Chinas exchange rate policy & growing global economic imbalance

The asset market, money, and pricesLecture 10Oct. 22, 2014AnnouncementsRevised Grading Break-Up Quizzes = 15% (4 or 5, lowest to be dropped) Assignments = 15%Midterm Exam = 25%Final Exam = 45%

Quiz 2 on Oct. 23rd (Thursday) Consumption, Saving, & Investment Saving & Investment in an Open EconomyContent to be coveredPreviously Labor MarketGoods MarketNow Asset MarketReal assets (land, houses, property, gold)Financial assets (currency, stocks, bonds)Money asset having special macroeconomic significance for the longest timeTopic OverviewWhat Is Money?Portfolio Allocation and the Demand for AssetsThe Demand for MoneyAsset Market EquilibriumMoney Growth and InflationWhat is Money?Money assets that are widely used and accepted as paymentThe functions of moneyMedium of exchangeUnit of accountStore of valueThe Functions of MoneyMedium of exchangeBarter is inefficient double coincidence of wantsMoney allows people to trade their labor for moneyThen use the money to buy goods and services in separate transactionsMoney permits people to trade with less cost in time and effortMoney allows specialization people dont have to produce their own food, clothing, and shelterThe Functions of MoneyUnit of accountMoney is basic unit for measuring economic valueSimplifies comparisons of prices, wages, and incomesThe unit-of-account function is closely linked with the medium-of-exchange functionCountries with very high inflation may use a different unit of account, so they dont have to constantly change pricesThe Functions of MoneyStore of valueMoney can be used to hold wealthMost people use money only as a store of value for a short period and for small amountsIt earns less interest than money in the bankMeasuring MoneyHow to measure money?Distinguishing what is money from what isnt money is sometimes difficultTheres no single best measure of the money stock

Monetary Aggregates (used in the US)The M1 monetary aggregateCurrency and travelers checks held by the publicDemand deposits (which pay no interest)Other checkable deposits (which may pay interest)

All components of M1 are used in making payments, so M1is the closest money measure to our theoretical descriptionof moneyMeasuring MoneyThe M2 monetary aggregateM2 = M1 + less money-like assetsAdditional assets in M2:savings depositssmall (< $100,000) time deposits Time deposits bear interest and have a fixed term (substantial penalty for early withdrawal)Non-institutional MMMFs (money market mutual funds) organizations that sell shares to the public & invest the proceeds in short-term govt. bonds, allow check writing for a small feemoney-market deposit accounts (MMDAs) offered by banks as a competitor to MMMFsInteresting FindingWhere are all the US dollars?In 2006, US currency averaged about $2500 per person,Surveys showed US residents held only about $100 eachSome is held by businesses and the underground economy, but most is held abroadForeigners hold dollars because of inflation in their local currency and political instabilitySince currency is 1/2 of M1 and over half of currency is held abroad, foreigners hold over 1/4 of M1The data show large fluctuations in M1 when major events occur abroad, like military conflictsUS benefits from foreign holdings of USD no interest to be paidThe Money SupplyMoney supply = money stock = total amount of money available in the economyDenoted by MCentral banks control money supply in an economyUS Federal ReserveState Bank of PakistanThe Money SupplyHow does the central bank control money supply?Use newly printed money to buy financial assets from the public an open-market purchaseTo reduce the money supply, sell financial assets to the public to remove money from circulation an open-market saleOpen-market purchases and sales are called open-market operations

The Money SupplyHow does the central bank of a country increase the money supply?Could also buy newly issued government bonds directly from the government (i.e. the Treasury)USD1bn. Expenditure on ISB Metro Bus ProjectFederal govt. buys USD1bn. govt. bonds from TreasuryTreasury using money to make paymentsThis is the same as the government financing its expenditures directly by printing moneyThis happens frequently in some poor countriesGovt. spending is much higher than revenues collected through taxesForbidden by law in the USPortfolio Allocation & Assets DemandHow do people allocate their wealth among various assets?The portfolio allocation decision Factors affecting this decision Expected ReturnAssociated riskLiquidityTime to MaturityThe Portfolio Allocation DecisionExpected return Rate of return = an assets increase in value per unit of timeBank account: Rate of return = interest rateCorporate stock: Rate of return = dividend yield + percent increase in stock priceInvestors want assets with the highest expected return (other things equal)Returns not known in advance, so people estimate their expected returnThe Portfolio Allocation DecisionRisk the degree of uncertainty in an assets returnPeople dont like risk, so they prefer assets with low risk (other things equal)

Liquidity the ease and quickness with which an asset can be tradedMoney is very liquidAssets like automobiles and houses are very illiquid long time and large transaction costs to trade themStocks and bonds are fairly liquidInvestors prefer liquid assets (other things equal)The Portfolio Allocation DecisionTime to maturity the amount of time until an asset matures and the investor is repaid the principal

Expectations Theory of the Term Structure of Interest Rates highlights The idea that investors compare returns on bonds with differing times to maturitySara chooses between two options Bond A (two-year bond, r= 7% per year) & Bonds B & C (1-year bonds each, r=5% in Y1, 6% in Y2)In equilibrium, holding different types of bonds over the same period yields the same expected returnThe Portfolio Allocation DecisionTime to maturityBecause long-term interest rates usually exceed short-term interest rates, a risk premium existsRisk premium the compensation to an investor for bearing the risk of holding a long-term bondE.g. risk premium on a two-year bond = 0.75%Comparing Assets - MoneyMoney (M1 and M2)Low expected rate of returnVery low risk (expected inflation may be higher than expected)Very liquidShort time to maturityComparing Assets - BondsBonds (fixed-income securities)Medium expected rate of returnLow to medium riskUS Govt. bonds (Treasury Bills) have minimal risk of defaultCorporate bonds some risk of defaultMedium to high liquidityUS Govt. bonds are readily tradable at low transaction costsCorporate bonds difficult to sell in hard economic timesTime to maturity varies 3 months to 30 yearsComparing Assets - StocksStocks Expected return = dividend + net capital gainsUncertain; varies with timeRiskConsiderable risk involved as stock prices are volatile & affected by several domestic & foreign factorsLiquidityStocks of large companies are easily traded on stock exchangesStock of companies not listed on stock exchanges are highly illiquidTime to maturityInfiniteComparison Real Estate & Consumer DurablesReal Estate (land, houses, etc.)High expected return; varies over timeRelatively low riskHighly illiquidInfinite time to maturity

Consumer Durables (furniture, automobiles, etc.)Low expected return (depreciation)Low riskHighly illiquidInfinite time to maturity

The Demand for AssetsAsset DemandsTrade-off among expected return, risk, liquidity, and time to maturityAssets with low risk and high liquidity, like currency & checking accounts, have low expected returnsInvestors consider diversification: spreading out investments in different assets to reduce riskThe amount a wealth holder wants of an asset is his or her demand for that assetThe sum of asset demands equals total wealthThe Money DemandThe demand for money is the quantity of monetary assets people want to hold in their portfoliosMoney demand depends on expected return, risk, and liquidityMoney is the most liquid assetMoney pays a low returnConsumers money-holding decisions depend on how much they value liquidity against the low return on moneyThe Money DemandKey macroeconomic variables that affect money demand Price levelReal incomeInterest rates

Price levelThe higher the price level, the more money you need for transactionsNominal money demand is thus proportional to the price level The Money DemandReal incomeThe more transactions you conduct, the more money you needReal income is a prime determinant of the number of transactions you conductSo money demand rises as real income risesBut money demand isnt proportional to real incomeHigher-income individuals use money more efficientlyA countrys 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 incomeThe Money DemandInterest ratesAn increase in the interest rate or return on non-monetary assets decreases the demand for moneyAn increase in the interest rate on money increases money demandThis occurs as people trade off liquidity for returnDifferent non-monetary assets have different interest ratesBecause these rates often move together we assume that for non-monetary assets theres just one nominal interest rate, iThe Money DemandThe money demand functionMd = P L(Y, i) Md is nominal money demand (aggregate)P is the price levelL is the money demand functionY is real income or outputi is the nominal interest rate on nonmonetary assetsMd is proportional to PA rise in Y increases money demandA rise in i reduces money demandThe Money DemandThe money demand functionAlternative expression:Md = P L(Y, r + e) A rise in r or e reduces money demandAlternative expression:Md /P = L(Y, r + e)Factors affecting Money DemandWealth A rise in wealth may increase money demand (partial increase may be held in the form of money) but not by muchRiskIncreased riskiness in the economy may increase money demandTimes of erratic inflation bring increased risk to money, so money demand declinesLiquidity of alternative assetsDeregulation, competition, & innovation have given other assets more liquidity, reducing the demand for moneyPayment technologiesCredit cards, ATMs, and other financial innovations reduce money demand

Elasticity of Money DemandStrength of the various effects on money demandStatistical studies on the money demand function show results in elasticities

Elasticity The % change in money demand caused by a 1% change in some factor Elasticity = (% in money demand)/ (% in some factor)

Elasticity of Money DemandIncome elasticity of money demand+ve : Higher income increases money demand