Chapter 4: Financial Markets

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Transcript Chapter 4: Financial Markets

C H A P T E R

Financial Markets

Prepared by: Fernando Quijano and Yvonn Quijano And Modified by Gabriel Martinez

How Is the Interest Rate Determined in the Short Run?

 By the condition that the supply of money equals the demand for money.

– Here, there are only two assets: bonds and money.

– Here, nominal income and prices are given, so there is no need to consider simultaneous equilibrium of goods and financial markets.

 Investment is a function of the interest rate, so output is affected by the interest rate.

4-1 The Demand for Money



Money,

which can be used for transactions, pays no interest. There are two types of money:

currency

and

checkable deposits



Bonds,

pay a positive interest rate, cannot be used for transactions.

, but they  Wealth = Money + Bonds – How much of your saving should you hold as money? Depends on your level of

transactions

and the

interest rate on bonds

The Demand for Money



Transactions

Demand for Money – You need money (a financial asset that is an accepted medium of exchange) to buy goods and services on a day to day basis.

 Buying food, paying the rent, filling up the tank.

–

Higher prices

money.

increase the demand for – –

Higher income

money.



M d

directly income.

increases the demand for proportional to

nominal

The Demand for Money

 The

interest rate on bonds

– People prefer to hold liquid assets, i.e., means of exchange.

– To get them to hold bonds (which are not liquid), people must be paid interest.

– Money doesn’t pay interest.

– If the interest rate is high, the opportunity cost of holding money is higher.

– There’s an inverse relation

(

) between the holding of liquid assets and the interest rate.

Deriving the Demand for Money

M d

 $

(

)  The demand for money: – increases in proportion to

nominal income

, and – depends negatively on the interest rate:

(

Deriving the Demand for Money

The Demand for Money

 For a given level of nominal income ( 

for a given M

 right.

of money.

curve

), a lower interest rate increases the quantity demanded At a given interest rate, an increase in nominal income shifts the demand for money to the © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

4-2 The Determination of the Interest Rate, Part I

 In this section, we assume that people only hold money in the form of currency.

 Then only the central bank supplies money, in an amount equal to M, so

M s .

The Determination of the Interest Rate, Part I

 Equilibrium in financial markets requires that money supply be equal to money demand:

 $ ( )  This is the

LM relation.

Money Demand, Money Supply; and the Equilibrium Interest Rate

The Determination of the Interest Rate

The interest rate must be such that the supply of money (

which is independent of the interest rate

) be equal to the demand for money (

which does depend on the interest rate

Money Demand, Money Supply; and the Equilibrium Interest Rate

The Effects of an Increase in Nominal Income on the Interest Rate

An increase in nominal income $Y leads to an increase in the interest rate

Equivalently, if M/$Y

falls,

and i will rise.

The Demand for Money and the Interest Rate: The Evidence

 The interest rate and the ratio of money to nominal income typically move in opposite directions.

The Demand for Money and the Interest Rate: The Evidence

 There is a “secular trend” in M/$Y: it has been falling for a long time, so it’s not clear that interest rates are the cause.

– Is velocity high when the interest rate is low? Not necessarily.

Econometric point: “Detrending” time series that have a trend

The Demand for Money and the Interest Rate: The Evidence

  So, instead, we look at the relation between the

change

and the

change

in M/$Y.

Figure 2 shows that there’s an inverse relation between the

changes

: – If

rises, M/$Y falls.

– If

falls, M/$Y rises.

The Demand for Money and the Interest Rate: The Evidence

Changes in

versus changes in

M/Y

-0.30

-0.20

0.04

0.03

0.02

-0.10

0.01

0.00

-0.01

0.00

-0.02

-0.03

0.10

0.20

D i= - 0.0016 - 0.0403

D M/Y 0.30

-0.04

Change in M1/GDP Macroeconomics, 3/e Olivier Blanchard

M1 vs GDP, in changes -2% 6% 4% 2% 0% -1% -2% 0% -4% 1% 2% 3% M1 = 0.0083 + 0.2408GDP

4% 5% 6% 7% GDP This graph would seem to support the thesis that higher GDP growth leads to higher money demand, which the Central Bank (or the banks accommodate.

Monetary Policy and Open-Market Operations

The Effects of an Increase in the Money Supply on the Interest Rate

An increase in the supply of money leads to a decrease in the interest rate.

Monetary Policy and Open-Market Operations

Open-market operations

, which take place in the “open market” for bonds, are the standard method central banks use to change the money stock in modern economies.

Monetary Policy and Open-Market Operations

The Balance Sheet of the Central Bank and the Effects of an Expansionary Open Market Operation

The assets of the central bank are the bonds it holds. The main liability is the stock of currency in the economy. An open market operation in which the central bank buys bonds and issues currency increases both assets and liabilities by the same amount.

Monetary Policy and Open-Market Operations

 In an

expansionary open market operation

, the central bank buys $1 million worth of bonds, increasing the money supply by $1 million.

 In a

contractionary open market operation

, the central bank sells $1 million worth of bonds, decreasing the money supply by $1 million.

Monetary Policy and Open-Market Operations

 When the central bank buys bonds (and issues currency), the demand for bonds goes up: the price of bonds rises.

 There is an inverse relation between the price of bonds and the interest rate.

– See next slide, or take ECO 342.

 Therefore, an expansionary open market operation raises the demand for bonds and their price and lowers interest rates.

Monetary Policy and Open-Market Operations

 The inverse relation between prices of bonds and the interest rate: – Suppose you buy a US government bond (i.e., a debt of the US government) at $P B and hold it until the government pays you back the full amount (say, $100).

– Then your return is:

 $

P B P B

 $

P B

 $100 1 

What did I learn in this chapter?



Tools and Concepts

–

Stock versus flow variables; wealth (a stock) versus income (a flow).

– –

Monetary policy and open market operations. The use of balance sheets for the central bank and private banks.

–

Various terms and concepts associated with the banking system: currency, checkable deposits, reserves, central bank money (high powered money, the monetary base), the federal funds market and the federal funds rate, and the money multiplier.

Chapter 4: Financial Markets

Transcript Chapter 4: Financial Markets

Financial Markets

Deriving the Demand for Money

Deriving the Demand for Money

Money Demand, Money Supply; and the Equilibrium Interest Rate

Money Demand, Money Supply; and the Equilibrium Interest Rate

The Demand for Money and the Interest Rate: The Evidence

The Demand for Money and the Interest Rate: The Evidence

The Demand for Money and the Interest Rate: The Evidence

The Demand for Money and the Interest Rate: The Evidence

Monetary Policy and Open-Market Operations

Monetary Policy and Open-Market Operations

Monetary Policy and Open-Market Operations

Monetary Policy and Open-Market Operations

Monetary Policy and Open-Market Operations

Monetary Policy and Open-Market Operations

What did I learn in this chapter?

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