Transcript Asset market money and prices

Study of asset market and our final target
 By asset market we mean the entire set of markets in which
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people buy and sell real and financial assets.
Money is one of the most significant asset that plays a very
crucial role in macroeconomic analysis.
Therefore, money will be the focus of our analysis of asset
market.
We have already established goods market and labor market
equilibriums.
In this class we shall establish money market equilibrium.
Then combining the goods market, labor market and money
market equilibriums we shall try to find the general equilibrium
conditions for the economy.
The general equilibrium conditions will be discussed in our class
on IS-LM framework.
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What is money?
 Money is something that has three properties:
 It serves as a medium of exchange
 It can be used as a unit of account
 It stores value
 In most of the cases only money functions as a
medium of exchange and only money serves as a unit
of account. However, other assets may also store
value like money. For example: real estate, stock,
bond.
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Measuring money: monetary aggregates
 Money is defined as those assets that are widely used
and accepted in payment.
 Therefore, we need to define clearly the distinction
between assets that should be counted as money and
those that should not.
 Assets vary according to their “liquid” nature.
Therefore, it is very difficult to have a single measure
of money.
 For this reason, a number of different measures are
used to quantify money stock. These are called
monetary aggregates.
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Monetary aggregates
 In many countries the most widely used monetary aggregates are M1
and M2.
 In general M1 is called “narrow money” and M2 is called “broad
money”.
 In Bangladesh M1 is defined as the sum of:
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Bangladesh Bank notes and coins
Government notes and coins
Currency in tills of DMBs
Demand deposits with DMBs (excluding demand deposits of banks
and government)
 Deposits with Bangladesh Bank other than DMBs
 M2 is defined as the sum of:
 M1 and
 Time deposits with DMBs (excluding demand deposits of banks and
government)
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Money supply
 Money supply is the amount of money available in an economy.
 The central bank of Bangladesh, Bangladesh Bank, controls the
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money supply.
Open market purchase and open market sale are two most
popular ways through which the central bank controls money
supply.
Open market sale and open market purchase together is called
open market operations.
M1 indicates the supply of narrow money and M2 indicates the
supply of broad money.
There is another way of increasing or decreasing money.
By simply printing money the central bank can increase money
supply.
Printing money is called Seiniorage.
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Portfolio allocation and demand for assets
 People decide about how to allocate their wealth on various
assets. Money is one of those assets.
 The set of assets that a consumer holds is called the
“portfolio” of that consumer.
 The decision about which assets and how much of each
asset to hold is called “portfolio allocation decision”.
 Fundamentally, only three characteristics of assets matter
for the portfolio allocation decision:
 Expected return
 Risk and
 Liquidity
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Expected return
 The rate of return to an asset is the rate of increase in its
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value per unit of time.
For example: the rate of return to a bank account is the
interest rate on the account.
Higher return portfolio enables the consumer to consume
more.
However, the rate of return is not always known.
For example: when we buy a stock we do not know what its
price will be after one year.
Holders of assets , in such cases, depend on expected rate
of return.
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Risk
 An asset or portfolio of assets has high risk if there is a
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significant chance that the actual return received will be
very different from expected returns.
Example: if we buy a stock financial fundamentals of which
are not sound then there is high risk that our expected
return will not be realized.
Generally what is the nature of people? Do we like to take
risk?
People will hold risky assets when the expected return from
that asset is much higher than a safe asset.
For example: we bought a lot of risky stocks instead of
putting money into fixed deposit accounts.
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Liquidity
 The liquidity of an asset is the ease and quickness with
which it can be exchanged for goods and services or other
assets.
 Example: Your mobile phone is illiquid whereas money in
the form of cash is the highest extent of liquidity.
Note:
 There is a trade-off among these three characteristics.
 For example: your savings bank account is safe and liquid,
but has low return. On the other hand, your stock market
investment is risky and not very liquid, but may give you
high return.
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Demand for money
 The demand for money is the quantity of monetary assets,
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such as cash, that people choose to hold in their portfolios.
Like any other assets, demand for money depends on the
expected return, risk and liquidity.
Cost of holding very liquid money is that its return is zero.
Therefore people wish to hold cash or highly liquid money
for transaction purpose or to avoid risk.
The macroeconomic variables that have the greatest effects
on demand for money are The price level
 Real income and
 Interest rate
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Price Level:
The higher the general level of prices, the more Taka people need to
conduct transactions and thus more Taka people will want to hold.
Higher price level increase demand for money, by raising the need for
liquidity. Therefore, the demand for money is proportional to the price
level.
Real income:
Higher real income induces people towards more transaction, and more
transaction means more need of liquidity. Unlike price level, real income
may not be proportional to money demand.
Interest rate:
Interest rate indicates the return from money. We get expected return by
deducting expected inflation from interest rate. If risk and liquidity held
constant, the demand for money depends on the expected returns from
both money and non-monetary assets. An increase in the expected return
from money increases demand for money. On the other hand, an increase
in the expected return from non-monetary assets will decrease demand
for money.
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Money demand function
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Other factors affecting money demand
 Wealth: part of extra wealth acquired may be kept as
money and thus demand for money rises.
 Risk: money usually pays a fixed nominal interest rate
(zero for holding cash, fixed rate for holding money in
the savings accounts etc.). However, if risks of nonmonetary assets, such as stock, increases, people
might want to hold more cash.
 Liquidity of non-monetary assets: if increases
demand for money will reduce.
 Payment technologies: if improved will reduce
demand for money.
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Summary of factors affecting money demand
An increase in
Causes money demand to
Reason
P
Rise proportionally
?
Y
Rise less than proportionally
?
Real interest rate (r)
Fall
?
Fall
?
Nominal interest rate on
money
Rise
?
Wealth
Rise
?
Risk
Rise: If risk of holding alternative assets
increases
Fall: If risk of holding money increases
?
Liquidity of alternative
assets
Fall
?
Efficiency of payment
technologies
Fall
?
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Asset market equilibrium
 The demand for any asset is the quantity of the asset that
holders of wealth want in their portfolios.
 Demand for each asset depends on … … … … … ?
 The supply of each asset is the quantity of that asset that is
available.
 At any particular point of time supplies of assets are
particularly fixed (although over time asset supplies
change).
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Asset market equilibrium: Assumptions
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Asset market equilibrium
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Asset market equilibrium
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Inflation, money growth and money demand
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Money growth and inflation in Bangladesh
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