Macroeconomics Prof. Juan Gabriel Rodríguez Chapter 3 The Financial Market

Question How is the interest rate determined in the short run? The interest rate is determined by equilibrium in the money market, i.e., by the condition that money supply equals money demand. Investment is a function of the interest rate, so output is affected by the interest rate. [N ominal income is taken as given, so there is no need to consider simultaneous equilibrium of goods and financial markets.]

FINANCIAL ASSETS Main characteristics: – EXPECTED RETURN: The larger, the better – RISK: Riskier assets must have a higher expected return – LIQUIDITY: The easier to exchange, the more attractive Functions of Money - MEDIUM OF EXCHANGE: Trade at less cost - UNIT OF ACCOUNT: Needs price stability - STORE OF VALUE: Way of storing wealth

The Demand for Money  Money (use for transactions) pays no interest. Types of money:  Currency: coins and bills (banknotes)  Checkable deposits: the bank deposits on which you can write checks.  Bonds pay a positive nominal interest rate, i, but they cannot be used for transactions. The proportions of money and bonds you wish to hold depend mainly on two variables:  Your level of transactions  The interest rate on bonds

The Demand for Money The demand for money: – increases in proportion to nominal income (€Y) – depends negatively on the interest rate Money market funds pool together the funds of many people. The funds are then used to buy bonds—typically government bonds. The demand for money,, is equal to nominal income, €Y, times a function L of the interest rate, i: €

The Demand for Money For a given level of nominal income, a lower interest rate increases the demand for money. At a given interest rate, an increase in nominal income shifts the demand for money to the right. M (Money) I (Interest rate) i M d (€Y) MM’ M d’ (€Y’)

According to household surveys, in 2006, U.S. household held in total $170 billion in currency. However, the Federal Reserve Board knows the amount of currency in circulation was much higher, $750 billion. Taking into consideration that some currency was held by firms and some was held by those involved in the underground economy (or in illegal activities) leaves 66% of the total unaccounted for… The fact that foreigners hold such a high proportion of the dollar bills in circulation (see the cases of Argentina and Russia! ) has two main macroeconomic implications. - The rest of the world, by being willing to hold U.S. currency, is making in effect an interest-free loan to the United States of $500 billion. - U.S. money demand depends not only on the interest rate and the level of transactions but also on other factors…International insecurity… The Dollar as the World’s reserve currency

The Determination of the Interest Rate Equilibrium in financial markets requires that money supply be equal to money demand, or that M s = M d. The equilibrium condition is: This equilibrium relation is called the LM relation. €

The Determination of the Interest Rate In equilibrium, the interest rate must be such that the supply of money (which is independent of the interest rate -it is exogenous) is equal to the demand for money (which does depend on the interest rate -it is endogenous). M (Money) I (Interest rate) i M d (€Y) M MsMs

The Determination of the Interest Rate An increase in nominal income leads to an increase in the interest rate. M I i M d (€Y) M MsMs i’ M d’ (€Y’) An increase in the supply of money leads to …

The Determination of the Interest Rate Open-market operations They take place in the “open market” for bonds and are the standard method central banks use to change the money stock. If the central bank buys bonds, this operation is called an expansionary open market operation because the central bank increases (expands) the supply of money. If the central bank sells bonds, this operation is called a contractionary open market operation because the central bank decreases (contracts) the supply of money.

The Determination of the Interest Rate The relationship between the interest rate and bond prices: – Treasury bonds are issued by the government promising payment in a year or less. If you buy the bond today and hold it for a year, the rate of return (or interest) on holding a €100 bond for a year is (€100 - €P B )/ €P B. – If we are given the interest rate, we can figure out the price of the bond using the same formula.

The Determination of the Interest Rate The central bank changes the supply of money through open market operations, which are purchases or sales of bonds for money: – Open market operations in which the central bank increases the money supply by buying bonds lead to an increase in the price of bonds and a decrease in the interest rate. – Open market operations in which the central bank decreases the money supply by selling bonds lead to a decrease in the price of bonds and an increase in the interest rate.

So far only two assets: money and bonds. This is a much simplified version of actual economies, with their many financial assets and many financial markets. Nevertheless, we will consider only the money market because of the Walras Law: Money Market Equilibrium implies Bond Market Equilibrium The Determination of the Interest Rate

N MARKETS N-1 in equilibrium IMPLIES N in equilibrium Supply Value equals Demand Value: But money is not only currency…

FINANCIAL INTERMEDIARIES BORROWERS FIRMS HOUSEHOLDS PUBLIC SECTOR COMMERCIAL BANKS SAVERS FIRMS AND PEOPLE INSURANCE COMPANIES PENSION FUNDS Receive Funds Make Loans

The Determination of Interest Rate Financial intermediaries are institutions that receive funds from people and firms, and use these funds to buy bonds or stocks, or to make loans to other people and firms. ■ Banks receive funds from people and firms who either deposit funds directly or have funds sent to their checking accounts. The liabilities of the banks are therefore equal to the value of these checkable deposits. ■ Banks keep as reserves some of the funds they receive.

Banks hold reserves for three reasons: 1.On any given day, some depositors withdraw cash from their checking accounts, while others deposit cash into their accounts. 2.In the same way, on any given day, people with accounts at the bank write checks to people with accounts at other banks, and people with accounts at other banks write checks to people with accounts at the bank. 3.Banks are subject to reserve requirements. The actual reserve ratio – the ratio of bank reserves to bank checkable deposits – is about 2% in the European Union today. The Determination of Interest Rate

Bank Runs Rumors that a bank is not doing well (loans are not repaid) will lead people to close their accounts at that bank. If enough people do so, the bank will run out of reserves—a bank run. To avoid bank runs, the governments provide deposit insurances. An alternative solution is narrow banking, which would restrict banks to holding liquid, safe, government bonds.

The Determination of Interest Rate Loans represent roughly 70% of banks’ non-reserve assets. Bonds count for the rest, 30%. The assets of the central bank are the bonds it holds. The liabilities of the central bank are the money it has issued, central bank money. The new feature is that not all of central bank money is held as currency by the public. Some of it is held as reserves by banks.

The Determination of Interest Rate

Let’s think in terms of the supply and the demand for central bank money. ■ The demand for central bank money is equal to the demand for currency by people plus the demand for reserves by banks. ■ The supply of central bank money is under the direct control of the central bank. ■ The equilibrium interest rate is such that the demand and the supply for central bank money are equal.

The Determination of Interest Rate

The demand for money involves two decisions: - People must decide how much money to hold. - They must decide how much of this money to hold in currency and how much to hold in checkable deposits. The demands for currency and checkable deposits are given by: Assuming that overall money demand is given by the same equation as before:

The Determination of Interest Rate The larger the amount of checkable deposits, the larger the amount of reserves the banks must hold, for both precautionary and regulatory reasons. The relation between reserves (R) and deposits (D): Therefore, the demand for reserves by banks is given by:

The Determination of Interest Rate The demand for central bank money is equal to the sum of the demand for currency and the demand for reserves: Hence, That is: H: Monetary Base

The Determination of the Interest Rate M (Money) I (Interest rate) i H d =CU d +R d H Supply of Central Bank Money The equilibrium interest rate is such that the supply of central bank money is equal to the demand for central bank money.

Other alternative interpretations The supply and the demand for bank reserves are equal in equilibrium: ■ The overall supply of money is equal to central bank money times the money multiplier: ■ High-powered money: the overall supply of money depends in the end on the monetary base or amount of central bank money (H).

STEP BY STEP MONEY CREATION cH(1-c)H  (1-c)H pH cpH(1-c)pH  (1-c)pH p2Hp2H cp 2 H(1-c)p 2 H  (1-c)p 2 H p3Hp3H Currency Deposits Reserves Loans ¿p?

Money Multiplier We have the sum of a geometric series: In equilibrium: What are the limits of the Multiplier w.r.t. c and  ?

Other alternative interpretations We can also think of the ultimate increase in the money supply as the result of successive rounds of purchases of bonds—the first started by the Central Bank in its open market operation, the following rounds by banks. Equilibrium in real terms?

The Determination of Interest Rate Excess supply M = Excess demand B Price increase and interest rate decrease Excess demand M = Excess supply B Price decrease. Interest rate increase i L M/P Y·L(i) E i is the bonds yield i is the money opportunity cost

Leverage Example: AssetsLiabilitiesCapitalLeverage Bank Bank What happens if the value of the assets falls from 100 to 80? Bank 2 becomes insolvent: it is bankrupt! A high leverage ratio is risky

Leverage Nevertheless, banks like having a high leverage ratio: Assets yield a return of 10%. Therefore, Bank 1: return on its capital of 50% (10/20) Bank 2: return on its capital of 200% (10/5) As long as house prices were rising, by keeping their leverage high banks could earn huge profits and none failed. When this honeymoon came to an end, many banks were bankrupt. Why the US government did not intervene, imposing a limit on leverage? - Widening the number of US citizens who own a home was a political objective - Bankers often translated into campaign contributions to politicians who then lobbied for lax rules on leverage.

Leverage Over time the situation of banks spread to other financial institutions like insurance companies…a huge volume of risky investments were held on a tiny pedestal of capital. When the value of their assets fell, some banks with high leverage went bust, which stopped lending.The rest of banks had used almost all their capital, alive but weak. To strength their position: - Raise more capital, but a crisis is not a good time to … - Reduce the amount of loans they were holding - Sell liquid assets (mostly stocks) Credit Freeze (any investment?) Fire sale in the stock market (lower value of household wealth….consumption!)