rise ?
Wealth Rise ?
Risk Rise If risk of holding alternative assets increases Fall If risk of holding money increases ?
Liquidity of alternative assets Fall ?
Efficiency of payment technologies Fall ?
Asset market equilibrium
  • The demand for any asset is the quantity of the
    asset that holders of wealth want in their
  • Demand for each asset depends on ?
  • The supply of each asset is the quantity of that
    asset that is available.
  • At any particular point of time supplies of
    assets are particularly fixed (although over time
    asset supplies change).

Asset market equilibrium Assumptions

Asset market equilibrium

Asset market equilibrium

Inflation, money growth and money demand

Money growth and inflation in Bangladesh