Asset Market Equilibrium

Discuss the fundamentals of asset market equilibrium.

Asset Market Equilibrium: An Aggregation Assumption

In analyzing the labor market in Chapter 3 and the goods market in Chapter 4, we relied on aggregation to keep things manageable.

Because there are many different types of assets, aggregation is equally neces­sary for studying the asset market. Thus we adopt an aggregation assumption for the asset market that economists often make for macroeconomic analysis: We assume that all assets may be grouped into two categories, money and nonmone­tary assets. Money includes assets that can be used in payment, such as currency and checking accounts. All money is assumed to have the same risk and liquidity and to pay the same nominal interest rate, i^m. The fixed nominal supply of money is M. Nonmonetary assets include all assets other than money, such as stocks, bonds, land, and so on. All nonmonetary assets are assumed to have the same risk and liquidity and to pay a nominal interest rate of i = r + π^e, where r is the expected real interest rate and π^e is the expected rate of inflation. The fixed nomi­nal supply of nonmonetary assets is NM.

Although the assumption that assets can be aggregated into two types ignores many interesting differences among assets, it greatly simplifies our analysis and has proved to be very useful. One immediate benefit of making this assumption is that, if we allow for only two types of assets, asset market equilibrium reduces to the condition that the quantity of money supplied equals the quantity of money demanded.

To demonstrate this point, let's look at the portfolio allocation decision of an individual named Ed. Ed has a fixed amount of wealth that he allocates between money and nonmonetary assets. If m^d is the nominal amount of money and nm^d is the nominal amount of nonmonetary assets that Ed wants to hold, the sum of Ed's desired money holdings and his desired holdings of nonmonetary assets must be his total wealth, or

This equation has to be true for every holder of wealth in the economy.

Suppose that we sum this equation across all holders of wealth in the economy. Then the sum of all individual money demands, m^d, equals the aggregate demand for money, M^d. The sum of all individual demands for nonmonetary assets is the aggregate demand for nonmonetary assets, NM^d. Finally, adding nominal wealth for all holders of wealth gives the aggregate nominal wealth of the economy, or

Equation (7.6) states that the total demand for money in the economy plus the total demand for nonmonetary assets must equal the economy's total nominal wealth.

Next, we relate the total supplies of money and nonmonetary assets to aggre­gate wealth. Because money and nonmonetary assets are the only assets in the economy, aggregate nominal wealth equals the supply of money, M, plus the sup­ply of nonmonetary assets, NM, or

Finally, we subtract Eq. (7.7) from Eq. (7.6) to obtain

(M^d - M) + (NM^d - NM) = 0. (7.8)

The term M^d — M in Eq. (7.8) is the excess demand for money, or the amount by which the total amount of money demanded exceeds the money supply. Similarly, the term NM^d — NM in Eq. (7.8) is the excess demand for nonmonetary assets.

Now suppose that the demand for money, M^d, equals the money supply, M, so that the excess demand for money, M^d — M, is zero. Equation ( 7.8) shows that, if M^d — M is zero, NM^d — NM must also be zero; that is, if the amounts of money supplied and demanded are equal, the amounts of nonmonetary assets supplied and demanded also must be equal. By definition, if quantities supplied and demanded are equal for each type of asset, the asset market is in equilibrium.

If we make the simplifying assumption that assets can be lumped into mone­tary and nonmonetary categories, the asset market is in equilibrium if the quantity of money supplied equals the quantity of money demanded. This result is conve­nient because it means that in studying asset market equilibrium we have to look at only the supply and demand for money and can ignore nonmonetary assets. As long as the amounts of money supplied and demanded are equal, the entire asset market will be in equilibrium.

The Asset Market Equilibrium Condition

Equilibrium in the asset market occurs when the quantity of money supplied equals the quantity of money demanded. This condition is valid whether money supply and demand are expressed in nominal terms or real terms. We work with this condition in real terms, or

The left side of Eq. (7.9) is the nominal supply of money, M, divided by the price level, P, which is the supply of money measured in real terms. The right side of the equation is the same as the real demand for money, M^d∣P, as in Eq. (7.3). Equation (7.9), which states that the real quantity of money supplied equals the real quantity of money demanded, is called the asset market equilibrium condition.

The asset market equilibrium condition involves five variables: the nominal money supply, M; the price level, P; real income, Y; the real interest rate, r; and the expected rate of inflation, π^e.

In this part of the book we have made the assumption that the economy is at full employment or, equivalently, that all markets are in equilibrium. Both classical and Keynesian economists agree that the full-employment assumption is reason­able for analyzing the long-term behavior of the economy. If we continue to assume full employment,^[125] we can use the analysis from previous chapters to describe how output and the real interest rate are determined. Recall from Chapter 3 that, if the labor market is in equilibrium—with employment at its full-employment level— output equals full-employment output, Y. In Chapter 4 we showed that, for any level of output, the real interest rate in a closed economy must take the value that makes desired national saving and desired investment equal (the goods market equilibrium condition).

With the values of output and the real interest rate established (endogenously) by equilibrium in the labor and goods markets, the only variable left to be deter­mined by the asset market equilibrium condition is the price level, P. To empha­size that the price level is the variable determined by asset market equilibrium, we multiply both sides of Eq. (7.9) by P and divide both sides by real money demand, L (Y, r + π^e), to obtain

According to Eq. (7.10), the economy's price level, P, equals the ratio of the nominal money supply, M, to the real demand for money, L (Y, r + π^e).

What forces lead the price level to its equilibrium value shown in Eq. (7.10)? A complete description of how the price level adjusts to its equilibrium value involves an analysis of the goods market as well as the asset market; we leave this task until Chapter 9, where we discuss the links among the three main markets of the economy in more detail. Briefly, in Chapter 9 we show that an increase in the money supply leads people to increase their nominal spending on goods and services; this increased nominal demand for output leads prices to rise. Prices continue to rise until people are content to hold the increased nominal quantity of money in their portfolios, satisfying the asset market equilibrium condition (rewritten as Eq. 7.10).

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