Macroeconomics 9th Edition

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Chapter 7
The Asset Market, Money, and Prices

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 Chapter 7 The Asset Market, Money, and Prices 143

◼ Learning Objectives
I. Goals of Chapter 7
A. Define money, discuss its functions, and describe how it is measured in the United States (Sec.
7.1)
B. Discuss the factors that affect how people choose which assets they own (Sec. 7.2)
C. Examine macroeconomic variables that affect the demand for money (Sec. 7.3)
D. Discuss the fundamentals of asset market equilibrium (Sec. 7.4)
D. Discuss the relationship between money growth and inflation (Sec. 7.5)

II. Notes to Eighth Edition Users

A. We modified the section on “The Expected Inflation Rate and the Nominal Interest Rate” and
now call it “The Inflation Rate and the Nominal Interest Rate”
B. We introduce the concept of the break-even inflation rate in discussing expected inflation

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◼ Teaching Notes
I. What Is Money? (Sec. 7.1)
A. Money: assets that are widely used and accepted as payment
B. The functions of money
1. Medium of exchange
a. Barter is inefficient—it requires a double coincidence of wants
b. Money allows people to trade their labor for money and then use the money to buy goods
and services in separate transactions
c. Money thus permits people to trade with less cost in time and effort
d. Money also allows specialization, since trading is much easier, so people don’t have to
produce their own food, clothing, and shelter

Theoretical Application
There have been a number of attempts to supply detailed microfoundations theory for money. An
explicit theory that shows the superiority of money to barter has been developed by Nobuhiro
Kiyotaki and Randall Wright (“On Money as a Medium of Exchange,” Journal of Political
Economy, August 1989, pp. 927–954). They show how introducing fiat money unambiguously
improves society’s welfare. Much recent research builds on this type of money model.

2. Unit of account
a. Money is the basic unit for measuring economic value
b. This simplifies comparisons of prices, wages, and incomes
c. The unit-of-account function is closely linked with the medium-of-exchange function
d. But countries with very high inflation may use a different unit of account, so they don’t
have to constantly change prices
3. Store of value
a. Money can be used to hold wealth
b. 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

Theoretical Application
Money’s usefulness as a store of value declines the higher the inflation rate. In hyperinflations
(very high inflations), people try to avoid the use of money; on receiving their wages, they rush to
buy things before prices rise. And they tend to use currencies other than their own, a phenomenon
known as currency substitution.

4. In touch with data and research: money in a prisoner-of-war camp

a. Radford article on the use of cigarettes as money
b. Cigarette use as money developed because barter was inefficient
c. Even nonsmokers used cigarettes as money
d. Characteristics of cigarettes as money: standardized (so value was easy to ascertain), low
in value (so “change” could be made), portable, fairly sturdy
e. Problem with having commodity money like cigarettes: can’t smoke them and use them
as money at the same time

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Policy Application
For an introduction to how technological changes affect the role for money in the economy, see
the article by James J. McAndrews, “Making Payments on the Internet,” Federal Reserve Bank
of Philadelphia Business Review, January/February 1997.

C. Measuring money—the monetary aggregates

1. Distinguishing what is money from what isn’t money is sometimes difficult
a. For example, MMMFs allow check writing but give a higher return than bank checking
accounts: Are they money?
b. There’s no single best measure of the money stock
2. The M1 monetary aggregate
a. Consists of currency and traveler’s checks held by the public, and transaction accounts
(which allow the owner to write checks)
b. All components of M1 are used in making payments, so M1 is the closest money measure
to our theoretical description of money
3. The M2 monetary aggregate
a. M2 = M1 + less money like assets
b. Additional assets in M2 include savings deposits, small (< $100,000) time deposits,
noninstitutional MMMF balances, money-market deposit accounts (MMDAs)
(1) Savings deposits include passbook savings accounts
(2) Time deposits bear interest and have a fixed term (substantial penalty for early
withdrawal)
(3) MMMFs invest in very short-term securities and allow limited check writing
(4) MMDAs are offered by banks as a competitor to MMMFs
4. Table 7.1 shows recent data

Analytical Problem 1 looks at portfolio changes and how they affect M1 and M2

D. In touch with data and research: where have all the dollars gone?
1. In 2015, U.S. currency averaged about $4000 per person
2. Some is held by businesses and the underground economy, but 30% or more is held abroad
3. Foreigners hold dollars because of inflation in their local currency and political instability
4. The data show large fluctuations in M1 when major events occur abroad, for example,
military conflicts
5. The United States benefits from foreign holdings of our currency, since we essentially get an
interest-free loan
E. The money supply
1. Money supply = money stock = amount of money available in the economy
2. How does the central bank of a country increase the money supply?
a. Use newly printed money to buy financial assets from the public—an open-market
purchase
b. To reduce the money supply, sell financial assets to the public to remove money from
circulation—an open-market sale
c. Open-market purchases and sales are called open-market operations
d. Could also buy newly issued government bonds directly from the government (i.e., the
Treasury)
(1) This is the same as the government financing its expenditures directly by printing
money

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(2) This happens frequently in some countries (though is forbidden by law in the
United States)
3. Throughout the text, use the variable M to represent money supply; this might be M1, M2, or
some other aggregate

II. Portfolio Allocation and the Demand for Assets (Sec. 7.2)
How do people allocate their wealth among various assets? The portfolio allocation decision
A. Expected return
1. Rate of return = an asset’s increase in value per unit of time
a. Bank account: Rate of return = interest rate
b. Corporate stock: Rate of return = dividend yield + percent increase in stock price
2. Investors want assets with the highest expected return (other things equal)
3. Returns aren’t always known in advance (e.g., stock prices fluctuate unexpectedly), so
people must estimate their expected return
B. Risk
1. Risk is the degree of uncertainty in an asset’s return
2. People don’t like risk, so prefer assets with low risk (other things equal)
3. The risk premium is the amount by which the expected return on a risky asset exceeds the
return on an otherwise comparable safe asset

Theoretical Application
Their separate work in developing financial theory brought the 1990 Nobel Prize in Economics
to Harry Markowitz, Merton Miller, and William Sharpe. Their main contributions were to
recognize the trade-off between risk and expected return (Markowitz), to develop the Capital
Asset Pricing Model as a general equilibrium theory for pricing assets (Sharpe), and to examine
the corporate financial decision about whether to raise funds via debt or equity (Miller). For an

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overview of their research, see Hal Varian, “A Portfolio of Nobel Laureates: Markowitz, Miller,
and Sharpe,” Journal of Economic Perspectives, Winter 1993, pp. 159–169.

C. Liquidity
1. Liquidity is the ease and quickness with which an asset can be traded
2. Money is very liquid
3. Assets like automobiles and houses are very illiquid—it may take a long time and large
transaction costs to trade them
4. Stocks and bonds are fairly liquid, some more so than others
5. Investors prefer liquid assets (other things equal)
D. Time to maturity
1. Time to maturity: the amount of time until a financial security matures and the investor is
repaid the principal
2. Expectations theory of the term structure of interest rates: the idea that investors compare
returns on bonds with differing times to maturity; in equilibrium, holding different types of
bonds over the same period yields the same expected return
3. 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
E. Types of assets and their characteristics
1. People hold many different assets, including money, bonds, stocks, houses, and consumer
durable goods
2. Money has a low return, but low risk and high liquidity
3. Bonds have a higher return than money, but have more risk and less liquidity
4. Stocks pay dividends and can have capital gains and losses, and are much more risky than
money
5. Ownership of a small business is very risky and not liquid at all, but may pay a very high
return
6. Housing provides housing services and the potential for capital gains, but is quite illiquid
7. Households must consider what mix of assets they wish to own; text Table 7.2 shows the mix
in 2006, 2009, and 2015. The table illustrates the large declines in the value of stocks,
pension funds, and housing in the financial crisis and shows how the value of stocks and
pension funds rebounded by 2015 to a level substantially higher than it was in 2006, while
the value of housing had almost returned to its 2006 level
F. In touch with data and research: the housing crisis of 2007–2011
1. People gained tremendous wealth in their houses in the 2000s
2. As house prices rose, houses became increasingly unaffordable, leading mortgage lenders to
create subprime loans for people who wouldn’t normally qualify to buy houses
3. Most subprime loans had adjustable interest rates, with a low initial interest rate that would
later rise in a process known as mortgage reset
4. As long as housing prices kept rising, both lenders and borrowers thought the subprime loans
would work out, as the borrowers could always sell their houses to pay off the loans
5. But housing prices stopped rising as much, leading more subprime borrowers to default, so
banks began to tighten their lending standards, reducing the demand for housing and leading
housing prices to start falling (text Figure 7.1)
6. Many homeowners lost their homes and financial institutions lost hundreds of billions of
dollars because of mortgage loan defaults
7. Because many mortgage loans had been securitized and were parts of mortgage-backed
securities, the increased default rate on mortgages led to a financial crisis in Fall 2008, as

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many investors simultaneously tried to sell risky assets, including mortgage-backed

securities and stocks

Data Application
Was the housing crisis caused by insiders trying to capitalize on foolish homeowners or a failure by
bank regulators? According to Christopher L. Foote, Kristopher S. Gerardi, and Paul S. Willen, in
their paper “Why Did So Many People Make So Many Ex Post Bad Decisions? The Causes of the
Foreclosure Crisis,” Federal Reserve Bank of Boston Public Policy Discussion Paper 12-2, May
2012, many people made bad decisions in an atmosphere that appeared to be a bubble in housing
prices. Given views about future housing prices that turned out to be too optimistic, homeowners,
lenders, and investors all made bad decisions.

G. Asset demands
1. Trade-off among expected return, risk, liquidity, and time to maturity
2. Assets with low risk and high liquidity, such as checking accounts, have low expected
returns
3. Investors consider diversification: spreading out investments in different assets to reduce risk
4. The amount a wealth holder wants of an asset is his or her demand for that asset
5. The sum of asset demands equals total wealth

III. The Demand for Money (Sec. 7.3)

A. The demand for money is the quantity of monetary assets people want to hold in their portfolios
1. Money demand depends on expected return, risk, and liquidity
2. Money is the most liquid asset
3. Money pays a low return
4. People’s money-holding decisions depend on how much they value liquidity against the low
return on money
B. Key macroeconomic variables that affect money demand
1. Price level
a. The higher the price level, the more money you need for transactions
b. Prices are 10 times as high today as 65 years ago, so it takes 10 times as much money for
equivalent transactions
c. Nominal money demand is thus proportional to the price level
2. Real income
a. The more transactions you conduct, the more money you need
b. Real income is a prime determinant of the number of transactions you conduct
c. So money demand rises as real income rises
d. But money demand isn’t proportional to real income, since higher-income individuals use
money more efficiently, and since a country’s financial sophistication grows as its income
rises (use of credit and more sophisticated assets)
e. Result: Money demand rises less than 1-to-1 with a rise in real income
3. Interest rates
a. An increase in the interest rate or return on nonmonetary assets decreases the demand for
money
b. An increase in the interest rate on money increases money demand
c. This occurs as people trade off liquidity for return

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d. Though there are many nonmonetary assets with many different interest rates, because
they often move together we assume that for nonmonetary assets there’s just one nominal
interest rate, i
e. The real interest rate, which affects saving and investment decisions, is r = i − e
f. The nominal interest paid on money is im
C. The money demand function
1. Md = P  L(Y, i) (7.1)
a. Md is nominal money demand (aggregate)
b. P is the price level
c. L is the money demand function
d. Y is real income or output
e. i is the nominal interest rate on nonmonetary assets
2. As discussed above, nominal money demand is proportional to the price level
3. A rise in Y increases money demand; a rise in i reduces money demand
4. We exclude im from Eq. (7.1) since it doesn’t vary much
5. Alternative expression:
Md = P  L(Y, r + e) (7.2)
A rise in r or  e reduces money demand
6. Alternative expression:
Md/P = L(Y, r + e) (7.3)
7. The left side of Eq. (7.3) is the demand for real balances, or real money demand
D. Other factors affecting money demand
1. Wealth: A rise in wealth may increase money demand, but not by much
2. Risk
a. Increased riskiness in the economy may increase money demand
b. Times of erratic inflation bring increased risk to money, so money demand declines
3. Liquidity of alternative assets: Deregulation, competition, and innovation have given other
assets more liquidity, reducing the demand for money
4. Payment technologies: Credit cards, ATMs, and other financial innovations reduce money
demand
E. Elasticities of money demand
1. How strong are the various effects on money demand?
2. Statistical studies on the money demand function show results in elasticities
3. Elasticity: The percent change in money demand caused by a one percent change in some
factor
4. Income elasticity of money demand
a. Positive: Higher income increases money demand
b. Less than one: Higher income increases money demand less than proportionately
c. Goldfeld’s results: income elasticity = 2/3
5. Interest elasticity of money demand
Small and negative: Higher interest rate on nonmonetary assets reduces money demand
slightly
6. Price elasticity of money demand is unitary, so money demand is proportional to the price
level
F. Velocity and the quantity theory of money
1. Velocity (V) measures how much money “turns over” each period

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2. V = nominal GDP/nominal money stock = PY/M (7.4)

Numerical Problem 1 is an empirical exercise calculating velocity from a money-demand

equation.

3. Plot of velocities for M1 and M2 (text Figure 7.2) shows fairly stable velocity for M2, erratic
velocity for M1 beginning in early 1980s
4. Plot of money growth (text Figure 7.3) shows that instability in velocity translates into erratic
movements in money growth

Analytical Problem 2 asks for explanations for the upward trend in M1 velocity prior to
the 1980s.

5. Quantity theory of money: Real money demand is proportional to real income

a. If so,
Md/P = kY (7.5)
b. Assumes constant velocity, where velocity isn’t affected by income or interest rates
c. But velocity of M1 is not constant; it rose steadily from 1960 to 1980 and has been erratic
since then
(1) Part of the change in velocity is due to changes in interest rates in the 1980s
(2) Financial innovations also played a role in velocity’s decline in the early 1980s
d. M2 velocity is closer to being a constant, but not over short periods

Data Application
Using the idea that M2 velocity is stable, economists at the Federal Reserve Board developed an
inflation model based on M2 growth. The model suggested that the price level would adjust to an
equilibrium level, P*, that was determined mainly by the level of M2. See Jeffrey J. Hallman,
Richard D. Porter, and David H. Small, “Is the Price Level Tied to the M2 Monetary Aggregate
in the Long Run?” American Economic Review, September 1991, pp. 841–858. However, almost
immediately after this article came out, M2 velocity began behaving very unpredictably, and the
Federal Reserve deemphasized the use of M2 for policy purposes.

Policy Application
The Federal Reserve’s job of conducting monetary policy is made more complicated by sweep
programs. For an introduction to these problems, see “Sweep Accounts Lower Reserve Balances,

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Complicate Fed Funds Targeting” in the Federal Reserve Bank of Atlanta Financial Update,
July–September 1999.

IV. Asset Market Equilibrium (Sec. 7.4)

A. Asset market equilibrium—an aggregation assumption
1. Assume that all assets can be grouped into two categories, money and nonmonetary assets
a. Money includes currency and checking accounts
(1) Pays interest rate im
(2) Supply is fixed at M
b. Nonmonetary assets include stocks, bonds, land, etc.
(1) Pays interest rate i = r +  e
(2) Supply is fixed at NM
2. Asset market equilibrium occurs when quantity of money supplied equals quantity of money
demanded
a. md + nmd = total nominal wealth of an individual
b. Md + NMd = aggregate nominal wealth (from adding up individual wealth) (7.6)
c. M + NM = aggregate nominal wealth (supply of assets) (7.7)
d. Subtracting (7.7) from (7.6) gives (Md − M) + (NMd − NM) = 0 (7.8)
e. So the excess demand for money (M − M) plus the excess demand for nonmonetary
d

assets (NMd − NM) equals 0.

f. So if money supply equals money demand, nonmonetary asset supply must equal
nonmonetary asset demand; then the entire asset market is in equilibrium
B. The asset market equilibrium condition
1. M/P = L(Y, r +  e) (7.9) real money supply = real money demand
a. M is determined by the central bank
b.  e is fixed (for now)
c. The labor market determines the level of employment; using employment in the
production function determines Y
d. Given Y, the goods market equilibrium condition determines r

Numerical Problem 2 is an exercise in calculating the equilibrium interest rate.

2. With all the other variables in Eq. (7.9) determined, the asset market equilibrium condition
determines the price level
a. P = M/L(Y, r + e) (7.10)
b. The price level is the ratio of nominal money supply to real money demand
c. For example, doubling the money supply would double the price level

For exercises dealing with price level determination, see Numerical Problems 3 and 5 and
Analytical Problem 4.

Theoretical Application
You might wonder why we don’t show a diagram of money demand and money supply on the
horizontal axis and the real interest rate on the vertical axis at this point in the textbook. The
reason is that we need to talk about general equilibrium first, so we wait to introduce such a
diagram until Chapter 9. Otherwise, students would correctly wonder why the goods market
equilibrium diagram determines the real interest rate and at the same time the asset market
equilibrium diagram also determines the real interest rate. Instead, for now, we just give them the
idea that the asset market equilibrium determines the price level. Later, we will show how both
markets come into equilibrium simultaneously.
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V. Money Growth and Inflation (Sec. 7.5)

A. The inflation rate is closely related to the growth rate of the money supply
1. Rewrite Eq. (7.10) in growth-rate terms:
P/P = M/M − L(Y, r + e )/L(Y, r + e ) (7.11)
2. 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
3. To predict inflation we must forecast both money supply growth and real money demand
growth
a. In long-run equilibrium, we will have i constant, so let’s look just at growth in Y
b. Let Y be the elasticity of money demand with respect to income
c. Then from Eq. (7.11),
 = M/M − Y Y/Y (7.12)
d. Example: If output grows 3% per year, the income elasticity of money demand is 2/3, and
the money supply is growing at a 10% rate, then the inflation rate will be 8%

Numerical Problem 4 gives practice in using elasticities to predict inflation.

B. Application: money growth and inflation in the European countries in transition

1. Though the countries of Eastern Europe are becoming more market-oriented, Russia and
some others have high inflation because of rapid money growth
2. Both the growth rates of money demand and money supply affect inflation, but (in cases of
high inflation) usually growth of nominal money supply is the most important factor
a. For example, if the income elasticity of money demand were 2/3 and real output grew
15%, real money demand would grow 10% (= 2/3  15%); or if income fell 15%, real
money demand would fall 10%
b. So money demand doesn’t vary much, no matter how well or poorly an economy is doing,
but nominal money supply growth differs across countries by hundreds of percentage

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points, so large inflation differences must be due to money supply, not

money demand
3. Text Figure 7.4 shows the link between money growth and inflation in these countries;
inflation is clearly positively associated with money growth
4. So why do countries allow money supplies to grow quickly, if they know it will cause
inflation?
a. They sometimes find that printing money is the only way to finance government
expenditures
b. This is especially true for very poor countries, or countries in political crisis

Data Application
For a review of the causes of inflation in the short run and long run in countries throughout the
world, see Larry Ball’s article, “What Causes Inflation?” Federal Reserve Bank of Philadelphia
Business Review, March/April 1993, pp. 3–12.

C. The inflation rate and the nominal interest rate

1. Expectations can’t be observed directly, except perhaps through surveys
2. If money growth is not expected to change much and if factors affecting money demand are
stable, inflation may not change much, so the expected inflation rate would be approximately
equal to the actual inflation rate
3. If the real interest rate is stable, then the nominal interest rate will move one for one with
inflation
Analytical Problem 3 shows how expected inflation depends on the money supply.

Data Application
There are many surveys of economists’ forecasts for inflation. The most well known monthly
survey is Blue Chip Economic Indicators. Two surveys that are available free of charge are the
quarterly Survey of Professional Forecasters, which began in 1968, and the semi-annual
Livingston Survey, which began in 1946. The Federal Reserve Bank of Philadelphia produces

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both, and historical datasets on the surveys are available on the Internet at
http://www.phil.frb.org/ econ/forecast/index.html.

3. Text Figure 7.5 plots U.S. inflation and nominal interest rates
a. Inflation and nominal interest rates have tended to move together
b. But the real interest rate is clearly not constant
c. The real interest rate was negative in the mid-1970s and then became much higher and
positive in the late-1970s to early-1980s; the real interest rate turned negative again
following the financial crisis of 2008

Data Application
A careful attempt to measure the world real interest rate was undertaken by Robert J. Barro and
Xavier Sala-i-Martin, “World Real Interest Rates,” in O. Blanchard and S. Fischer, eds., NBER
Macroeconomics Annual, Cambridge, MA: MIT Press, 1990, pp. 15–61.

D. Application: measuring inflation expectations

1. How do we find out people’s expectations of inflation?
a. We could look at surveys
b. But a better way is to observe implicit expectations from bond interest rates
2. The U.S. government issues nominal bonds and Treasury Inflation-Protected Securities
(TIPS)
a. TIPS bonds make real interest payments by adjusting interest and principal for inflation
b. Compare nominal interest rate with real interest rate (text Figure 7.6)
3. The break-even inflation rate: interest rate on nominal bonds minus real interest rate on TIPS
bonds
a. The break-even inflation rate is a rough measure of expected inflation
b. TIPS bonds have lower inflation risk, so the break-even inflation rate may be too high
c. TIPS bonds do not have as liquid a market, so the break-even inflation rate may be too
low
d. The net effect of the two effects is likely to be small, so the break-even inflation rate may
be about right
4. The data show fluctuations in the break-even inflation rate (text Figure 7.7)
a. In contrast, the rate of expected inflation measured in surveys has been fairly constant
b. Either bond market participants have very different inflation expectations than
forecasters, or else the degree of inflation risk and liquidity on TIPS bonds varied
substantially from 1998 on

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◼ Additional Issues for Classroom Discussion

1. How Has Technology Changed Money?
Ask your students how they think improved technology has changed the role of money in the economy.
They might mention such things as computer banking, which allow people to pay bills easier and to move
money between accounts without difficulty; phone banking, allowing people to deposit checks without
going to a bank; improved information systems, which allow banks to target credit cards for particular
types of borrowers and which reduce fraud by authorizing transactions instantaneously. Even newer
products include e-money, such as Bitcoin.

2. How Will Money’s Role Change in the Future?

Imagine an age in which the balance in your checking account is invested immediately and automatically
in the stock or bond market, earning substantially more interest than is typical today. Suppose all payments
become electronic, so we never need to touch a dollar bill. What role would money play in such a
payments system?
These questions have been discussed for the past 20 years, and while we’re getting closer to such a system,
it isn’t here yet. The idea is that we would no longer use currency as a store of value or as a medium of
exchange, but it might continue to be used as a unit of account. After all, we have to have some unit in
which we measure our investments and price our goods and services.

3. Should You Buy Indexed Bonds?

Given a choice between buying nominal bonds and indexed bonds, what would you choose? Ask your
students to list the pros and cons of buying indexed bonds.
You may need to give them a bit of historical background. Though introduced for the first time in the
United States in 1997, bonds whose nominal payments adjust for inflation have been available in other
countries for some time, beginning with Finland in 1945. Typically, countries have started issuing indexed
bonds after a bout with inflation.
As you discuss the bonds with your students, you may want to note a few special features that prevent the
bonds from being as desirable as an economist might like them to be. First, the principal of the bond is
adjusted regularly, so that it maintains its real value, but you must pay taxes immediately on the principal
adjustment. That is, before receiving the money, you get taxed on it. Also, because the U.S. government
didn’t want to allow a tax advantage to the indexed bonds, taxes on principal and interest are both based
on the nominal returns to the bonds, not the real returns. So the bonds don’t fully protect you against
inflation, since your taxes will be higher as the inflation rate becomes higher.

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◼ Answers to Textbook Problems

Review Questions
1. Money is the economist’s term for assets that can be used in making payments, such as cash and
checking accounts. In everyday speech, people often use the term “money” to refer to their income or
wealth, but in economics money means only those assets that are widely used and accepted as
payment.

2. The three functions of money are (1) the medium of exchange function, which contributes to a better-
functioning economy by allowing people to make trades at a lower cost in time and effort than in a
barter economy; (2) the unit of account function, which provides a single, uniform measure of value;
and (3) the store of value function, by which money is a way of holding wealth that has high liquidity
and little risk.

3. The size of the nation’s money supply is determined by its central bank; in the United States, the
central bank is the Federal Reserve System. If all money is in the form of currency, the money supply
can be expanded if the central bank uses newly minted currency to buy financial assets from the
public or directly from the government itself. To reduce the money supply, the central bank can sell
financial assets to the public or the government, taking currency out of circulation.
4. The four characteristics of assets that are most important to wealth holders are (1) expected return,
(2) risk, (3) liquidity; and (4) time to maturity. Money has a low expected return compared with other
assets, low risk since it always maintains its nominal value, is the most liquid of all assets, and has the
lowest (zero) time to maturity.

5. The expectations theory of the term structure of interest rates originates in the idea that investors
compare bonds with different times to maturity and choose the ones that yield the highest return. In
equilibrium, the theory implies that the expected rate of return on an N-year bond should equal the
average of the expected rates of return on one-year bonds during the current year and the N – 1
succeeding years.
The expectations theory is not sufficient because on average, long-term interest rates exceed short-
term interest rates, in violation of the theory’s implications. To form a more accurate theory, a risk
premium must be added to the analysis.

6. The macroeconomic variables that have the greatest impact on money demand are the price level, real
income, and the nominal interest rate on other assets. The higher the price level, the higher the
demand for money, since more units of money are needed to carry out transactions. The higher the
level of real income, the higher the need for liquidity, and so the higher is money demand. When the
nominal interest rate on other assets is high, the quantity of money demanded is low, because the
opportunity cost of holding money (i.e., the interest you forgo on other assets because you are
holding money instead) is high.
7. Velocity is a measure of how often money “turns over” in a period. It is equal to nominal GDP
divided by the nominal money supply. The quantity theory of money assumes that velocity is
constant, which implies that real money demand is proportional to real income and is unaffected by
the real interest rate.

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8. Equilibrium in the asset market is described by the condition that real money supply equals real
money demand because when supply equals demand for money, demand must also equal supply for
nonmonetary assets. The aggregation assumption that is needed for this is that we can lump all wealth
into two categories: (1) money and (2) nonmonetary assets.

9. In equilibrium, the price level is proportional to the nominal money supply; in particular it equals the
nominal money supply divided by real money demand. Similarly, the inflation rate is equal to the
growth rate of the nominal money supply minus the growth rate of real money demand.

10. Factors that could increase the public’s expected rate of inflation include a rise in money growth or a
decline in income growth. With no effect on the real interest rate, the increase in the expected
inflation rate would increase the nominal interest rate by the same amount.

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158 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

Numerical Problems
1. For a two-year bond, according to the expectations theory, the interest rate would be the average of
the two one-year bonds, which is (6% + 4%)/2 = 5%. Adding the risk premium of 0.5% gives an
interest rate on the two-year bond of 5.5%.
For the three-year bond, according to the expectations theory, the interest rate would be the average
of the three one-year bonds, which is (6% + 4% + 3%)/3 = 4.33%. Adding the risk premium of 1.0%
gives an interest rate on the three-year bond of 5.33%.
The yield curve would show the interest rate on a one-year bond of 6%, the interest rate on a two-year
bond of 5.55%, and the interest rate on a three-year bond of 5.33%, so it would be downward sloping,
which is called “inverted” in the market.
2. (a) Real money demand is
Md/P = 500 + 0.2Y − 1000i
= 500 + (0.2  1000) − (1000  0.10)
= 600.
Nominal money demand is
Md = (Md/P)  P = 600  100 = 60,000.
Velocity is
V = PY/Md = 100  1000/60,000 = 1 2/3.
(b) Real money demand is unchanged, because neither Y nor i has changed.
Nominal money demand is
Md = (Md/P)  P = 600  200 = 120,000.
Velocity is unchanged, because neither Y nor Md/P has changed, and we can write the equation
for velocity as
V = PY/Md = Y/(Md/P).
(c) It is useful to use the last expression for velocity,
V = Y/(Md/P) = Y/(500 + 0.2Y − 1000i).
(1) Effect of increase in real income:
When i = 0.10,
V = Y/[500 + 0.2Y – (1000  0.10)]
= Y/(400 + 0.2Y)
= 1/[(400/Y) + 0.2].
When Y increases, 400/Y decreases, so V increases. For example, if Y = 2000, then V = 2.5,
which is an increase over V = 1 2/3 that we got when Y = 1000.
(2) Effect of increase in the nominal interest rate:
When Y = 1000, V = 1000/[500 + (0.2  1000) − 1000i]
= 1000/(700 − 1000i)
= 1/(0.7 − i).
When i increases, 0.7 − i decreases, so V increases. For example, if i = 0.20, then V = 2,
which is an increase over V = 1 2/3 that we got when i = 0.10.
(3) Effect of increase in the price level:

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There is no effect on velocity, since we can write velocity as a function just of Y and i.
Nominal money demand changes proportionally with the price level, so that real money
demand, and hence velocity, is unchanged.

3. (a) Md = $100,000 − $50,000 − [$5000  (i − im)  100]. (Multiplying by 100 is necessary since i and
im are in decimals, not percent.) Simplifying this expression, we get
Md = $50,000 − $500,000(i − im).
(b) Bd = $50,000 + $500,000(i − im).
Adding these together we get Md + Bd = $100,000, which is Mr. Midas’s initial wealth.
(c) This can be solved either by setting money supply equal to money demand, or by setting bond
supply equal to bond demand.
Md = Ms
$50,000 − $500,000(i − im) = $20,000
$30,000 = $500,000 i [Setting im = 0]
i = 0.06 = 6%
Bd = Bs
$50,000 + $500,000i = $80,000
$500,000i = $30,000
i = 0.06 = 6%

4. (a) From the equation MV = PY, we get M/P = Y/V. At equilibrium, Md = M, so Md/P = Y/V =
10,000/5 = 2000. Md = P  (Md/P) = 2  2000 = 4000.
(b) From the equation MV = PY, P = MV/Y.
When M = 5000, P = (5000  5)/10,000 = 2.5.
When M = 6000, P = (6000  5)/10,000 = 3.

5. (a) P/P = − Y Y/Y = − 0.5  6% = −3%. The price level will be 3% lower.
(b) P/P = − r r/r = −(−0.1)  0.1 = 1%. The price level will be 1% higher.
(c) With changes in both income and the real interest rate, to get an unchanged price level would
require Y Y/Y + r r/r = 0, so [0.5  (Y – 100)/100] − [0.1  0.1] = 0, so Y = 102.

6. (a)  e = M/M = 10%. i = r + e = 15%. M/P = L = 0.01  150/0.15 = 10. P = 300/10 = 30.
(b)  e = /M = 5%. i = r + e = 10%. M/P = L = 0.01  150/0.10 = 15. P = 300/15 = 20. The
slowdown in money growth reduces expected inflation, increasing real money demand, thus
lowering the price level.

7. (a) With a constant real interest rate and zero expected inflation, inflation is given by the equation
 = M/M − Y Y/Y. To get inflation equal to zero, the central bank should set money growth so
that M/M = Y Y/Y = 2/3  0.045 = 0.03 = 3%. Note that the interest elasticity isn’t relevant,
since interest rates don’t change.
(b) Since V = PY/M, V/V = P/P + Y/Y – M/M
= 0 + 0.045 − 0.03
= 0.015

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160 Abel/Bernanke/Croushore • Macroeconomics, Ninth Edition

So velocity should rise 1.5% over the next year.

Analytical Problems
1. (a) People would probably take money out of checking accounts and put it into money market
mutual funds and money market deposit accounts. Money market mutual funds and money
market deposit accounts are included in M2 but are not part of M1. The result is a decrease in
M1, but no change in M2. M2 does not increase because M1 is part of M2, so the decrease in M1
offsets the increase in the rest of M2.
(b) This would reduce both M1 and M2, as people would have reduced need for money in checking
accounts, and home equity lines of credit are not included in either M1 or M2.
(c) If people fear a stock market collapse, they will want greater liquidity, so they will hold more
money. Also, since stocks are an alternative asset to money, and the expected return to stocks has
fallen, money demand will increase. Both effects will lead to people investing less in stocks and
more in cash, checking accounts, and other items that provide liquidity and safety, so M1 and M2
will both rise.
(d) People would have less need for money in checking accounts, and would put more in savings
deposits. So M1 will decrease, while M2 will remain unchanged. (Again, M1 is part of M2, so
reducing the amount that is in M1, and increasing the amount that is in M2 but not in M1, has no
effect on M2.)
(e) If currency demand falls, this decreases M1, thus also decreasing M2.

2. The general rise in velocity from 1959 to 1980 is most likely due to changes in income, in interest
rates, and in financial institutions. Higher income led to a less than proportional rise in real money
demand, so velocity increased. Rising inflation and rising nominal interest rates in this period led
people to seek alternatives to non–interest-bearing money, such as money market mutual funds.
The result was lower money demand, and thus higher velocity. Financial innovations also reduced the
need for money. Examples include the development of cash management accounts and the use of
automated teller machines.

3. (a) New cigarettes mean an increase in the money supply. With higher nominal money supply and
no change in real money demand, the equilibrium price level must rise.
(b) If people anticipate prices rising when the new cigarettes arrive, they will hold less money so that
they will not lose purchasing power when prices go up. But if their real money demand is
reduced, with the same nominal money supply the equilibrium price level must rise. The result is
that when prices are anticipated to rise in the future, people may take actions that cause prices to
rise immediately.

4. (a) A temporary increase in government purchases reduces national saving, causing the real interest
rate to rise for a fixed level of income. If the real interest rate is higher, then real money demand
will be lower. So prices must rise to make money supply equal money demand. The result is that
output is unchanged, the real interest rate increases, and the price level increases.
(b) When expected inflation falls, real money demand increases. With no effect on employment or
saving and investment, output and the real interest rate remain unchanged. With higher real
money demand and an unchanged nominal money supply, the equilibrium price level must
decline. So output and the real interest rate are unchanged and prices decline.

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(c) When labor supply rises, full-employment output increases. Also, with higher output, saving will
increase, so the real interest rate will decline. Both higher output and a lower real interest rate
increase real money demand. The price level must decline to equate money supply with money
demand. The result is an increase in output and a decrease in both the real interest rate and the
price level.
(d) When the interest rate paid on money increases, real money demand rises. With no effect on
employment or saving and investment, output and the real interest rate remain unchanged. With
higher real money demand and an unchanged nominal money supply, the equilibrium price level
must decline. So output and the real interest rate are unchanged and prices decline.

Working with Macroeconomic Data

1. Answers vary, depending on recent data.

2. In the 1960s and early 1970s, M1 growth was more closely related to inflation. In the 1980s, M2 growth was
more closely related to inflation. The relationships are stronger in the long run than in the short run. The
relationship between M2 growth and inflation weakened after 1990.

3.
a. Interest rates move in the same direction as inflation. That is not surprising because if real interest rates do
not change too much, and because the nominal interest rate equals the real interest rate plus the inflation rate
(if actual and expected inflation rates are similar), then nominal interest rates will move in the same
direction as inflation.
b. The three-month rate is more sensitive to current changes in inflation. The ten-year rate would be sensitive
to long-run changes in inflation, but many inflation movements are short-lived.

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