Copyright 1998 R.H. Rasche Economics 827 Module 6 Conditional Forecasting and Macroeconomic Models

Copyright 1998 R.H. Rasche Asset Markets  Macroeconomic models historically distinguish two forms of holding wealth –Money - easy to measure, controllable –Non-money assets - hard to measure, harder to control, rarely considered in 1st world economies

Copyright 1998 R.H. Rasche Money - Definition  Characteristics of Money (M) –medium of exchange - generally acceptable in exchange for goods and services –unit of account - prices quoted in domestic currency units –store of value - an asset form in which purchasing power can be transferred to future –results in the final discharge of a debt  Money is whatever people will accept as money...

Copyright 1998 R.H. Rasche Money - Measurement  M1 –coin –currency –deposits in transactions accounts (transferable to third parties on demand) »demand deposits »NOW account »Negotiable CDs »Check-writing money market mutual funds, etc.

Copyright 1998 R.H. Rasche Demand for Money  Demand for Real Money Balances (M/P) –P = measure of Price Level –assumption that all else equal, changes in price level will produce proportional change in holdings of nominal money balances (M).  What is the real money balance? –Given the supply of nominal money (M) and the price level (P), there is some practical (real) level of money circulating in society. If either the amount of nominal money rises or the price level falls, the “value” of the amount of money in circulation will go up.

Copyright 1998 R.H. Rasche Real Money Balances  Two principle factors affecting demand –amount of monetary transactions - typically (though not always) proxied by real GDP. »The richer or busier you are, the more money you need to hold for transactions –opportunity cost of holding money = nominal interest rate »The higher the interest rate, the less keen you are on having “idle” money in the form of cash, checking accounts etc.

Copyright 1998 R.H. Rasche Velocity of Money  Definition: Nominal GDP/Money –Measures the number of times, on average,each dollar of the money stock changes hands in GDP transactions per time period  Alternatively = ratio of Real GDP to Real Money balances  In theory, as interest rates rise, velocity should also rise, as we want money to pass through our hands as rapidly as possible, rather than “holding onto it”.

Copyright 1998 R.H. Rasche Historical Evidence: M1 Velocity Velocity - Commercial Paper Rate Real commercial paper rate

Copyright 1998 R.H. Rasche Asset Market Equilibium  Private Agents holding desired portfolio of money will necessarily hold desired portfolio of nonmoney assets –one is mirror image of the other  Macro models concentrate on portfolio equilibrium for money balances  Portfolio equilibrium condition: –supply of real balances = demand for real balances.

Copyright 1998 R.H. Rasche LM Curve: Definition and Construction  LM Curve: Those values of real output and real interest rates for which agents are just willing to hold the amount of real balances supplied to the economy (Portfolio equilibrium). –along LM curve nominal money supply, price level and expected future rate of inflation are held constant.  LM Curve: –M/P = L(Y, r+ t p t+1 )

Copyright 1998 R.H. Rasche LM Curve: Slope  The government (through the Federal Reserve) sets the supply of real balances. Businesses and individuals constitute the demand for real balances.  If interest rates go up, we would normally want to hold less real balances, but the supply of real balances is still fixed. For us to still be willing to demand all the real balances the Fed supplies, we must have some other reason for wanting more real balances than usual: transactions demand from high income.

Copyright 1998 R.H. Rasche LM Curve: Slope II  What if interest rates were low and incomes were high? –Low interest rates would make us not mind holding large sums of cash. High incomes would make us want to hold large sums of cash. So, both effects increase our desire to hold cash. –The supply of real balances is still fixed, but we’re demanding more. What happens? –The price of money (the interest rate) rises, until we’re back again at a point where the demand and supply of real balances are equal to one another.

Copyright 1998 R.H. Rasche LM Curve: Slope II  Thus, the LM curve is a positively sloped relationship between real output (Y) and the real interest rate (r), for fixed values of –nominal money supply (M), –the price level (P) –and the expected rate of inflation ( t p t+1 ).

Copyright 1998 R.H. Rasche LM Curve r Y LM Along LM curve, an increase in the real interest rate must be accompanied by an increase in real output to maintain portfolio equilibrium

Copyright 1998 R.H. Rasche Shifts in the LM Curve I  An increase in nominal money supply (M) or a decrease in price level (P) increases the real money supply in the economy.  Under these conditions, at original values of Y and r, demand for real balances would be less than the supply of real balances.  To restore portfolio equilibrium either Y must increase or r must fall (or some combination). Implies that LM curve shifts down (or to right)

Copyright 1998 R.H. Rasche LM Curve Shifts r Y LM LM’ A decrease in nominal money supply (M), or an increase in the price level (P) reduce the supply of real balances and shift the LM curve up (left)

Copyright 1998 R.H. Rasche Shifts in the LM Curve II  Increases in expected future rate of inflation increase nominal interest rates, for fixed value of real interest rate.  Higher nominal rate reduces demand for real balances below the fixed supply of real balances  To restore portfolio equilibrium, either Y must increase or r must decrease (or combination - LM shifts down (or to right)

Copyright 1998 R.H. Rasche Summary of LM Curve Shifts  M increases (decreases); LM shifts down (up)  P increases (decreases); LM shifts up (down)  t p t+1 increases (decreases); LM shifts down (up)