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CHAPTER 7

CHAPTER 7. The Asset Market, Money and Prices. The Functions of Money. 1.Medium of exchange - Barter is inefficient: it requires a double coincidence of wants. - Money allows people to trade their labor for money, then use the money to buy goods and services.

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CHAPTER 7

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  1. CHAPTER 7 The Asset Market, Money and Prices

  2. The Functions of Money 1.Medium of exchange - Barter is inefficient: it requires a double coincidence of wants. - Money allows people to trade their labor for money, then use the money to buy goods and services. - Money thus permits people to trade and allows specialization, they don't have to produce their own food, clothing, and shelter. 2.Unit of account - Money is the basic unit for measuring economic value. - It simplifies comparisons of prices, wages, and incomes. 3. 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.

  3. Measuring Money The M1 monetary aggregate - Consists of currency and traveler's checks held by the public, demand deposits (which pay no interest), and other checkable deposits (which may pay interest). The M2 monetary aggregate (M2 = M1 + less moneylike assets) - Additional assets in M2 include savings deposits, small (< $100,000) time deposits, noninstitutional MMMF balances, money-market deposit accounts (MMDAs). The M3 monetary aggregate (M3 = M2 + less moneylike assets) - Include large denomination (> $100,000) time deposits and MMMFs held by institutions, overnight loans, short-term deposits held in foreign banks.

  4. Weighted Monetary Aggregates - The Fed's money measures add up all the amounts in each category directly. - But some assets are more moneylike than others. - An alternative approach is to weight each asset by how moneylike it is: i.e. Currency has a high weight, Treasury securities have a low weight. - This approach seems useful, but is controversial. - The Fed has not adopted any official weighted monetary aggregate yet, just the simple-sum aggregates.

  5. The Money Supply Money supply Money stock Amount of money available in the economy = = How does the central bank of a country increase the money supply? - Through Open Market Operations: - Use newly printed money to buy financial assets from the public in an open-market purchase. [To reduce the money supply, sell financial assets to the public to remove money from circulation in an open-market sale.] - Could also buy newly issued government bonds directly from the government (i.e. the Treasury). M … represents money supply; either M1, M2, or other aggregates

  6. 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, but returns aren't always known in advance (for example, stock prices fluctuate unexpectedly), so people must estimate their expected return.

  7. Portfolio Allocation and the Demand for Assets Risk: Risk is the degree of uncertainty in an asset's return, people who don't like risk prefer assets with low risk. Liquidity: Liquidity is the ease and quickness with which an asset can be traded and investors prefer liquid assets. i.e. Money is very liquid. Assets like automobiles and houses are very illiquid, it may take a long time and large transaction costs to trade them. Stocks and bonds are fairly liquid.

  8. Portfolio Allocation and the Demand for Assets Asset demands: - Trade-off among expected return, risk, and liquidity. - Assets with low risk and high liquidity, like checking accounts, have low expected returns. - 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.

  9. End of Lecture 1 Week 6 • The Functions of Money • Measuring Money • Weighted Monetary Aggregates • Money Supply • Portfolio Allocation • Demand for Assets

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