Portfolio Allocation and the Demand for Money

Macroeconomics I

ECON222

Fall 2017

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Portfolio allocation and the demand for assets

A portfolio is a set of assets that a holder of wealth chooses to own

The portfolio allocation decision is based on assetskey

characteristics:
,! expected returns
,! risks of each asset return and correlation between them
,! liquidity ease and speed with which it can be exchanged
,! time to maturity

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Interest rates and time to maturity: an example

Firm investment at date 0 in an asset with 2 period lifetime

,! assume repayment is in period 2

Two nancing options:

(1) Short term debt which is "rolled over" each period
,! expected repayment (per $):

R S = (1 + i1 )(1 + i2e )

(2) Long term loan lasting 2 periods

,! expected repayment
R L = (1 + i1L )2
If the rm is risk-neutral it will choose the lowest repayment

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Arbitrage behaviour of nancial investors

If lenders are also risk-neutral, nancial arbitrage implies

(1 + i1L )2 = (1 + i1 )(1 + i2e )

The expectations hypothesis:

,! the current long-term interest rate depends on the current and
expected future short term interest rates

If future short term interest rates are expected to remain equal to

todays: i2e = i1 then i1L = i1

If instead i2e > i1 , then i1L > i1 and if i2e < i1 , then i1L < i1

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The term structure of interest rates: the Yield Curve
In reality there are interest rates at many maturity periods

The yield curve plots these rates at each maturity

,! tells us about the expectations of nancial market participants

If future short-term rates are expected to rise, the yield curve should
be upward sloping

If future short-term rates are expected to fall, the yield curve should
be downward sloping

In practice the yield curve is (almost) always upward sloping because

long term bonds are also riskier
,! this term premium compensates bondholders for the increased risk

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Four large classes of assets

Money highly liquid, ination risk, short term to maturity

Bonds diering default risk, term to maturity and liquidity

Stocks dividends not guaranteed, substantial price uctuations,

varying liquidity, no maturity

Real Estate very illiquid, provides shelter services, no maturity

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The demand for money

The quantity of monetary assets that people choose to hold in their

portfolios

Money is the most liquid asset but pays a low return (zero nominal
return)

The demand for money depends on its expected return, risk and
liquidity relative to other assets

Also depends on key macroeconomic variables: P, Y i

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Macro variables aecting the demand for money

Higher price level, P ) more dollars needed to conduct transactions

,! all else equal, the nominal demand for money is proportional to P

Higher real income, Y ) more transactions and need for liquidity

,! need not be proportional

An increase in the expected return on alternative assets, i

) wealth-holders to switch from money to higher-return alternatives.

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The money demand equation
The aggregate demand for money is expressed as

M d = P.L(Y , i )

where L is a function that is increasing in Y and decreasing in i

This can also be expressed as

M d = P.L(Y , r + e )

where

r = expected real interest rate

e
= expected rate of ination

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The real money demand function

Real money demand or demand for real balances is:

Md
= L(Y , r + e )
P

Real money demand may also increase as a result of:

,! higher wealth
,! higher riskiness of alternative assets
,! lower liquidity of alternative assets
,! higher e ciency of payment technologies.

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Elasticities of money demand

The income elasticity of money demand

,! the % change in M d resulting from a 1% increase in Y
,! empirical evidence: positive but less than one (about 0.5)

The interest elasticity of money demand

,! the % change in M d resulting from a 1% increase in the interest rate
,! empirical evidence: small negative value (about -0.3)

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Velocity and the quantity theory of money
Velocity (V ) is given by
P.Y
V =
M

The quantity theory of money asserts that real money demand is

proportional to real income:
Md
= kY
P
where k is a constant

This is a special case where L(Y , r + e ) = kY

,! velocity is a constant, 1/k, and does not depend on Y and r + e

In fact, velocity varies considerably over time

,! it has declined in Canada since the early 1980s
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