Understanding Asset Markets and Monetary Systems

Posted on Jan 26, 2025 in Economy

Asset Markets and Their Characteristics

T.4: Markets of Assets. We can distinguish between real assets or capital goods and financial assets (bonds and money).

Walras’ Law: If we have equilibrium in n-1 markets, we have equilibrium in the remaining market.

Money: Definition, Functions, and Types

Money is a financial asset universally accepted as a means for repaying debts that appear in economic transactions with legal tender.

Functions of Money

  • Medium of exchange to pay debts
  • Unit of account to account for debts
  • Store of value

Types of Money

  • Legal Money (notes and coins)
  • Bank Money (Deposits in view of banks)

Features of Money

  • It is a financial asset
  • It has zero profitability
  • It has total liquidity (Liquidity of an asset: the ability of an asset to be converted into cash quickly, accurately, and without suffering losses)

Demand for Money

Demand for money is related to providing useful services to individuals holding money and the existence of substitute goods. The price of a good substitute matters.

Types of Demand for Money

  • Transactions: People need cash for purchases. It depends on short-term questions. It is a stable function of real income and price level.

    Lt = Lt (Y, P)

    Y = income, P = price level

  • Precaution: To meet unforeseen needs (illness, job loss, etc.). If the cost of maintaining idle balances is high, demand will be lower. It is a very rigid decreasing function of the interest rate.

    Lp = Lp (r)

    dLp/ dr < 0

  • Speculative: It is a function of the price of securities (bonds) and varies directly with them. If the price of bonds is very high (in terms of people’s expectations), the interest rate will be low. Interest (r = rate / price). If the price of bonds is high and performance is low, expectations are that it will decrease. There is a higher offer for sale of bonds and a greater demand for money. Bond prices and interest rates move inversely. It is a very elastic and decreasing function of the interest rate.

    Le = Le (r)

    dLe / dr < 0

Ld = (Y, P, r) if we speak in nominal terms, and Ld/ P = (Y, r) if expressed in real terms.

Changes in Y and transactions will cause shifts in the demand curve, and changes in r, speculative demand, will cause movements along the curve.

Monetary System

Monetary System: A set of institutions that can create money (central bank and commercial banks). Assets accepted as money: cash and demand deposits.

Non-monetary sectors: foreign, public, private, domestic economy, businesses other than commercial banks.

Bank reserves: Bills held by commercial banks + demand deposits of commercial banks at the central bank.

Legal Money: Notes held by the public + notes held by banks.

Money Banking: Private sector deposits in commercial banks.

Monetary Base (H): Notes held by the public + bills held by commercial banks + commercial banks’ deposits in BC (BC liabilities less capital) = Cash + Reserves.

Money supply (Ls): Notes held by the public + demand deposits of the private sector in commercial banks.

Central Bank Functions

  • Bank of government and bankers’ bank
  • Holds foreign exchange reserves
  • Has the privilege of issuing money
  • Controls the amount of money in the system
  • Supervisor of the financial system

Commercial Banks

Private institutions whose main activity is financial intermediation, providing finance to the economic system through high-risk assets and attracting liabilities with high yield, low risk, and low profitability.

The LM Curve and Equilibrium in Asset Markets

LM Curve: Equilibrium in the asset market will occur when the money supply equals money demand.

Ls / P = L (Y, r)

LM Curve Equation

Ls = Ld = (Y, r)

Expression of the LM Curve

r = -L / h + (k / h) Y

Intercept: -L/h

Slope of the curve: (k / h) Y, is positive and explained given the growing relationship between the type of interest and income.

Points on the LM Curve

  • Points within the curve represent equilibrium situations in the money market.
  • Points to the right of the LM: Excess demand for money for transactions.
  • Points to the left of the LM: Excess money supply.

Displacement of the LM Curve

  • Increased money supply Ls by changing the multiplier (m) or changes in the monetary base: right shift of the LM.
  • Increased liquidity preference (right shift) in monetary demand Ld: shift to the left of the LM.