Chapter 7: The Asset Market, Money, and Prices (Market #3: The Asset Market)

Relevant Textbook Solutions (some have been omitted)

Review Questions

1. Money is the economist’s term for assets that can be used in making payments, such as cash
and checking accounts. In everyday speech, people often use the term “money” to refer to their
income or wealth, but in economics money means only those assets that are widely used and
accepted as payment.

2. The three functions of money are (1) the medium of exchange function, which contributes to a
better-functioning economy by allowing people to make trades at a lower cost in time and effort
than in a barter economy; (2) the unit of account function, which provides a single, uniform
measure of value; and (3) the store of value function, by which money is a way of holding wealth
that has high liquidity and little risk.

3. The size of the nation’s money supply is determined by its central bank; in the United States,
the central bank is the Federal Reserve System. If all money is in the form of currency, the
money supply can be expanded if the central bank uses newly minted currency to buy financial
assets from the public or directly from the government itself. To reduce the money supply, the
central bank can sell financial assets to the public or the government, taking currency out of
circulation.

4. The four characteristics of assets that are most important to wealth holders are (1) expected
return, (2) risk, (3) liquidity; and (4) time to maturity. Money has a low expected return
compared to other assets, low risk since it always maintains its nominal value, is the most liquid
of all assets, and has the lowest (zero) time to maturity.

5. Omitted

6. The macroeconomic variables that have the greatest impact on money demand are the price
level (P), real income (Y), and the nominal interest rate on other assets (i). The higher the price
level, the higher the demand for money, since more units of money are needed to carry out
transactions. The higher the level of real income, the higher the need for liquidity, and so the
higher is money demand. When the nominal interest rate on other assets is high, money demand
is low, because the opportunity cost of holding money (that is, the interest you forgo on other
assets because you are holding money instead) is high.

7. Velocity is a measure of how often money “turns over” in a period. It is equal to nominal GDP
divided by the nominal money supply. The quantity theory of money assumes that velocity is
constant, which implies that real money demand is proportional to real income and is unaffected
by the real interest rate.

8. Equilibrium in the Asset Market is described by the condition that real money supply equals
real money demand because when supply equals demand for money, demand must also equal

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supply for nonmonetary assets. The aggregation assumption that is needed for this is that we can
lump all wealth into two categories: (1) money and (2) nonmonetary assets (as per Walras’s
Law).

9. In equilibrium, the price level is proportional to the nominal money supply; in particular it
equals the nominal money supply divided by real money demand. Similarly, the inflation rate is
equal to the growth rate of the nominal money supply minus the growth rate of real money
demand.

10. Factors that could increase the public’s expected rate of inflation include a rise in money
growth or a decline in income growth. With no effect on the real interest rate, the increase in the
expected inflation rate would increase the nominal interest rate.

Numerical Problems

1. Omitted

2. Omitted

3.
(a) MD = $100,000 − $50,000 − [$5000 ∗ (i − im) ∗ 100]. (Multiplying by 100 is necessary since i
and im are in decimals, not percent.) Simplifying this expression, we get MD = $50,000 −
$500,000(i − im).

(b) BD = $50,000 + $500,000(i − im). Adding these together we get MD + BD = $100,000, which
is Mr. Midas’s initial wealth.

(c) This can be solved either by setting money supply equal to money demand, or by setting bond
supply equal to bond demand.

MD = MS
$50,000 − $500,000(i − im) = $20,000
$30,000 = $500,000 i [Setting im = 0]
i = 0.06 = 6%

BD = BS
$50,000 + $500,000 i = $80,000
$500,000 i = $30,000
i = 0.06 = 6%

4.
(a) From the quantity equation MV = PY, we get M / P = Y / V. At equilibrium, MD = MS, so
MD / P = Y / V = 10,000 / 5 = 2000. MD = P ∗ (MD / P) = 2 ∗ 2000 = 4000.

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(b) From the quantity equation MV = PY, P = MV / Y. When MS = 5000, P = (5000 ∗ 5) /
10,000 = 2.5. When MS = 6000, P = (6000 ∗ 5) / 10,000 = 3.

5.
(a) ∆ P / P = − η Y ∆ Y / Y = − 0.5 ∗ 6% = −3%. The price level will be 3% lower.

(b) ∆ P / P = − η r ∆ r / r = −(−0.1) ∗ 0.1 = 1%. The price level will be 1% higher.

(c) With changes in both income and the real interest rate, to get an unchanged price level would
require η Y ∆ Y / Y + η r ∆ r / r = 0, so [0.5 ∗ (Y – 100) / 100] − [0.1 ∗ 0.1] = 0, so Y = 102.

6.
(a) π e = ∆ MS / MS = 10%. i = r + π e
= 15%. MD / P = L = 0.01 ∗ 150 / 0.15 = 10. P =
300 / 10 = 30.

(b) π e = ∆ MS / MS = 5%. i = r + π e = 10%. MD / P = L = 0.01 ∗ 150 / 0.10 = 15. P =

300 / 15 = 20. The slowdown in money growth reduces expected inflation, increasing real
money demand, thus lowering the price level.

7.
(a) With a constant real interest rate and zero expected inflation, inflation is given by the
equation π = ∆ MS / MS − η Y ∆ Y / Y. To get inflation equal to zero, the central bank should
set money growth so that ∆ MS / MS = η Y ∆ Y / Y = 2/3 ∗ 0.045 = 0.03 = 3%. Note that the
interest elasticity isn’t relevant, since interest rates don’t change.

(b)
Since V = PY / MS, ∆ V / V = ∆ P / P + ∆ Y / Y – ∆ MS / MS
= 0 + 0.045 − 0.03
= 0.015

So velocity should rise 1.5% over the next year.

Analytical Problems

Omitted