Chapter 7. Asset Market. Overheads. F2016

Chapter 7: The Asset Market, Money and Prices: Abel, Bernanke, Croushore, Kneebone
Economics 303: OVERHEADS: D. McClintock
Chapter 7
The Asset Market, Money and Prices
Table of Contents
7.1 What is Money?
- Early Money
- Functions of Money
- Measuring Money: The Monetary Aggregates
7.2 Portfolio Allocation and the Demand for Assets

- Expected Return, Risk and Liquidity
- Time to Maturity
- Types of Assets and Their Characteristics
- Asset Demand
7.3 The Demand for Money

- The Price Level
- Real Income
- Interest Rates
- The Money Demand Function
- Other Factors Affecting Money Demand
- Elasticities of Money Demand
- Velocity and the Quantity Theory of Money
7.4 Asset Market Equilibrium

- Asset Market Equilibrium
7.5 Money Growth and Inflation

- Inflation Equation
- The Expected Inflation Rate and The Nominal Interest Rate
Intellectual property of Douglas McClintock and authors cited above Page 1

7.1 What is Money?
In economics, the meaning of money is different from its everyday meaning.

People often say money when they mean income or wealth. Some people may say,
he makes a lot of money or, she has a lot of money.
In this context, they actually mean income in the first example and wealth in the
second.
 In economics, money refers specifically to assets that are widely used and
accepted as payment.
 Historically, the forms of money have ranged from beads to shells to gold
and silver and in some cases, cigarettes. Goods that are used as money but
have another purpose (such as cigarettes, beaver pelts, gold and silver) is
known as commodity money.
 Money is the most universal and most efficient system of trust ever devised.
(see the book Sapiens by Yuval Harari, page 180)
First Money
According to many scholars, it is widely agreed that barley was first commodity to
be used as money. It is known as Sumerian Barley money, which was used about
3000 - 3500 BC in Sumer, which is now part of Turkey.
(It is interesting to note that the Sumerians are credited with the first written word
and the invention of the wheel.)
Barley money was simply barley, where fixed amount of barley grains were used
for the purchase of goods and services. The most common measurement was the
sila (approx. 0.82 of a litre) and even wages were set in silas.
Problem: Inconvenient. Mold, mice and making large purchases would be difficult.

Early Non-intrinsic money – shekels and coins
The real gain in monetary history took place when people gained trust in
money that lacked inherent value, (i.e. eat it ,drink it or wear it) but was
easier to store and transport. That was the silver shekel.
 The silver shekel appeared in Mesopotamia around 2500 to 3000

BC.
 The silver shekel was not a coin but rather 8.33 grams of silver.
 This was much easier than handling barley and shekels were used
for thousands of years.

Coins
Sumerians (the first known culture to use coins as money – were also credited with
the invention of the wheel and the first written word. (for accounting purposes)
Lydian coins
Lydian Lion and an ancient Lydian coin
The Lydian Lion head can be viewed in the British Museum in London, England

Island of Yap (Stone Money)
Source: Google, Island of Yap Stone Money. August 2016.

FUNCTIONS OF MONEY
Money has three useful functions in an economy
1. Medium of Exchange
The medium of exchange means that money is used for making transactions.
In an economy with no money, trading takes the form of barter, which is the direct
exchange of certain goods for other goods.
Barter is Inefficient – an example
Suppose I want to take my girlfriend out for a very romantic meal. I would first
have to find a restauranteur who is willing to trade a meal for an economics lecture
– which might not be easy to do.
Money makes searching for the perfect trading partner unnecessary. With an
economy that uses money, I do not have to find a restaurant owner who is hungry
for knowledge.
Instead, I can give a lecture to young, very smart students and then use that money
to buy a meal. Money is therefore used as a medium of exchange as the
restauranteur will accept money for the meal. You can see that people can trade
with much less time and effort.
It also allows people to specialize.

The number of relative prices (or exchange rates)
# of possible exchanges = N (N-1)/2 where N = # number of goods to be traded.
2. Unit of Account
As a unit of account, money is the basic unit for measuring economic value.
In Canada, virtually all prices, wages, asset values and debts are expressed in
dollars.
In the UK, these prices are expressed in terms of sterling pounds and in Australia,
Australian dollars as an example.
A currency that is used as a unit of account also applies that there is no loss of
value if smaller denominations are used.
3. Store of Value
As an asset, money is a way of holding wealth. If a local currency did not have a
store of value than citizens would start to use a different currency and the local
currency would cease to exist. (or used very infrequently)
Many assets have a store of value but money is the most liquid.
Liquidity means the ease or speed in which an asset can be converted as a medium
of exchange. Although bonds, term deposits, cars and houses also have a store of
value, it is difficult (and some can be expensive) to convert these assets as a
medium of exchange. As a result, money is the most liquid.

MEASURING MONEY: THE MONETARY AGGREGATES
M1+ (Money Aggregate)
M1+ is the narrowest definition of the money supply.
M1+ is made up of currency in circulation (currency not held my banks) and

chequable deposits in personal and non-personal (businesses and corporations)
deposits. These include deposits at Credit Unions, Mortgage and Trust Companies,
Caisse Populaires and the large chartered banks.
M1+ is perhaps the closest counterpart to the theoretical definition of money

because all its components are actively used and widely accepted for making
payments.
Table 7.1
The Canadian Monetary Aggregates (November 2013)
M1+ $644.7 billion
Currency $64.7 billion
Chequable deposits $582.0 billion
M2 $1,232.0 billion
M1+ $644.7 billion
Personal savings deposits 548.5 billion
M3 $1,747.6 billion
M2 $1,232.0 billion
Non-personal term deposits $274.8 billion
Foreign currency deposits of residents $251.0 billion

M2 is a more broadly defined measure of the money supply.
M2 includes M1 but also includes personal and non –personal non-chequable

deposits. These are savings accounts for firms and individuals. As cheques cannot
be written on these deposits, they are less convenient as a medium of exchange so
they are a little less “money like”. (Able, Bernanke et. Al)
M3 includes non-personal term deposits by firms. Term deposits pay a higher rate
of interest and there is usually a high penalty if the money is withdrawn before the
maturity date. Once again, money held as M3 is less convenient to use as a
medium of exchange than either M1+ or M2 making M3 a more broadly defined
definition of the money supply.

The Money Supply
The money supply is the amount of money available in an economy. In modern

economies, the money supply is partially determined by the central bank – The
Bank of Canada in Canada.
The Bank of Canada can increase or decrease the money supply in two important
ways.1) through open market operations and 2) lending to financial institutions
from its Standing Liquidity Facility.
OMO
 Open market operations is when the B of C buys and sells securities with the
Primary Dealers, who are financial institutions that are allowed to buy and
sell with the B of C at the weekly bond auction.
 These financial institutions have large portfolios of securities that come from
their own portfolio and bonds from the public.
 The B of C also uses open market operations to keep the key overnight
lending rate within the a 50 basis point range that is established by the Bank
of Canada.
 This overnight lending rate is the short term overnight rate (or band) that
financial institutions can lend or borrow from each other.
The Standing Liquidity Facility
 The Standing Liquidity Facility was established after the near collapse of the
world financial system in 2008 and it provides short term financing for
financial institutions.
 If these financial institutions find themselves short of cash reserves, they can
borrow from Standing Liquidity Facility for a period of 6 months and extend
these loans if deemed necessary. (usually for another 6 months)

Bank of Canada’s Updated Definition of the Money Aggregates – 2016
Macroeconomics 203
Money Supply Diagram
Money Supply
(dollars x 1,000,000)
Narrow Definition of the Money Supply
$1,213,538
Non-chequing
accounts
( savings
accounts)
excluding fixed
term deposits
held at
Chartered banks,
TML,
CU
Caisse
Populaires
$824,228
Currency outside
banks
+
chequing accounts TML = Trust, Mortgage and
held at Loan Companies
Chartered banks, CU = Credit Unions
Trust and Mortgage CP = Caisse Populaires
Loan Companies,
Credit Unions and M1+
Caisse Populaires
Diagrams not to scale
M1+ M1++
Note: Dollar amounts obtained from Stats Canada, Table 176-0020. These amounts are for January
2016.

Macroeconomics 203
Money Supply Diagram
Money Supply
(dollars x 1,000,000)
$2,745,019*
Broad Definition of the Money Supply
Canada Savings
Bonds, non-money
mutual funds
$1,772751*
personal deposits
(including term
deposits)
+
Bank non-personal
demand
and
notice
Deposits
At
TML
CU
CP
Life Insurance
Annuities
+
Money Market
Mutual Funds
$1,391,083
Currency outside
banks
+
Chartered Bank M2
personal deposits
(including term
deposits)
+
Bank non-personal
demand
and
notice
deposits
M2 M2+ M2++
Note: Dollar amounts obtained from Stats Canada, Table 176-0020. (January 2016)
* December 2015.
Diagrams not to scale

Portfolio Allocation and the Demand for Assets
Our next goal is to understand how people determine the amount of money they
choose to hold. There are many different asset classes and money is just one of
them.
The decision about which assets and how much of each asset to hold is called the
portfolio allocation decision.
The portfolio allocation decision can be quite complex but it determines the mix of
assets one should hold to maximize their returns (and minimize risk) over a given
period. The study of portfolio allocation is called financial economics.
Expected Return
Although future returns are not known with certainty, the holders of wealth must
base their portfolio allocations based on expected returns. With everything else
being equal, the higher an asset’s expected return, the more desirable the asset is
and the more of its holders of wealth will want to own it.
Risk
The uncertainty about the return of an asset is the second important characteristic
of an asset. An asset or a portfolio of assets has a high risk if there is a significant
chance that the actual return of the asset will be significantly different from the
expected return.
Investing in a new start-up company has a significantly higher risk that a blue chip
company that has been around for a long time. (E.g. Microsoft, Bell Canada, TD
Bank, Proctor Gamble etc.)
The risk of an asset is often determined by the price movement of the asset around
the price movement of the market. If the stock price fluctuates widely relative to
the market, it has a high beta and the stock is riskier than the stock market. If stock
has a beta of 1.2, it is 20% riskier than the market. If the beta of the stock is 0.8, it
is approx. 80% less risky than the market. A stock with a high beta has much more
price volatility relative to the market than a stock with a low Beta.

Liquidity
As mentioned earlier, liquidity is the ease or speed in which an asset can be

converted to a medium of exchange. Money is the most liquid since it can be used
immediately to make purchases of goods and services.
Time to Maturity
Time to maturity is an important characteristic in determining the risk/reward

trade-off. Generally speaking, the longer the maturity date of the asset (such as a
bond) the higher the return on the asset. The investor will want to be compensated
with a higher interest rate if he/she has to hold on to the asset longer than say, a
shorter term bond.
The longer term bond is more risky because the company may go bankrupt, or
have financial difficulties in making these future payments. In addition, people
generally want consumption to occur earlier than later so they have to be
compensated for future consumption.

THE DEMAND FOR MONEY
The demand for money is the amount of cash or chequing accounts that people
choose to hold in their portfolios. Choosing how much money to hold is therefore
part of a broader portfolio allocation decision.
In general, the demand for money (like other assets) depends on the expected
return, risk, liquidity. In practice, two features of money are important:
1) Money is the most liquid of all assets

2) Money give a very low (or zero) rate of return.
Since money has a very low rate of return, the low rate of return relative to other
assets is the major cost of holding money.
The macroeconomic variables that have the greatest effects on money demand are
the price level, real income and interest rates. Higher prices or incomes increase
people’s need for liquidity and thus, raise money demand. Interest rates affect
money demand through the expected return channel.
The higher the interest rate paid on alternative investments (say government bonds)
the more people will want to switch from money to those alternative assets such as
bonds.
THE MONEY DEMAND FUNCTION
The money demand function can be expressed as:
Md = P x L(Y, i)
Where Md = the aggregate demand for money, in nominal terms

P = the general price level (say CPI)
L= function relating money demand to real income and the nominal interest rate.
Y = real income or output
i = the nominal interest rate earned by alternative nonmonetary assets. (Govt
bonds)

Recall
Md = P x L(Y, i)
Therefore,
Md = PL(Y, i) (equation 7.1 in text)
The equation above indicates that for any price level P, money demand depends
(through the function L) on the level, real income Y (or output) and the nominal
interest rate on non-monetary assets. (Such as bonds, term deposits, other assets
etc.)
The equation states that there is a proportional relationship between the demand for
money and the price level. Hence, if the price level doubles (and real output and
the interest rate remained unchanged) the nominal demand for money will double.
In the equation above “i” is the nominal interest rate. Because the nominal interest
rate has two components, the real interest rate plus the expected rate of inflation,
i = r + πe.
It is assumed that the interest on money (money assets) is zero since the interest
rate on holding cash in your pocket is zero but also, the interest rate on money in
chequing accounts would be very small. Thus this assumption is reasonable.
The equation above says that any price level P, Md is positively related to real
output (as economic activity increases, people want to hold more money for
payments and transactions) and negatively related to the nominal interest rate on
non-monetary assets.
If the interest rate, say on bonds or other assets increase, the opportunity cost of
holding money increases so the demand for money falls.

Real Money Demand
Sometimes it is more convenient to express the nominal demand for money in

terms of the real demand for money.
The nominal demand for money is the amount of dollars that people wish to hold
as money where the real demand for money represents the amount of money
demanded in terms of the goods and services it will buy.
This is why the real demand for money is sometimes called the demand for real
balances.
Recall:
Md = PL(Y, i) or
Md = PL(Y, r + πe) (equation 7.2)
By rearranging
Md/P = L(Y, r + πe) (equation 7.3) (Money Demand Function)
The equation states that real money demand if related to real output and the
nominal interest rate.
This equation states that if real income increases (and the price level and nominal
interest rates do not change) then real money demand will increase.
Or
If the price level doubles, (and nominal money demand and interest rates does not
change) then real output Y will fall.

Other Factors Affecting Money Demand
The money demand function in the previous pages captures the main
macroeconomic determinants. However there are other determinants that also
affect money demand.
Wealth: When wealth increases, this will also increase money demand. Wealth can
increase if their balance sheet increases, say through an increase in real estate
holdings, their stock market portfolio, bond holdings or a combination of these
assets.
However, economists feel that the wealth effect on money demand will be small.
Holding income and the level of transactions constant, a holder of wealth will have
little incentive to hold more money. However, the level of transactions will
obviously increase so in this respect, money demand will increase.
Risk: Money itself usually pays a fixed rate of interest (cash pays a zero interest
rate) so holding money itself isn’t risky.
Yet, in periods of rapid inflation the holding of money can be very risky. In this
case, people will want to switch their holdings into more inflation-proof assets
such as real estate, consumer goods and gold. Money demand in this case would
fall.
On the other hand, if people feel there is a bubble (in the stock market or in real
estate – so there is more risk in these markets) people may want to hold more cash)
Liquidity of Alternative Assets: The quickly and easily alternative assets can be
converted into cash, the less need there is to hold money. Today, we have
electronic trading accounts where a person can sell financial assets very quickly to
access cash. Furthermore, the introduction of financial lines of credit and
innovative life insurance policies, people have access to cash very quickly. These
are other reasons why the demand for money is less.

Payment Technologies
The way we do banking and make payments has changed dramatically in the last
10 years. When I was working up north in the late 1970’ and early 1980’s, we had
to physically go to the bank to get cash or we went without.
Nowadays, we can use credit cards, ATM’s or web-banking to make payments.

Because we can access this new technology so easily, we don’t have to have as
much money in our chequing accounts or on our persons to make payments and
transactions. For this reason, the demand for money is less. As technology and
innovation becomes more sophisticated, it is possible that the demand for
traditional forms of money will be close to zero.

MACROECONOMIC DETERMINANTS OF THE DEMAND FOR MONEY
All else equal Causes Money Demand Reason

An increase in to
Price level P Rise Proportionally The double of prices doubles

the number of dollars needed
for (same) transactions
Real Income Y Rise less than proportionally Higher real income implies
more transactions and thus
greater demand for liquidity.
As real income increases, not
all this money would be used
for transactions so money
demand rises less than
proportionally.
Nominal interest rate (i) and Fall Higher interest rates means
real interest rate higher returns on alternative
i = r + πe investments so people switch
away from money
Nominal interest rate on Rise A higher return on money
money makes people want to hold
more money. However,
money usually earns a very
low interest rate and cash -
zero
Wealth Rise Part of an increase in wealth
may be held in the form of
money
Risk Rise, if risk of alternative Higher risk of alternative
assets increase assets makes money more
attractive. (stock market or
real estate bubble)
Liquidity of Alternative Fall If alternative assets become
Assets more liquid, people will want
to hold less money.
Efficiency of Payment Fall People can operate with less
Technologies money

ELASTICITIES OF MONEY DEMAND
Income elasticity of money demand
Income elasticity of money demand is the percentage change of money demand

resulting from a 1% increase in real income. For example, if the income elasticity
of money demand is 2/3, a 3 percent increase in real income will increase money
demand by 2% (2/3 by 3% = 2%)
Similarly, the interest elasticity of money demand is the percentage change in

money demand resulting from a 1% increase in the interest rate.
When working with the interest elasticity of money demand, we have to be careful
and to avoid a potential pitfall. To illustrate, suppose that the interest rate increases
from 5% to 6% per year. The interest rate has gone up my 1%.
However, the percentage change is much more than 1%. The percentage change is
actually 20% (1/5 = 0.20 or 20%). If the interest elasticity of money demand is -
0.1, an increase of the interest rate from 5% to 6% reduces money demand by
2%.(-0.1x20% = -2.0%) Note, that if the interest elasticity of money demand is
negative, an increase in the interest rate reduces money demand.
What are the actual values of the income elasticity and interest elasticity of money
demand?
Income elasticity of money demand is around +0.5. A positive income elasticity

implies money demand rises as real income rises. An income elasticity of less than
one (0.5 is less than one) implies that money demand rises less than proportionally
with real income.
Interest elasticity of money demand is about -0.3. A negative value for the interest
elasticity of money demand implies that as the interest rate rises, money demand
falls. In other words, as the interest rate of nonmonetary assets increase (bonds,
term deposits, stocks) people reduce their holdings of money. (As the theory
predicts)

VELOCITY AND THE QUANTITY THEORY OF MONEY
Recall from econ 203 that velocity means the number of time that money is used (r
turns over) each period, such as a year.
Velocity can be measure by taking nominal GDP and dividing it by the money
supply. Most measurements use M1+ and M2 as measurements for the money
supply.
Recall from Econ 203: M x V = P x Y
V = (Nom GDP)/nominal money stock
Equals: V = (PxY)/M where PxY is the price level x real GDP = nominal GDP
The concept of velocity comes from one of the earliest theories of money demand,
the quantity theory of money. (Irving Fisher, 1911)
The quantity theory of money asserts that real money demand is proportional to real
income, or
Md/P = kY
Where Md/P is real money demand, Y is real income and k is a constant
The real money demand function L(Y, r + πe) takes the simple form of kY. This
way of writing money demand is based on the strong assumption that velocity is
constant, 1/k – and does not depend on income or interest rates.
Insert figure 7.2 (page 220)

However, observations over many years have shown that velocity is not constant.
Why?
1) The popularity of new interest bearing chequing accounts raised the demand
for demand for m1+, which lowers the velocity. (Recall [(PxY)/M] is the
velocity and the denominator M increases at any given level of GDP.
2) But in addition, the quantity theory of money’s assumption that interest rates
do not affect money demand has been refuted by most empirical studies. If
so, this would cause a fall in the velocity of M1+. (Page 221)
(As interest rates fell during the 1990’s and 2000’s, this increased people’s
willingness to hold low interest or zero-interest money, which raised the
demand for M1+ and lower the velocity.)
3) M2 velocity has shown to be more stable. It shows a gradual downward

trend over the period 1975 to 1993 before levelling off. However, M2’s
velocity has been somewhat unpredictable over short periods and most
economists would be reluctant to say it was constant.

ASSET MARKET EQUILIBRIUM (page 221)
In this section, we are going to show that the asset market is in equilibrium when
the demand for money equals the supply of money. Remember that we are looking
at the economy in aggregate and not individual markets, such as the labour market
or the market for individual goods and services.
Recall that the asset market is actually a set of markets, in which real and financial
assets are traded. The demand for any asset (say gov’t bonds) is the quantity of the
asset that holders of wealth want in their portfolios. The demand for each asset
depends on the rate of return, risk and liquidity to other assets.
The supply of each asset is the quantity of that asset that is available. At any given
time, the supplies of individual assets are typically fixed, although over time asset
supplies change (gov’t can issue new bonds, firm’s issues new shares, firms mint
more gold, and so on)
Therefore, the asset market is in equilibrium when the quantities of each asset that
holders of wealth demand equal the (fixed) supply of that asset.
Assumptions
In this section, Bernanke and Kneebone adopt an aggregation assumption n in the

asset market. This assumes that all assets may be grouped into two categories,
money and non-monetary assets. (such as bonds – since bonds are interest bearing
assets)
Money includes cash and chequing accounts – or any asset that can be readily used
as a form of payment. All money is assumed to have the same risk and liquidity
and pay the same nominal interest rate.
The fixed nominal money supply of money is M.
Nonmonetary assets include all other assets other than money, such as bonds,
stocks, foreign bank accounts, land and so on. All nonmonetary assets are assumed
to have the same risk and pay the nominal interest rate of r + πe, where r is the
expected real interest rate and πe is the expected inflation rate.
The fixed nominal supply of nonmonetary assets is NM.

Although the assumption that assets can be aggregated in to two types ignores
many interesting differences among assets, it greatly simplifies our analysis and
had proven very useful. (Page 222) One immediate benefit of making this
assumption is that if we allow for two types of assets:
“The asset market equilibrium reduces to the conditions that the quantity of
money supplied equals the quantity of money demanded.”
Let’s demonstrate.
Let’s look at the portfolio allocation of someone named Andre De Grasse.
Andre has a fixed amount of wealth that he allocates between money and
nonmonetary assets. (Such as land, bonds or stocks – where assuming that his
running skills are not an asset but rather, a skill to be used later to make gold)
If “md” is the nominal amount of money and “nmd” is the nominal amount of
nonmonetary assets that Andre wants to hold, the sum of Andre’s desired money
holdings and his desired holdings of nonmonetary assets must be his total wealth,
Or
md + nmd = Andre’s total nominal wealth
This equation has to be true for every holder of wealth in the economy.
If we sum this across all holders of wealth in the econo
Md + NMd = Aggregate nominal wealth (equation 7.6)
The equation above states that total nominal wealth in an economy is the sum of
the total demand for money in an economy plus the total demand for nonmonetary
assets.

Total Supplies of Money to Aggregate Wealth
Because money and nonmonetary assets are the only assets in the economy,
aggregate nominal wealth equals the supply of money M plus the supply of
nonmonetary assets NM or
M + NM = aggregate nominal wealth (equation 7.7)
Finally, if we subtract equation 7.6 from 7.7, we get
(M + NM) – (Md + NMd)
Equals
(Md – M) + (NMd – NM) = 0
Md – M is the excess demand for money – or the amount that money demand
exceeds money supply and NMd – NM is the excess demand for nonmonetary
assets.
Now suppose demand for money (Md) equals the supply of money (M) so the
excess demand for money Md – M = 0. Then the if demand and supply of
nonmonetary assets (NMd – Nm) must also be zero.
By definition, if quantity supplied and demanded are equal for each type of asset,
the asset market is in equilibrium.

ASSET MARKET EQUILIBRIUM
Equilibrium in the asset market is when the quantity of money supplied equals the
quantity of money demanded. This condition is valid whether money supply and
demand are expressed in nominal terms or real terms.
In real terms, recall
M/P = L(Y, r + πe) (Equation 7.9)
The left-hand side is the money supply expressed in real terms. The right-hand side
is the same is the real demand for money Md/P, (and equation 7.9), which states
that the real quantity of money supplied equals the real quantity of money
demanded. This means the asset market is in equilibrium.
Recall that the nominal money supply (M) is determined, in part, by the Bank of
Canada through its open market operations and we treat the expected rate of
inflation (πe ) as fixed. This leaves three variables in the asset market condition
whose values we have not yet specified – that is output Y, the real interest rate and
the price level.(Note: the text assumes at this stage that we are at full employment)
By rearranging the above equation
P = M /L(Y, r + πe ) (equation 7.10)
According to this equation, the economy’s Price level equals the ratio of the
nominal money supply (M) to real demand for money L(Y, r + πe ).
For given values of real output Y, the real interest rate “r” and the expected rate of
inflation, the real demand for money is fixed.
Therefore, the Price level is proportional to the nominal money supply.
This means that if the central bank doubled the money supply, the price level
would double if the other factors remained constant. (fixed)

The existence of a close link between the money supply and the price level in an
economy is one of the oldest and most reliable conclusions about macroeconomic
behaviour , having been recognized in some form for hundreds if not thousands of
years. (page 224)
In sum, if people hold money or non-monetary assets. (and we lump all non-
monetary assets under the heading of bonds – since these are interest bearing
assets) then if the money market is in equilibrium, then the non-monetary asset
market must be in equilibrium.

Chapter 7. Asset Market. Overheads. F2016

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Chapter 7: The Asset Market, Money and Prices: Abel, Bernanke, Croushore, Kneebone

Economics 303: OVERHEADS: D. McClintock

7.2 Portfolio Allocation and the Demand for Assets

7.3 The Demand for Money

7.4 Asset Market Equilibrium

7.5 Money Growth and Inflation

Intellectual property of Douglas McClintock and authors cited above Page 1

7.1 What is Money?

In economics, the meaning of money is different from its everyday meaning.

Intellectual property of Douglas McClintock and authors cited above Page 2

Early Non-intrinsic money – shekels and coins

 The silver shekel appeared in Mesopotamia around 2500 to 3000

Intellectual property of Douglas McClintock and authors cited above Page 3

Lydian Lion and an ancient Lydian coin

Intellectual property of Douglas McClintock and authors cited above Page 4

Island of Yap (Stone Money)

Source: Google, Island of Yap Stone Money. August 2016.

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Money has three useful functions in an economy

Barter is Inefficient – an example

It also allows people to specialize.

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The number of relative prices (or exchange rates)

# of possible exchanges = N (N-1)/2 where N = # number of goods to be traded.

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MEASURING MONEY: THE MONETARY AGGREGATES

M1+ (Money Aggregate)

M1+ is the narrowest definition of the money supply.

M1+ is made up of currency in circulation (currency not held my banks) and

M1+ is perhaps the closest counterpart to the theoretical definition of money

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M2 is a more broadly defined measure of the money supply.

M2 includes M1 but also includes personal and non –personal non-chequable

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The Money Supply

The money supply is the amount of money available in an economy. In modern

The Standing Liquidity Facility

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Bank of Canada’s Updated Definition of the Money Aggregates – 2016

Narrow Definition of the Money Supply

Diagrams not to scale

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Portfolio Allocation and the Demand for Assets

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As mentioned earlier, liquidity is the ease or speed in which an asset can be

Time to maturity is an important characteristic in determining the risk/reward

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THE DEMAND FOR MONEY

1) Money is the most liquid of all assets

THE MONEY DEMAND FUNCTION

The money demand function can be expressed as:

Where Md = the aggregate demand for money, in nominal terms

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Md = PL(Y, i) (equation 7.1 in text)

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Real Money Demand

Sometimes it is more convenient to express the nominal demand for money in

Md = PL(Y, r + πe) (equation 7.2)

Md/P = L(Y, r + πe) (equation 7.3) (Money Demand Function)

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Other Factors Affecting Money Demand

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