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Study of asset market and our final target By asset market we mean the entire set of markets in which 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. 2 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. 3 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. 4 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: 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) 5 Money supply Money supply is the amount of money available in an economy. The central bank of Bangladesh, Bangladesh Bank, controls the 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. 6 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 7 Expected return The rate of return to an asset is the rate of increase in its 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. 8 Risk An asset or portfolio of assets has high risk if there is a 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. 9 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. 10 Demand for money The demand for money is the quantity of monetary assets, 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 11 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. 12 Money demand function 13 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. 14 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 ? 15 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). 16 Asset market equilibrium: Assumptions 17 Asset market equilibrium 18 Asset market equilibrium 19 Inflation, money growth and money demand 20 Money growth and inflation in Bangladesh 21