1 Chp. 7: The Asset Market, Money and Prices Focus: Equilibrium in the asset market Demand and Supply of Money Quantity Theory of Money

2 Money is an asset which is widely used and accepted as payment. Three roles of money: 1) Medium of Exchange 2) Unit of Account 3) Store of Value

3 Supply of money refers to the amount of money available in an economy. Methods to influence money supply: 1) Open market operations : Purchase and sale of government bonds by the Central Bank is called. 2) Seniorage: Printing of new currency.

4 Portfolio Allocation Decision: Allocation of wealth among different assets, physical or financial. Demand for money arises from the portfolio allocation decision. Portfolio allocation decision depends on 1) Expected Return, 2) Risk, and 3) Liquidity of assets.

5 The money demand function relates the demand for real balance (M/P) to output and interest rates M d /P = L(Y, i) = L(Y, r+ ∏ e ) where i= net nominal rate of interest ∏ e = expected inflation rate

6 Income Elasticity of Money Demand: Percentage change in money demand for one percent increase in real income. Interest Elasticity of Money Demand: Percentage change in money demand for one percent increase in the interest rate. Velocity of Money (V): The ratio of nominal GDP (PY) to the nominal stock of money (M).

7 Quantity Theory of Money: Real money demand is proportional to real income. It assumes that V is constant. M d /P = kY Where k is a constant. Under the assumption that there are only two types of assets (Money and some other asset), assets market attains equilibrium when demand for money equals supply of money.

8 The equilibrium condition is given by M/P = L(Y, r+ ∏ e ) Relationship between money growth and inflation ∆P/P = ∆M/M - ∆L(Y, r+ ∏ e )/L(Y, r+ ∏ e ) or, ∏ = ∆M/M – ά_ Y ∆Y/Y Where ά_ K = Income Elasticity of Money Demand