CHAPTER SUMMARY

1. Money is the set of assets that are widely used and accepted as payment, such as currency and checking accounts. Money functions as a medium of exchange, a unit of account, and a store of value.

2. The supply of money is set by the central bank—the Federal Reserve System in the United States. The cen­tral bank's official measures of money are called the monetary aggregates. M1 is made up primarily of currency and checking accounts and M2 includes a broader set of monetary assets.

3. A portfolio allocation decision is made by a holder of wealth when determining how much of each asset to hold. The characteristics of assets that most affect their desirability are expected return, risk, liquidity, and, for financial securities, time to maturity. The major assets that people hold are money, bonds, stocks, houses, and consumer durable goods.

4. Money demand is the total amount of money that peo­ple choose to hold in their portfolios. The principal macroeconomic variables that affect money demand are the price level, real income, and interest rates. Nominal money demand is proportional to the price level. Higher real income increases the number of trans­actions and thus raises real money demand. A higher interest rate on alternative, nonmonetary assets lowers real money demand by making the alternative assets more attractive relative to money. The money demand function measures the relationship between real money demand and these macroeconomic variables.

5. Velocity is the ratio of nominal GDP to the nominal money stock. The quantity theory of money is an early theory of money demand based on the assump­tion that velocity is constant, so that money demand is proportional to income. Historically, M2 velocity has been more stable than M1 velocity, although even M2 velocity isn't constant.

6. Under the simplifying assumption that assets can be grouped into two categories—money and nonmone­tary assets—the asset market is in equilibrium if the quantity of money supplied equals the quantity of money demanded. When all markets are in equilib­rium (the economy is at full employment), the level of output is determined by equilibrium in the labor market, the real interest rate is determined by equi­librium in the goods market, and the price level is determined by equilibrium in the asset market. The equilibrium price level is proportional to the nominal money supply.

7. The inflation rate equals the growth rate of the nominal money supply minus the growth rate of real money demand. The growth rate of real money demand in turn depends primarily on the real income growth rate. Expected inflation depends on expected growth rates of the nominal money supply and real income. For a given real interest rate, the nominal interest rate responds one-for-one to changes in expected inflation.

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