4 - The Asset Market

Only government can take
perfectly good paper, cover it

with perfectly good ink and make
the combination worthless.
~ Milton Friedman
The Asset Market
Wong Wei Kang
Do not circulate without permission
The Big Picture
Goods Mkt
Equil. Expectations-aug.
Sd=Id IS IS-LM Phillips Curve
Ch 4 curve model
Ch 9
Asset Mkt LM Explanation
Equil. curve of short-run
L(Y,i)=M/P fluctuations
Agg.
Ch 7
demand
curve Business
Labor Cycle
FE Agg. Theories
Mkt
line supply
Equil. Ch 10-11
curve
Ch 3
3
Outline
• What Is Money?
• Portfolio Allocation & the Demand for Assets
• The Demand for Money
• Asset Market Equilibrium
• Money Growth and Inflation
• The Central Bank
• The Open-Economy Trilemma / Impossible Trinity
4
Outline
• What Is Money?
5
Money
• Assets that are widely used and accepted as payment
• Three functions of money
– Medium of exchange
– Unit of account
– Store of value
6
Some Definitions
• Liquidity
• The relative ease and speed with which an asset
can be converted into a medium of exchange
• Fiat money
• has no intrinsic value
• E.g., the paper currency we use
• Commodity money
• has intrinsic value
• E.g., gold coins, cigarettes in P.O.W. camps
Table 7.1 U.S. Monetary Aggregates (April 2018)
M1 3691.8
Currency 1564.8
Travelers’ checks 1.8
Transaction accounts 2125.2
M2 14,047.9
Components of M1 3691.8
Savings deposits, including MMDAs 9194.2
Small-denomination time deposits 443.7
MMMFs (noninstitutional) 718.2
Note: Numbers may not add to totals shown owing to rounding.

Source: Federal Reserve Statistical Release H.6, May 31, 2018. Data are not
seasonally adjusted.
8
Figure 25.1HO U.S. Money Supply (July 2015)
• U.S. currency holdings are unusually high by world standards;

people in other countries sometimes hold and use U.S. dollars.
9
Figure 7.3 Growth rates of M1, M2 and nominal GDP, 1960-2018Q1
M1 and M2 tell a very different story about the course of monetary policy
during 1992–1994 and 2004–2007
10
The Money Supply
• The amount of money available in the economy
– M to represent money supply; M1 or M2
• The central bank changes the money supply (Ms)
through open-market operations
– Open market purchases: use newly printed money to buy
financial assets from the public → ↑ Ms
– Open market sale: sells financial assets to the public → ↓ Ms
– Can also buy newly issued government bonds directly from
the government → Finance expenditures directly by printing
money → Inflation
11
Outline
• What Is Money?
12
Portfolio Allocation and Asset Demand
• How do people allocate their wealth among various assets?
Tradeoff among…
– Expected return
– Risk
– Liquidity
• Asset demand
– The amount a wealth holder wants of an asset
– The sum of asset demands = total wealth because all wealth must be
held as some type of asset
• Money demand
– The quantity of monetary assets that people want to hold in their
portfolios
Outline
• What Is Money?
14
The Money Demand Function
+ −
d
(M P) = L(Y, i )
(M/P )d = real money demand, depends
§ positively on Y
higher Y Þ more spending and transactions
Þ so, need more money
§ negatively on i
i is the opportunity cost of holding money
(L is used for the real money demand function
because money is the most liquid asset)
15
The Money Demand Function
d
(M P) = L(i, Y)
e
= L(r + π , Y)
When people are deciding whether to hold money or
bonds, they don’t know what inflation will turn out to be
Hence, the nominal interest rate relevant for money
demand is r + pe
Henceforth, unless stated otherwise, i = nominal interest
rate on nonmonetary assets and this is the money demand
function we will use
16
Fisher Relation:
Real and Nominal Rates of Interest
• Real: the growth rate of purchasing power, r
– The rate of return in units/terms of goods
• Nominal: the growth rate of money invested, i
– The rate of return in units/terms of money/dollars
• Inflation rate: the growth rate of “prices”, π
– π = (Pt+1– Pt) / Pt
– Pt: The price level at time t
1+ i
1+ r =
1+ π
17
Understanding the Fisher Relation
• 1 + i = the return in terms of money/dollars next period from
giving up $1 this period
• 1 + r = the return in terms of goods next period from giving up
one unit of goods this period
• $1 this period =1/Pt units of goods this period
• $(1 + i) next period = (1 + i ) / Pt+1 units of goods next period
• Thus, real return/interest rate equals
1+i
Pt+1 1+ i 1+ i
1+ r = = Pt+1
=
1
Pt Pt
1+ π
18
Fisher Relation:
Real and Nominal Rates of Interest
• Real: the growth rate of purchasing power, r
• Nominal: the growth rate of money invested, i
• Inflation rate: the growth rate of “prices”, π
1+ i
1+ r = ⇔ 1+ r + π + rπ = 1+ i
1+ π
i−π
r= or r ≈ i − π or i ≈ r + π
1+ π
19
Outline
• What Is Money?
20
Asset Market Equilibrium
• Assume that all assets can be grouped into two
categories, money and nonmonetary assets
– Money includes currency and checking accounts
• Pays interest rate im
– Unless stated explicitly otherwise, we assume that im=0 (i.e.,
money pays no interest)
• Supply is fixed at M
– Nonmonetary assets include stocks, bonds, land, etc.

• Pays interest rate i ≈ r + πe
• Supply is fixed at NM
21
• Supply = Demand for each type of asset
• If the money market is in equilibrium
– Total wealth is held either as monetary or non-monetary assets
– The non-money market must also be in equilibrium
– Asset market is in equilibrium (Walras Law)
• Asset Market Equilibrium ↔ Money Market

Equilibrium
Md/P = Ms/P
22
↔ Money Market Equilibrium
M e
= L(r + π , Y)
P
The supply of real Real money
money balances demand
23
Real Money supply
r s
The nominal ( M P)
interest
money supply is rate
exogenously fixed
by the central bank
while prices are
assumed to be fixed
in the short run:
S
⎛M⎞ ⎛M⎞ M/P
M P
⎜ ⎟ =⎜ ⎟ real money
⎝P⎠ ⎝P⎠
balances
24
Real Money demand
r
s
interest ( M P)
rate
Demand for real
money balances:
d
⎛M⎞ e
⎜ ⎟ = L(r + π , Y)
⎝P⎠ L (Y, i )
M/P
M P
real money
balances
25
Equilibrium
r
In the short run, interest ( M P)
s
the real interest rate

rate r adjusts to
equate the supply
and demand for
r1
money:
L (Y, i )
e
M P = L(r + π , Y)
M/P
M P
real money
balances
26
How does the interest rate get to the
equilibrium point?
• If the interest rate is above the equilibrium level, the
quantity of real money balances supplied exceeds the
quantity demanded
• People will adjust their portfolio allocation
– People holding the excess supply of money try to use money in
their portfolio to buy non-monetary assets (e.g., bonds)
– As more people try to buy bonds, bond issuers will respond by
lowering the interest rates they offer
• At the equilibrium interest rate, people are content with
their portfolios of monetary and nonmonetary assets
• In the short run, r has to clear both goods and asset markets 27
What Determines What in the Long Run?
M e
= L(r + π , Y)
P
Variable How Determined (in the Long Run)?

M Exogenous (the Fed – Open Market Oper.)
r Adjusts to make Sd = Id (Goods Market)
Y Y = AF ( K, N ) (Labor Market)
P Adjusts to make M = L(i, Y ) (Asset Market)
P
28
Outline
• What Is Money?
29
How P Responds to DM?
M e
= L(r + π , Y)
P
• For given values of r, Y, and pe,

a change in M causes P to change by the same
percentage
30
Money and the Price Level in the United States
31
Money and Inflation
• Asset market equilibrium → rate of inflation = growth rate of
nominal money supply - growth rate of real money demand
M
P=
L(Y, r + π e )
ΔP ΔM ΔL(Y, r + π e )
= −
P M L(Y, r + π e )
ΔM ΔY Δi
π= − ηY − ηi
M Y i
• In countries with high inflation, the growth of nominal money
supply tends to be much more important than the growth of real
money demand
32
Money Growth & Inflation
ΔM ΔY Δi
π= − ηY − ηi
M Y i
• Inflation rate = Growth rate of the nominal money supply
− Adjustment for the growth rate of real money demand
arising from growth in real output Y
− Adjustment for the growth rate of real money demand
arising from growth in nominal interest rate i
• Milton Friedman
– Inflation is always and everywhere a monetary
phenomenon (Figure 7.4)
33
Figure M5.1 U.S. inflation and money growth
High money growth leads to high inflation
34
Figure M5.2 International data on inflation and money growth
35
Hyperinflation
• def: p ³ 50% per month
• The costs of hyperinflation are HUGE
• Money ceases to function as a store of value, and may not serve its other
functions (unit of account, medium of exchange)
• People may conduct transactions with barter or a stable foreign currency
• Hyperinflation is also caused by excessive money supply growth
• Thus, the solution to hyperinflation is simple: stop printing money.
– So why do countries allow money supplies to grow quickly, if they know it will
cause inflation?
• They sometimes find that printing money is the only way to finance
government expenditures
• Especially true for very poor countries, or countries in political crisis
– This often involves painful fiscal reform (↓ G to reduce budget deficit)
36
A few examples of hyperinflation
CPI Inflation M2 Growth
country period
% per year % per year
Israel 1983-85 338% 305%
Brazil 1987-94 1,256 1,451
Bolivia 1983-86 1,818 1,727
Ukraine 1992-94 2,089 1,029
Argentina 1988-90 2,671 1,583
Dem. Republic
1990-96 3,039 2,373
of Congo / Zaire
Angola 1995-96 4,145 4,106
Peru 1988-90 5,050 3,517
Zimbabwe 2005-07 5,316 9,914
37
The Fisher Effect
• With constant real interest rate, the nominal interest
rate changes one-for-one with changes in the
expected inflation rate
• In other words, with r = constant, Δ i = Δ pe
– Unless people expect large changes in the growth rates of
M or Y, pe ≈ π
– Expect i to comove with π, i.e., Δ i ≈ Δ π
– The comovement won’t be perfect because r will most
likely not remain constant
38
Figure 7.5 Inflation and the nominal interest rate in the U.S.
39
Outline
• What Is Money?
40
The Central Bank
• In the US, the Fed (Federal Reserve System) is the central
bank, whereas the Treasury implements fiscal policy
• The Fed has a “dual mandate”
– Price stability (low and stable inflation)
– Full-employment
• The Fed seems to be doing nominal interest rate targeting
– The FOMC (Federal Open Market Committee) meets 8 times a
year to decide on a target for federal funds rate, the interest rate
on interbank overnight lending (of reserves)
• Is the central bank independent from the government?
41
42
Figure 14.4HO The Federal Reserve System
In 1913, Congress divided the country into 12 Federal Reserve districts, each of which
provides services to banks in the district.
But the real power of the Fed lies in Washington DC, with the Board of Governors.
The Central Bank
• MAS is the central bank in Singapore
• MAS conducts monetary policy to maintain price stability
conducive to sustained growth of the economy
– Singapore is a small and open economy
• Gross exports and imports of goods and services are more than 300
percent of GDP
• Domestic expenditure has a high import content
– The exchange rate has a much stronger influence on inflation
than the interest rate
– Accordingly, MAS’ monetary policy framework is centred on
managing the Singapore dollar against a trade-weighted basket
of currencies 43
Outline
• What Is Money?
44
The Open-Economy Trilemma
• Impossible for a country to achieve more than two
items from the following list:
1. Exchange rate stability
– Fixed exchange rate to reduce future uncertainty
2. Independent monetary policy
– Ability to use monetary policy to stabilize the domestic economy
3. Free capital movement
– Ability of local investors to invest abroad and of foreign
investors to invest domestically (and to withdraw investment)
• All three are desirable but cannot be achieved
simultaneously → Trilemma
45
The Impossible Trinity
A nation cannot have free
capital flows, independent Free capital
monetary policy, and a fixed flows
exchange rate simultaneously
Option 1 Option 2
A nation must choose

one side of this
triangle and
give up the Independent Option 3
Fixed
opposite monetary exchange
corner policy rate
46
Monetary Authority of Singapore
• Three main features of the exchange rate system in
Singapore
– The Singapore dollar is managed against a basket of
currencies of our major trading partners
– MAS operates a managed float regime for the Singapore
dollar with the trade-weighted exchange rate allowed to
fluctuate within a policy band
– The exchange rate policy band is periodically reviewed to
ensure that it remains consistent with the underlying
fundamentals of the economy
47
Monetary Authority of Singapore
• The choice of the exchange rate as the intermediate target
of monetary policy implies that MAS gives up control
over domestic interest rates (and money supply)
• In the context of free capital movements, interest rates in
Singapore are largely determined by foreign interest rates
and investor expectations of the future movements in the
Singapore dollar
• Domestic interest rates have typically been below US
interest rates and reflect market expectations of a trend
appreciation of the Singapore dollar over time
48
Appendix: Glossary for Open Economy
• Exchange rate
– The number of units of foreign currency that can be purchased with one
unit of the home currency
• Fixed exchange rate
– An exchange rate that is set by the central bank’s willingness to buy and
sell the domestic currency for foreign currencies at a predetermined price
• Flexible or floating exchange rate
– An exchange rate that is determined by conditions of supply and demand in
the foreign exchange market, without central bank intervention
• Managed float or dirty float
– The system of partially floating the exchange rates
– A hybrid of the “pure” fixed and floating rate systems
– A system in which governments may attempt to moderate exchange rate
movements without keeping exchange rates rigidly fixed
49

4 - The Asset Market

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

4 - The Asset Market

Uploaded by

Copyright:

Available Formats

Only government can take

perfectly good paper, cover it

Small-denomination time deposits 443.7

MMMFs (noninstitutional) 718.2

Note: Numbers may not add to totals shown owing to rounding.

• U.S. currency holdings are unusually high by world standards;

– Nonmonetary assets include stocks, bonds, land, etc.

• Asset Market Equilibrium ↔ Money Market

the real interest rate

Variable How Determined (in the Long Run)?

• For given values of r, Y, and pe,

Figure 14.4HO The Federal Reserve System

A nation must choose

You might also like