Domestic residents' stock of wealth is the aggregate stock
of assets they own---the sum total of their ownership of human
capital, physical capital, and real money balances. Often, of
course, a particular individual's ownership of these primary
assets is indirect. Instead of holding capital goods, she may
hold a bond, stock, or other piece of paper signifying an obligation
of the person or institution issuing the paper to redirect
income flows from directly held capital to the holder of that paper.
Individuals are free to adjust the mix of different types of
assets in their portfolios by exchanging assets for money. When
they have the desired mix of assets of various types in their
portfolios, they are in a situation of portfolio equilibrium.
Since human capital is typically embodied in its owner, it cannot
be bought and sold, apart from conditions where slavery is present.
Non-human assets, however, will be exchanged until portfolio
equilibrium occurs. At that point people will have the desired mix
of money and non-monetary assets in their portfolios.
Domestic residents are in asset or portfolio equilibrium when they have
no desire to exchange non-monetary assets for each other or for
money. It turns out that, given free exchange of non-human capital assets,
all that is necessary for this to happen is that the aggregate quantity
of money demanded equal the quantity in circulation. Given one's overall
level of wealth, which is fixed by previous decisions to save rather than
consume, a willingness to hold one's existing stock of money is equivalent
to a willingess to hold one's stock of non-monetary assets. An excess
demand for money must have as its counterpart an excess supply of
non-monetary assets and vice versa.
The condition of aggregate portfolio equilibrium is thus a
very simple one---that the demand for real money balances in the
economy equal the supply. Behind the scenes, of course, the existing
mix of non-monetary assets held must equal the mix that asset holders
desire to hold---such asset-mix issues stay in the background as long
as we think of non-monetary asset holdings as an aggregate quantity
and assume for analytical purposes that there is a single domestic
interest rate.
The supply of money in circulation is ultimately
determined by the government's monetary policy. The question then is:
What determines the demand for real money holdings? Since money is held
to facilitate making transactions, the amount of it demanded will clearly
depend on the volume of transactions being made which will, in turn,
depend on the level of income. We would expect that the higher the level
of income, the greater the real stock of money people and organizations will
choose to hold. Note that we refer here to real rather than nominal money
holdings. The reason is that the usefulness of any given stock of dollar
balances for making transactions will be less, the higher are the prices
that have to be paid to buy and sell the items being exchanged. So a rise
in the price level will reduce the usefulness of money in proportion---what
counts is the stock of money measured in units of output, not in dollars,
pounds, or whatever the currency unit is.
The quantity of real money holdings demanded will also depend on the cost
of holding money instead of other assets. If one has to give up a lot of
earnings from other assets to hold an additional unit of money, it will pay
to hold less real money balances and use a bit more labour and capital in
making transactions. The higher the interest rate on non-monetary assets,
therefore, the smaller will be the quantity of money demanded. To the
extent that one can earn interest on money by holding it as an interest-earning
savings deposit, this cost will be reduced. But interest is never earned on
pocket cash and rarely on chequing or savings account balances.
How can a transactor substitute labor and capital resources for money in
making transactions? Essentially by holding a smaller inventory of money
balances and running the risk of not having enough cash to pay bills.
A short-fall of cash generates interest costs of temporarily borrowing funds
and/or time and service costs of making phone calls, selling securities, and
transferring funds. If the interest foregone by holding cash is great enough,
it will be worth risking and bearing these transactions costs.
It should be noted here that it is the nominal interest rate on other assets,
not the real rate, that represents the cost of holding non-interest-bearing
money. The nominal interes rate, it will be recalled from the module entitled
Interest Rates and Asset Values, is equal to the real rate
of interest plus the expected rate of inflation. Since high inflation erodes
the real value of money holdings by reducing the amount of goods those money
balances will buy in the future, the expected rate of inflation must be added
to the real interest rate that can be earned on non-monetary assets in
calculating the cost of holding money.
The demand for money can thus be expressed as
1. (M/P)d =
γ − θ i + εY
where M is the nominal money stock, (M/P)d
is desired real money holdings, i is the nominal
interest rate and Y is the level of output and income produced
by domestically employed resources. An increase in the level of income
or a reduction in the nominal interest rate increases the real quantity of
money demanded. A fall in the nominal interest rate can occur through a fall
in the world real interest rate or a fall in the expected rate of domestic
inflation.
Aggregate domestic asset or portfolio equilibrium occurs when
2. M/P
= (M/P)d
so the condition of stock or asset equilibrium becomes
3. M/P =
γ − θ ( r*
+ τ ) + ε Y
where r* is the real domestic interest rate determined
by conditions in the world capital market, the risk of holding domestic assets
and the expected appreciation of those assets resulting from any expected
appreciation of the domestic real exchange rate, and τ is the
expected rate of domestic inflation.
This condition must be combined with the condition of flow or
real goods market equilibrium outlined in the previous topic to
obtain the overall equilibrium of the small open economy. The
condition of real goods market equilibrium is reproduced here as
Equation 4.
4. Y
= ( a + δ
+ ΦBT + DSB)/(s + m)
− μ/(s + m) r*
+ m* /(s + m) Y*
− σ/(s + m) Q
where it will be recalled that s and m are the domestic
marginal propensities to save and import and Q is the domestic
real exchange rate. The domestic nominal interest rate is given by conditions
in the world as a whole together with past movements in the relevant domestic
variables. And income will be fixed at its full-employment level when the the
domestic resources are fully employed with the price level being fixed when
there is less than full employment. Accordingly, when the nominal exchange rate
is flexible the above two equations must be solved simultaneously to produce the
equilibrium levels of the endogenous variables Y and Q
under less-than-full-employment conditions and P and Q
under conditions of full employment.
The natural way to understand this equilibrium is to put
the two equations on a diagram as separate curves and find the
spot where they cross. But what variables should we put on the
two axes? We portrayed income-expenditure equilibrium in the previous lesson,
The Balance of Payments and the Exchange Rate,
by putting the real exchange rate or income on one axis and the real
current account balance (net lending) on the other. And in the previous topic
of this current lesson we portrayed income-expenditure equilibrium it by
putting desired expenditure on the vertical axis and income on the horizontal
one. Unfortunately, neither of these graphings can be usefully extended to
incorporate asset equilibrium. This leads directly to our next topic.
It is time for a test. Make sure you have thought up your own answers before
looking at the ones provided.
We now turn to the second condition of small open economy
equilibrium---that desired holdings of assets equal actual holdings.
Domestic output is a flow of returns from the domestically employed
human and physical capital stock. Ownership of this capital stock
represents rights to receive the income flows from it---such ownership
claims are called assets. Another asset present in the economy is
the real stock of money. The income flow from money is the additional
amounts of consumption and investment goods that can be produced
because human and physical capital resources do not have to be
tied up making transactions that can be more cheaply made by
simply exchanging money.