The Central Bank and the money market equilibrium The role of central banks The money market equilibrium

The Central bank and the Money market Last we clarified the nature and functions of money in an economy Classical functions related to exchange Keynesian functions related to liquidity and uncertainty As a result, there is a demand for money from agents, and a supply of money from the banking system. This week we examine how these balance out, including the role of the central bank

The Central bank and the Money market The link between asset markets and money markets Central bank intervention on the financial markets Equilibrium in the money market

Asset markets and money markets The first aspect is to clarify the linkage between the money market and the market for assets. Agents spread their wealth spread over assets and money (liquidity) Assets earn a return, but cannot be exchanged easily Money can be exchanged freely (liquidity) but earns no return To simplify the picture we will assume there is only a single kind of asset: bonds

Asset markets and money markets The agent therefore allocates his wealth over bonds and money Equilibrium on both financial markets requires: Both equilibria are simultaneous, because of the inverse price/interest relationship on the bond market.

Asset markets and money markets Importantly: the return of a bond is a “coupon”, i.e. A fixed pre-agreed nominal amount, which is a given % of the original issue price When you buy the same bond on the market, the rate of return of the bond (its interest rate) is

Asset markets and money markets Imagine that when the bond was issued, the rate of interest rate was 5%. A bit later, interest rates are lowered to 2.5%, so new bonds are issued with a smaller coupon. What happens to the value of my 5% bond with respect to the value of newer bonds? My bond is more valuable, because its coupon is larger ! The price of my bond increase until the effective rate of return of the coupon is 2.5% (the price will double)

Asset markets and money markets The inverse relation between bond prices and interest rates is crucial: Money has no intrinsic “price” It only has an opportunity cost (the interest rate) This means that intervention in one market will have effects on the other market through the joint determination So equilibrium in the money market means equilibrium on the bonds market

Asset markets and money markets Just a quick annex on the fisher equation Gives the difference between nominal and real rates of return in the presence of inflation Imagine you have a bond that nominally pays 15% per year : Is this a large amount? That depends on the level of inflation ! The fisher equation says that This is an approximation, valid for low inflation

The Central bank and the Money market The link between asset markets and money markets Central bank intervention on the financial markets Equilibrium in the money market

Central Bank Intervention It is important to distinguish between two different policy-issues: Objectives What is the goal of the central bank in its intervention? What is the central bank trying to achieve? Often these are either determined by law or by the statutes of the institution Instruments How does the central bank achieve its objectives?

Central Bank Intervention Central bank objectives: ECB: The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community. FED: The Federal Reserve’s duties is to conduct the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.

Central Bank Intervention How does a central bank intervene? 1: Changing the reserve ratio Remember that the (simplified) multiplier between money base (controlled by the CB) and the money supplied by banks is Changing the multiplier therefore changes the amount of money supplied in the economy

Central Bank Intervention How does a central bank intervene? 1: Changing the reserve ratio This policy is not used, however. It is not subtle: even small changes in the reserve ratio bring large changes in money supply It would force banks to review constantly the structure of their assets (costly) Most of these “prudential ratios” are agreed internationally, so they are difficult to change

Central Bank Intervention How does a central bank intervene? 2: Changing the Repo rate Is what happens when the bank “change the interest rates” The “repo” rate is the interest rate at which the central bank lends to regular banks on the interbank market The central bank makes it more or less expensive to borrow monetary base, giving more or less of an incentive to keep excess reserves in the bank.

Central Bank Intervention How does a central bank intervene? 2: Changing the Repo rate It is important to understand that the central bank doesn’t control all the interest rates ! Typically, banks then carry the rate forwards to customers, so all interest rates will follow the repo rate However, most of the time the rates follow the repo, but not always...

Central Bank Intervention How does a central bank intervene? 2: Changing the Repo rate

Central Bank Intervention How does a central bank intervene? 3: Open market operations The central banks intervene directly into the interbank market to by buying or selling bonds to increase or reduce the amount of base money available Example: when the Central Banks intervened to inject liquidities after the subprime bubble burst. This is a policy commonly used for changing interest rates other than the repo

Central Bank Intervention How does a central bank intervene? 3: Open market operations If the CB buys bonds (against money) then there is excess money supply, and excess bond demand. The price of bonds increases, reducing the excess bond demand This reduces interest rates (inverse relation), which increases demand for money, correcting the excess supply of money.

Central Bank Intervention How does a central bank intervene? 3: Open market operations If the CB sells bonds (reducing money) then there is excess bond supply, and excess money demand The price of bonds falls, increasing demand for bonds, correcting the excess bond supply This increases interest rates (inverse relation), which reduces the excess demand for money.

Central Bank Intervention Importantly: in real life, a central bank’s control of money supply is not precise. Money is ultimately supplied by banks, which have motivations of their own. The bank has strong influence, but it isn’t perfect Likewise, its control of interest rates is not precise The bank only controls directly the repo rate. Other rates can be modified by open market operations, but again, the CB does not set them.

The Central bank and the Money market The link between asset markets and money markets Central bank intervention on the financial markets Equilibrium in the money market

Equilibrium in the money market Given all this, how do we model equilibrium in the financial markets ? Wealth is spread over several markets: agents want to hold money, but they also want assets. What about the other financial markets? A change in interest rates/money supply doesn’t just affect the money market, it also changes the bond/money balance that agents hold Asset markets are therefore affected too!

Equilibrium in the money market Given all this, how do we model equilibrium in the financial markets ? We use equilibrium in the money market: Money supply = money demand The inverse relation between asset prices and the interest rate means that adjustment in one market brings adjustments in the other Therefore we only need to look at the money market equilibrium to describe equilibrium on the other financial markets

Equilibrium in the money market Money supply We assume that money supply Ms is set exogenously by the central bank This is a convenient simplification Money demand We use the demand for liquidity function we derived last week

Equilibrium in the money market Demand for Real Money Balances is a negative function of interest rates Below a certain interest rate, the opportunity cost of holding money is low enough that agents will not want to hold assets, and will demand only money Liquidity trap M

Equilibrium in the money market Demand for Real Money Balances is a positive function of output A higher level of output increases money demand all other things constant, as agents require more money for transaction and precaution purposes Liquidity trap M

Equilibrium in the money market Money supply is exogenous The market equilibrium occurs at the level of interest of which money supply is equal to money demand i* Liquidity trap M* M

Equilibrium in the money market An increase in money supply reduces interest rates There is excess money supply, which agents will want to convert into asset holdings. This increases the price of bonds, and reduces the rate of interest. The opportunity cost of holding money falls, and money demand increases i* i*2 Liquidity trap M* M*2 M

Equilibrium in the money market An increase in output increases interest rates Because the increased output increases money demand, interest rates have to increase to compensate and keep the money demand equal to the fixed money supply i*2 i* Liquidity trap M* M