Chapter 7

1. Chapter 7 The Asset Market, Money, and Prices

2. Chapter Outline What Is Money? Portfolio Allocation and the Demand for Assets The Demand for Money Asset Market Equilibrium Money Growth and Inflation

3. What Is Money? Money: assets that are widely used and accepted as payment The functions of money Medium of exchange Unit of account Store of value

4. What Is Money? The functions of money Medium of exchange Barter is inefficient—double coincidence of wants Money allows people to trade their labor for money, then use the money to buy goods and services in separate transactions Money thus permits people to trade with less cost in time and effort Money allows specialization, so people don’t have to produce their own food, clothing, and shelter

5. What Is Money? The functions of money Unit of account Money is basic unit for measuring economic value Simplifies comparisons of prices, wages, and incomes The unit-of-account function is closely linked with the medium-of-exchange function

6. What Is Money? The functions of money Store of value Money can be used to hold wealth 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

7. What Is Money? In Touch with Data and Research: Money in a prisoner-of-war camp Radford article on the use of cigarettes as money Cigarette use as money developed because barter was inefficient Even nonsmokers used cigarettes as money Characteristics of cigarettes as money: standardized (so value was easy to ascertain), low in value (so “change” could be made), portable, fairly sturdy Problem with having a commodity money like cigarettes: can’t smoke them and use them as money at the same time

8. What Is Money? Measuring money The M1 monetary aggregate Currency and traveler’s checks held by the public Demand deposits (which pay no interest) Other checkable deposits (which may pay interest) All components of M1 are used in making payments, so M1 is the closest money measure to our theoretical description of money

9. What Is Money? Measuring money The M2 monetary aggregate M2 = M1 + less moneylike assets Additional assets in M2: savings deposits small (< $100,000) time deposits noninstitutional MMMF balances money-market deposit accounts (MMDAs)

10. What Is Money? Measuring money The M2 monetary aggregate Savings deposits include passbook savings accounts Time deposits bear interest and have a fixed term (substantial penalty for early withdrawal) MMMFs invest in very short-term securities and allow checkwriting MMDAs are offered by banks as a competitor to MMMFs

11. What Is Money? In Touch with Data and Research: Where have all the dollars gone? In 2009, U.S. currency averaged about $2800 per person, but surveys show people only hold about $100 Some is held by businesses and the underground economy, but most is held abroad Foreigners hold dollars because of inflation in their local currency and political instability

12. What Is Money? Where have all the dollars gone? Since currency is 1/2 of M1 and over half of currency is held abroad, foreigners hold over 1/4 of M1 The data show large fluctuations in M1 when major events occur abroad, like military conflicts The United States benefits from foreign holdings of our currency, since we essentially get an interest-free loan

13. What Is Money? The money supply Money supply = money stock = amount of money available in the economy

14. What Is Money? The money supply How does the central bank of a country increase the money supply? Use newly printed money to buy financial assets from the public—an open-market purchase To reduce the money supply, sell financial assets to the public to remove money from circulation—an open-market sale Open-market purchases and sales are called open-market operations, Repo, Reverse Repo

15. What Is Money? OPEN MARKET OPERATIONS (OMO’s) • The buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system. Purchases inject money into the banking system and stimulate growth while sales of securities do the opposite. • Open market operations are the principal tools of monetary policy. The U.S. Federal Reserve's goal in using this technique is to adjust the federal funds rate - the rate at which banks borrow reserves from each other.

16. REPO and Reverse REPO • Repos are classified as a money-market instrument. They are usually used to raise short-term capital. They are mainly used for Inflation targeting, or to achieve or maintain fixed exchange rate. • When banks require short term money, SBP will lend member banks against securities held by them. SBP will charge interest on these loans and this rate of interest is called Repo Rate. At present, Repo Rate is 9.5%. • When SBP wants to decrease the lending activities in the country, it will increase the Repo Rate. Once the Repo Rate is increased, the cost of funds to banks from SBP will increase and it will in turn increase the lending rates to customers. This will reduce the lending transactions. But if the SBP feels the need of more lending activities, it will decrease the Repo Rate and reduce the cost of funding. This will translate into lower rates on loans and lending will pick up.

17. Reverse REPO • If banks have excess amount with them, they can park the surplus money with SBP and earn interest on this. The interest on such amount is called Reverse Repo Rate. At present the Reverse Repo Rate is 13%. • SBP will increase the reverse Repo rate, if it wants to reduce liquidity in the system. Banks will be tempted to park money with SBP rather than lending, if this rate is high. At present Reverse Repo Rate is kept 100 basis points below Repo Rate. • By adjusting CRR, SLR, Repo Rate and Reverse Repo Rate, SBP will ensure that the banking system is working fine.  It will adjust these factors to promote an orderly growth of the economy by controlling interest rates and liquidity in the system.

18. Cash Reserve Ratio (CRR). Each bank has to keep a certain percentage of its total deposits with SBP as cash reserves. It is called Cash Reserve Ratio (CRR). On 30th October.2012, RBI reduced the CRR by 25 basis points to 5%. If the bank is having a deposit of 100/-, it has to keep Rs.5 as cash reserve with SBP and it can use only the balance 95 for lending or investments. SBP uses CRR as a means to control the money supply in the system. When the money supply is on the higher side, SBP will increase the CRR to reduce the supply and vice versa. Apply on the Instruments whose Maturity is less than 1 year and it does not generate any return.

19. Statutory Liquidity Ratio (SLR) Every bank has to maintain at the close of every day a certain percentage of its total liabilities (Deposits) in cash, gold or government approved securities. This is called SLR. At present, the SLR is 15%. Its role is more or less similar to CRR and controls the money circulation the banking system. If SBP wants to suck, excess liquidity from the system, it will increase the SLR. Banks will be forced to keep the higher percentage as liquid assets and its power to lend will come down. Apply on the securities whose maturity is more than one year. They do generate return.

20. Portfolio Allocation and the Demand for Assets How do people allocate their wealth among various assets? The portfolio allocation decision

21. Portfolio Allocation and the Demand for Assets Expected return Rate of return = an asset’s increase in value per unit of time Bank account: Rate of return = interest rate Corporate stock: Rate of return = dividend yield + percent increase in stock price Investors want assets with the highest expected return (other things equal) Returns not known in advance, so people estimate their expected return

22. Portfolio Allocation and the Demand for Assets Risk Risk is the degree of uncertainty in an asset’s return People don’t like risk, so they prefer assets with low risk (other things equal)

23. Portfolio Allocation and the Demand for Assets Liquidity Liquidity: the ease and quickness with which an asset can be traded Money is very liquid Assets like automobiles and houses are very illiquid— long time and large transaction costs to trade them Stocks and bonds are fairly liquid Investors prefer liquid assets (other things equal)

24. Portfolio Allocation and the Demand for Assets Time to maturity Time to maturity: the amount of time until a financial security matures and the investor is repaid the principal 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

25. Portfolio Allocation and the Demand for Assets Time to maturity 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

26. Portfolio Allocation and the Demand for Assets Types of assets and their characteristics People hold many different assets, including money, bonds, stocks, houses, and consumer durable goods Money has a low return, but low risk and high liquidity Bonds have a higher return than money, but have more risk and less liquidity Stocks pay dividends and can have capital gains and losses, and are much more risky than money Ownership of a small business is very risky and not liquid at all, but may pay a very high return Housing provides housing services and the potential for capital gains, but is quite illiquid

27. Portfolio Allocation and the Demand for Assets Asset Demands Trade-off among expected return, risk, liquidity, and time to maturity Assets with low risk and high liquidity, like checking accounts, have low expected returns Investors consider diversification: spreading out investments in different assets to reduce risk The amount a wealth holder wants of an asset is his or her demand for that asset The sum of asset demands equals total wealth

28. The Demand for Money The demand for money is the quantity of monetary assets people want to hold in their portfolios Money demand depends on expected return, risk, and liquidity Money is the most liquid asset Money pays a low return People’s money-holding decisions depend on how much they value liquidity against the low return on money

29. The Demand for Money Key macroeconomic variables that affect money demand Price level Real income Interest rates

30. The Demand for Money Price level The higher the price level, the more money you need for transactions Prices are 10 times as high today as in 1935, so it takes 10 times as much money for equivalent transactions Nominal money demand is thus proportional to the price level

31. The Demand for Money Real income The more transactions you conduct, the more money you need Real income is a prime determinant of the number of transactions you conduct So money demand rises as real income rises

32. The Demand for Money Real income 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) Result: Money demand rises less than 1-to-1 with a rise in real income

33. The Demand for Money Interest rates An increase in the interest rate or return on nonmonetary assets decreases the demand for money An increase in the interest rate on money increases money demand This occurs as people trade off liquidity for return

34. The Demand for Money Interest rates 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

35. The Demand for Money Other factors affecting money demand Liquidity of alternative assets: Deregulation, competition, and innovation have given other assets more liquidity, reducing the demand for money Payment technologies: Credit cards, ATMs, and other financial innovations reduce money demand

36. Summary 9