Financial Markets Chapter 4

© 2013 Pearson Education, Inc. All rights reserved The Demand for Money Suppose the financial markets include only two assets: 1.Money: used to purchase goods and services and pays no interest. 2.Bonds: cannot be used for transactions, but pay a positive interest rate i. Financial wealth equals the sum of money and bonds. Financial wealth is a stock variable, i.e., a variable whose value can be measured at any point in time. Saving is a flow variable, i.e., a variable whose value is meaningful only when expressed in terms of a time period.

© 2013 Pearson Education, Inc. All rights reserved The Demand for Money Money is needed for transactions. Assume that the level of transactions is proportional to nominal income, denoted $Y. Allocating wealth to money comes at the cost of forgone interest where the function L decreases as the interest rate increases.

© 2013 Pearson Education, Inc. All rights reserved The Demand for Money Figure 4-1 The Demand for Money The lower the interest rate, the higher the amount of money people want to hold. For a given interest rate, an increase in nominal income increases the demand for money.

© 2013 Pearson Education, Inc. All rights reserved Determining the Interest Rate: I Assume all money is currency, so there are no checking accounts or banks. Consider the supply of money to be fully in the control of the central bank. Take nominal income as given. Then, equilibrium in the money market occurs when the supply of money (M) equals the demand for money (M d ) given in equation (4.1).

© 2013 Pearson Education, Inc. All rights reserved Determining the Interest Rate: I Figure 4-2 The Determination of the Interest Rate The money supply is equal to M and is independent of the interest rate. Equilibrium occurs at point A, and the equilibrium interest rate is i.

© 2013 Pearson Education, Inc. All rights reserved Determining the Interest Rate: I Figure 4-3 The Effects of an Increase in Nominal Income on the Interest Rate An increase in nominal income leads to an increase in i. The reason: At the initial interest rate, the demand for money exceeds money supply. A rise in i is needed to decrease money demand and reestablish equilibrium.

© 2013 Pearson Education, Inc. All rights reserved Determining the Interest Rate: I Figure 4-4 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. The Reason: At the initial interest rate, the supply of money exceeds money demand. A fall in i is needed to make money more attactive relative to bonds.

© 2013 Pearson Education, Inc. All rights reserved Determining the Interest Rate: I Figure 4-5 The Balance Sheet of the Central Bank and the Effects of an Expansionary Open Market Operation

© 2013 Pearson Education, Inc. All rights reserved.4-10 Monetary Policy and Open Market Operations Central banks change the supply of money by buying and selling bonds in the bond market. These actions are called open market operations. To increase the money supply, the central bank creates currency to purchase bonds, thus increasing assets (through the additional bonds) and liabilities through the new currency created and exchanged for bonds To reduce the money supply, the central bank sells bonds for existing currency, thus reducing assets (through the sale of bonds) and liabilities (through the reduction of currency held by the general public).

© 2013 Pearson Education, Inc. All rights reserved.4-11 Bond Prices and Bond Yields Suppose a bond promises a payment of $F one year in the future. Call the current price of the bond $P B. Then, the interest rate (or rate of return) on this bond is given by i=($F-$P B )/$P B. If F=$100 and P B =$95, i=5.3% If F=$100 and P B =$90, i=11.1% The higher the price of the bond, the lower the interest rate.

© 2013 Pearson Education, Inc. All rights reserved.4-12 Bond Prices and Bond Yields Price of the bond is given by $P B =$F/(1+i). If the interest rate is positive, price of the bond is less than the final payment. The higher the interest rate, the lower the price of the bond today. When the central bank purchases bonds, it increases the demand for them and tends to increase their price, which reduces the interest rate.

© 2013 Pearson Education, Inc. All rights reserved.4-13 What we have learned so far The interest rate is determined by the equality of supply of money and demand for money. By changing the supply of money, the CB can affect the interest rate. The CB changes the supply of money through open market operations (purchases or sales of bonds for money). OMOs in which the CB increases (decreases) the supply of money by buying (selling) bonds lead to a(n) increase (decrease) in the price of bonds and a(n) decrease (increase) in the interest rate.

© 2013 Pearson Education, Inc. All rights reserved Determining the Interest Rate: II What banks do Liabilities: Banks receive funds from depositors (individuals and firms) and allow their depositors to write checks against (or withdraw) their account balances. Assets: Banks use the funds received to buy bonds or to make loans to people and firms. Banks also hold reserves. Some bank reserves are held in cash and the rest in accounts at the central bank. Banks hold reserves in part to protect against daily excesses of withdrawals over deposits and in part because they are required to do so by the central bank. Reserve ratio is the ratio of bank reserves to the bank checkable deposits.

© 2013 Pearson Education, Inc. All rights reserved Determining the Interest Rate: II Figure 4-6 The Balance Sheet of Banks, and the Balance Sheet of the Central Bank Revisited

© 2013 Pearson Education, Inc. All rights reserved Determining the Interest Rate: II After adding banks, central bank liabilities now consist of currency held by the public plus reserves held by banks. Central bank liabilities—the money the central bank has created—are called central bank money. The Supply and demand for central bank money The demand for CBM is the demand for currency by people plus the demand for reserves by banks The supply of CBM is under the control of the CB. The equilibrium interest rate is such that the demand and supply of money are equal.

© 2013 Pearson Education, Inc. All rights reserved Determining the Interest Rate: II Figure 4-7 Determinants of the Demand and the Supply of Central Bank Money

© 2013 Pearson Education, Inc. All rights reserved.4-18 The Demand for Money On the demand side, assume that overall money demand is determined as before and the demand for currency (as opposed to checkable deposits) is a fraction c (where 0<c<1) of overall money demand. where CU d refers to the demand for currency and D d to the demand for checkable deposits.

© 2013 Pearson Education, Inc. All rights reserved.4-19 The Demand for Reserves Assume that banks keep a fixed fraction  of checkable deposits as reserves: where R denote the reserve of banks and D denote the dollar amount of checkable deposits. Combining equations (4.5) and (4.6) yields

© 2013 Pearson Education, Inc. All rights reserved.4-20 The Demand for the Central Bank Money The demand for central bank money is the sum of the demand for currency and the demand for reserves. Replace CU d,R d and M d with their expressions from equations (4.3), (4.4) and (4.7).

© 2013 Pearson Education, Inc. All rights reserved.4-21 The Determination of the Interest Rate Or, using equation (4.9) If c<1, central bank money is less than overall demand for money because the demand for reserves by banks is only a fraction of the demand for checkable deposits. The supply of central money (H) is under the control of the central bank. Equilibrium is given by

© 2013 Pearson Education, Inc. All rights reserved Determining the Interest Rate: II Figure 4-8 Equilibrium in the Market for Central Bank Money and the Determination of the Interest Rate The effects of changes in nominal income and changes in supply of central bank money are qualitatively the same as in the previous section.

© 2013 Pearson Education, Inc. All rights reserved Two Alternative Ways of Looking at the Equilibrium There are two ways to think about equation (4.5). 1.Consider equilibrium in the market for reserves. The demand for reserves is R d. Equating the supply and demand for reserves gives H-CU d =R d 2.Consider equilibrium in terms of the overall supply and the overall demand for money (currency and checkable deposits). Reorganize equation (4.5) to read

© 2013 Pearson Education, Inc. All rights reserved.4-24 Money Multiplier 1/[c+(1-c)] is called the money multiplier. The money supply equals central bank money times the multiplier. Note that 0<c<1 and 0<<1 together imply that the money multiplier is greater than one. Thus, a given increase in central bank money leads to a larger increase in the overall money supply. Since c and  are assumed to be fixed, the central bank can control the money supply by controlling H. For this reason, central bank money is often called high powered money or the monetary base.

© 2013 Pearson Education, Inc. All rights reserved.4-25 Understanding the money multiplier Assume that c=0 and =0.1 so that multiplier is 1/0.1=10. Suppose the CB buys $100 worth of bonds and pays seller 1 $100 and creates $100 in CB money. Seller 1 deposits $100 in a checking account at Bank A. Checkable deposits increase by $100. Bank A keeps $100*0.1=$10 in reserves and buys bonds with the rest and pays $90 to seller 2. Seller 2 deposits $90 in a checking account at Bank B. Checkable deposits increase by $90. Bank B keeps $90*0.1=$9 in reserves and buys bonds with the rest and pays $81 to seller 3. Seller 3 deposits $81 in a checking account at Bank C. Checkable deposits increase by $81 and so on.

© 2013 Pearson Education, Inc. All rights reserved.4-26 Understanding the money multiplier Eventual increase in money supply is the sum of each increase in checkable deposits: $100( ) The series in paranthesis is geometric series and its sum is equal to 1(1-0.9)=10. the money supply increases by $100*10=$ times the initial increase in central bank money. Increase in money supply is the result of successive rounds of purchases of bonds.