Chapter 7-Asset Market, Money and Prices

What is money?

Money is an asset that can be accepted as a form of payment, it has the functions of being a medium of exchange, unit of account and a store of value.

What does it mean for an asset to be a medium of exchange?

This refers to the fact that money acts as a medium of exchange for goods and services. This function allows people to maximize their utility from trade.

What does it mean for an asset to be a unit of account?

This refers to the fact that money can be used to standardize the value of a good or service, in countries where erratic inflation occurs the unit of account is constantly changing

What does it mean for an asset to be a store of value?

Money is a store of value in that it’s a method of holding wealth, any asset can be a store of wealth.

What is a money market mutual fund?

MMMFs are funds that allow companies to invest from the public, with the goal of the company being a high return on investment (MMMFs are a nonmonetary asset).

What is a nonmonetary asset?

This is an asset that doesn’t count as money.

What are monetary aggregates?

These refer to the different measures of assets based on their liquidity

What assets are included in the M1 monetary aggregate?

Currency and Liquid Deposits (Liquid deposits are transactions that allow depositors to write checks and saving accounts)

What assets are included in the M2 monetary aggregate?

Components of M1, Small denomination time deposits and Retail Money market funds. (Time deposits are interest bearing deposits with a fixed term)

What is an open market purchase?

This is when the Fed uses money to purchase government bonds, this will increase the amount of money that the public holds.

What is an open market sale?

This is when the central bank sells government bonds to the public to reduce money supply.

What are open market operations?

Open market purchases and sales done by the central bank to control money supply are known as open market operations.

What are the four characteristics of portfolio allocation?

Expected return, liquidity, risk and time to maturity

What is the expected return on an asset?

This is expected rate of return on an asset (expected because we never know the actual return on an asset until after it has been invested into), you always want higher expected returns on assets.

What is the risk of an asset?

This refers to the uncertainty of a return on the asset, an asset is considered to be “high risk” if there is a chance that the actual return received will be very different from expected return.

What is the “risk premium” on an asset?

This is the amount that the expected return exceeds the return on a relatively safe asset.

What is the liquidity of an asset?

This refers to how quickly an asset can be used to exchange goods and services, the more liquid an asset, the more attractive it is for holders of wealth.

What is the Time to maturity of an asset?

This refers to the amount of time until a financial security matures and the investor is repaid their principal( the amount they put into the asset times 1 plus the real interest rate).

What is the expectations theory of the term structure?

“Term Structure” is a theory that in equilibrium, holding bonds with different maturity rates should yield the same expected return, (a two year bond with a set interest rate should yield the same return as 2 one-year bonds with different interest rates should have the same average interest rate per year as the two year bond with a set interest rate).

What is Term premium?

Since long term bonds have higher interest rates and short-term bonds have lower interest rates, long term bonds are considered riskier because they are subject to more potential issues as they mature- this term refers to the higher interest rate on long term bonds.

What are some common assets?

Money, bonds, stocks and houses are common assets.

What are fixed income securities?

This is mainly the type of asset that a bond is, they are named this type of bond b/c they are promised to be paid back to shareholders in specific amounts, on specific dates.

What is asset demand?

This is the combination of wealth in assets (i.e. $3000 in bonds, $5000 in MMMFs, and $10000 in cash equals an asset demand and total wealth of $18000)

What is demand for money?

This is the quantity of monetary assets that people hold in their accounts.

How does an increase price level affect money demand?

A higher price level will result in a higher nominal demand for money through assets.

How does an increase in real income affect money demand?

An increase in real income will cause money demand to increase because people will need more monetary assets to store their new income.

How does a rise in interest rates affect the demand for money?

This can both decrease and increase the demand for money as money will become more valuable to hold at higher interest rates, nonmonetary assets will also become more valuable to hold at higher interest rates- the latter would cause the decrease in money demand.

What is the nominal interest rate on money denoted as?

This is i^m for simplicity, a rise in this variable will lead to a rise in money demand.

What is the nominal interest rate on the demand for nonmonetary assets?

This would just be the nominal interest rate, i.

What is the money demand function?

Since price level is proportional to money demand, demand for money is mainly reliant on an increase in income and a decrease in the nominal interest rate

How could we yield money demand when given the real interest rate as opposed to the nominal interest rate?

The above equation uses the real interest rate plus the expected inflation rate to substitute for the nominal interest rate.

What is the equation for real money demand (aka demand for real balances)?

If we divide both sides of the equation by the price level then we get the real money demand (M/P) the demand for real balances is measured as a function of real income and the nominal interest rate.

What is the income elasticity of money demand?

This is the percentage change in money demand resulting in a 1% increase in real income (if income elasticity of demand is ⅔, a 3 percent increase in real income will increase money demand by 2%- ⅔ x 3% = 2%)

What is the interest elasticity of demand?

This is the percentage change in money demand resulting from a 1% increase in the interest rate.

What is the condition that must be met in order for the asset market to be in equilibrium?

Money supplied must equal the money demanded.

What is aggregate nominal wealth?

The total supply of money and total supply of nonmonetary assets is equal to aggregate nominal wealth.

How do we find the excess demand for money? The excess demand for nonmonetary assets?

If equilibrium conditions are met, then excess demand is zero.

What is the economy’s price level in terms of an equation?

Price is equal to the nominal money supply divided by the real demand for money.