ECON – Speak Financial Markets Income: A flow of compensation over time Wealth: A stock of assets at a given time: Financial Assets minus Financial Liabilities Money: A financial asset (a stock variable) used for transactions. Money equals Currency plus Checkable Deposits Investment: The purchase of new capital goods

The Demand for Money Money: Used for transactions (currency and checkable deposits) Bonds: Cannot be used for transactions and pays a positive interest rate (i) Two financial assets to choose from The demand for money (M d ) depends on: The level of transactions, proportional to nominal income ($Y)The level of transactions, proportional to nominal income ($Y) The interest rate on bonds (i)The interest rate on bonds (i)

The Demand for Money Demand for money M d = $YL(i) (-) M d = $YL(i) (-) The liquidity demand for Money, a function of i Nominal income (-) M d is inversely related to i

M d ($Y) The Demand for Money Money, M Interest Rate, i M i a c M1M1 i1i1 b i2i2 M d and i are inversely related Given $Y at i, M = M (P*, A) i 2, M = M 2 i 1, M = M 1 M2M2

M d (for $Y´ > $Y) M d (for nominal Income $Y) The Demand for Money Money, M Interest Rate, i M i M´ Graphically M d = $YL (i)

The Demand for Money

Money Demand and the Interest Rate: The Evidence Observations Negative relation between

The LM relation: M d = $YL(i) = M s Demand for Liquidity = Supply of Money Money Demand, Money Supply & the Equilibrium Interest Rate

M d ($Y) The Determination of the Interest Rates Money, M Interest Rate, i M MsMs i1i1 Equilibrium interest, I, M d = M S A The Equilibrium Graphically

M d ($Y) M d´ ($Y´ > $Y) Increase $Y to $Y´ M d increases to M d ´ M MsMs Money, M Interest Rate, i i1i1 A The effects of an increase in National Income on i A´ i2i2 Equilibrium moves from A to A´ i increases from i 1 to i 2

M d ($Y) The effects of an increase in the Money Supply on i Money, M Interest Rate, i MsMs M i1i1 A M s´ Increase M s to M s ´ M´ Equilibrium moves from A to A´ A´ i2i2 Interest rate falls from i 1 to i 2

Summary: i is determined by M D & M S Central bank changes i by changing M S Central bank changes M S with open market operations Buying bonds increases the M S and reduces i Selling bonds decreases the M S and increases i The Determination of the Interest Rates

Banks/Depository Institutions Reserves Loans Bonds Assets Bonds Assets Checkable deposits Liabilities Central Bank Money =Reserves +Currency Liabilities Central Banks

high-powered Supply and demand for central bank high-powered money H = Currency + Bank Reserves c = fraction of money public holds in currency (1-c) = fraction of money public holds in checkable deposits at banks Θ = fraction of deposits banks hold in reserves (vault cash + deposits at central bank) high-powered Supply and demand for central bank high-powered money H = Currency + Bank Reserves c = fraction of money public holds in currency (1-c) = fraction of money public holds in checkable deposits at banks Θ = fraction of deposits banks hold in reserves (vault cash + deposits at central bank) Public’s Demand for Money, M d Money, M d Demand for checkable deposits D d = (1 – c)M d Demand for Central Bank Money H d = CU d + R d Demand for currency CU d = cM d Supply of Central Bank Money H s = Demand for Reserves, R d (by banks) R d = Θ D d

If people hold deposits of D d, banks hold reserves of  D d Demand for central bank high-powered money H d = CU d + R d H d = CU d + R d H d = cM d + R d = cM d + ΘD d = cM d + Θ(1-c)M d H d = [c + Θ(1-c)] M d

Supply of Central Bank Money = Demand for Central Bank Money In equilibrium And, of course, Demand for Money = Supply of Money  Money Market Equilibrium = money multiplier

The supply of money depends on H s, controlled by central bank c, controlled by the public Θ, controlled by banks (central bank may set minimum) The supply of money depends on H s, controlled by central bank c, controlled by the public Θ, controlled by banks (central bank may set minimum) Recall: Therefore: Supply of Money = Demand for Money Therefore: Money market equilibrium: For given M s, $Y and i have to adjust so no more or less money is demanded than is supplied.

Monetary Policy and Open Market Operations The Price of Bonds and the Interest Rate Calculating the price of a bond-- Assume a bond with a $100 value in one year How does M s change? The price of a bond and the interest rate are inversely related. The price of a bond and the interest rate are inversely related.

The supply and demand for reserves The Federal Funds Market: The market for bank reserves The Federal Funds Rate: The interest rate that equates the supply of Reserves (H s - CU d ) with demand for reserves (R d ) When the Fed steps into the open market for government bonds and buys bonds –It bids up the price of bonds: P B  i –It increases its bond holding (assets) and hence H s –Bank reserves increase, reducing the fed funds rate.