Financial MarketsFinancial MarketsIncome: A flow of compensation per unit of time

Wealth: A stock variable at a given point in time. Equal to financial assets minus financial liabilities

Money: A stock variable equal to financial assets used for transactions. Is equal to currency plus checkable deposits

Investment: The purchase of new capital goods

The Demand for MoneyThe Demand for Money

Money: Used for transactions (currency and checkable deposits)

Bonds: Cannot be used for transactions and pays a positive interest rate (i)

A Scenario…A Scenario…

Two financial assets to choose from

The Demand for MoneyThe Demand for MoneyA Summary:A Summary:

The demand for money (Md) depends on:

•The level of transactions which are proportional to nominal income ($Y)

•The interest rate on bonds

The Demand for MoneyThe Demand for Money

dM Demand for money

Md = $YL(i) (-)

Md = $YL(i) (-)

Y$The liquidity demand forMoney is a function of i

)(iLNominal income

(-) Md is inversely related to i

Md (for $Y´ > $Y)Md

(for nominalIncome $Y)

The Demand for MoneyThe Demand for Money

Money, M

Inte

rest

Rat

e, i

M

i

M´

Graphically Md = $YL (i)

Md ($Y)

The Demand for MoneyThe Demand for Money

Money, M

Inte

rest

Rat

e, i

M

ia

c

M1

i1

bi2

• Md and i are inversely related• Given $Y at i, M = M (P*, A)

i2, M = M2

i1, M = M1

M2

The Demand for MoneyThe Demand for Money

Money, M

Inte

rest

Rat

e, i

Md

($Y)

M M´

i

Graphically Md = $YL (i)

Md´

($Y´ > $Y)

a b

• Increase $Y to $Y´; Md shifts to Md´• M increases from M to M´ (a to b)

The Demand for MoneyThe Demand for Money

The Demand for MoneyThe Demand for MoneyMoney Demand and the Interest Rate: The EvidenceMoney Demand and the Interest Rate: The Evidence

ObservationsObservations

Negative relation between iY

M&

$

Assume: • All money (M) is currency, supplied by the central bank

• Financial Market Equilibrium Occurswhen:Money Supply = Money Demand

M = $YL(i)

Money Demand, Money Supply & the Equilibrium InterestRateMoney Demand, Money Supply & the Equilibrium InterestRate

The Determination of the Interest Rates: IThe Determination of the Interest Rates: I

•The LM relation: M = $YL(i)

•The demand for Liquidity (L) = Supply of Money

The Determination of the Interest Rates: IThe Determination of the Interest Rates: IMoney Demand, Money Supply & the Equilibrium InterestRateMoney Demand, Money Supply & the Equilibrium InterestRate

Md ($Y)

The Determination of the Interest Rates: IThe Determination of the Interest Rates: I

Money, M

Inte

rest

Rat

e, i

M

Ms

i1Equilibrium interest, I, Md = MS

A

The Equilibrium Graphically

Md ($Y)

Md´ ($Y´ > $Y)

• Increase $Y to $Y´ • Md increases to Md´

M

Ms

The Determination of the Interest Rates: IThe Determination of the Interest Rates: I

Money, M

Inte

rest

Rat

e, i

i1A

The effects of an increase in National Income on i

A´i2• Equilibrium moves from A to A´

• i increases from i1 to i2

Md ($Y)

The Determination of the Interest Rates: IThe Determination of the Interest Rates: IThe effects of an increase in the Money Supply on i

Money, M

Inte

rest

Rat

e, i

Ms

M

i1

A

Ms´

• Increase Ms to Ms´

M´

• Equilibrium moves from A to A´

A´i2

• Interest rate falls from i1 to i2

Monetary Policy and Open Market OperationsMonetary Policy and Open Market Operations

The Price of Bonds and the Interest RateThe Price of Bonds and the Interest Rate

Calculating the price of a bond--

Assume a bond with a $100 value in one year

iPB

1

100$

95053.1

100$3.5

BPi

90111.1

100$1.11

BPi

The Determination of the Interest Rates: IThe Determination of the Interest Rates: I

The price of a bond andthe interest rate are

inversely related.

The price of a bond andthe interest rate are

inversely related.

Monetary Policy and Open Market OperationsMonetary Policy and Open Market Operations

Observation!Observation!

The Determination of the Interest Rates: IThe Determination of the Interest Rates: I

A Summary:A Summary:

• i is determined by MD & MS

• Central bank changes i by changing MS

• Central bank changes MS with open market operations

• Buying bonds increases the MS and reduces i

• Selling bonds decreases the MS and increases i

The Determination of the Interest Rates: IThe Determination of the Interest Rates: I

The Determination of the Interest Rates: IIThe Determination of the Interest Rates: IIInterest rates in an economy with currency and checkable depositsInterest rates in an economy with currency and checkable deposits

What banks do:What banks do:

Banks

ReservesLoansBonds

Assets

Bonds

Assets

Checkable deposits

Liabilities

Central Bank Money=Reserves+Currency

LiabilitiesCentral Banks

The supply and demand for central bank moneyThe supply and demand for central bank money

The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II

Demand for money

Demand forcheckabledeposits

Demand for Central Bank

MoneyDemand for

currency

Supply of Central Bank

Money=

Demand for reserves

(by banks)

The demand for moneyThe demand for money

The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II

Assume: Assume:

The demand for currency is: CUd

The demand for checkable deposits is: Dd

CUd = cMd: Demand for currency (Central Bank Money)

Dd = (1-c)Md: Demand for Reserves (Central Bank Money)

CUd = cMd: Demand for currency (Central Bank Money)

Dd = (1-c)Md: Demand for Reserves (Central Bank Money)

The demand for reservesThe demand for reserves

The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II

Assume: Assume:

: Represents the reserve ratio (reserves to checkable deposits)

R: Represents the dollar amount of reserves

D: Represents the dollar amount of checkable deposits

Therefore: Therefore:

)1.0%10:( orUSDR

The demand for reservesThe demand for reserves

The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II

If people hold deposits of Dd, then banks must holdreserves (R) of Dd. If people hold deposits of Dd, then banks must holdreserves (R) of Dd.

dd

dd

d

McR

McD

DR

)1(

)1(

The demand for reservesThe demand for reserves

The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II

The Equilibrium The Equilibrium

MoneyBankCentralofSupply:H

moneyfor Demand :Dd RCU

:dd RCUH Equilibrium (Supply of Money = Demand for Money)

The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II

Supply of Central Bank Money = Demand for Central Bank Money

)($)1( iLYccH Assume: People only hold currency: C=1

)($)($11(1 iLYiLYH

Banks do not impact the money supply.

The supply and demand for moneyThe supply and demand for money

The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II

)($)1( iLYccH Recall:Recall:

Therefore:Therefore: Supply of Money = Demand for Money

)($)1(

1iYLH

cC

The supply and demand for moneyThe supply and demand for money

The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II

Observations:Observations:

MultiplierMoney )1(

1

CC•The supply of money is a multiple of theCentral Bank money.•Central Bank money (monetary base) is High-powered money (H)

The supply and demand for reservesThe supply and demand for reserves

The Determination of the Interest Rates: II

• The Federal Funds Market: The market for bank reserves

• The Federal Funds Rate: The interest rate that equates the supply of Reserves (H-Cud) with demand for reserves (Rd)

• Increases in Central Bank money (Fed buys bonds) decrease the interest rate

• Decreases in Central Bank money (Fed sells bond) increase the interest rate

The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II

A Summary:A Summary: