Chapter 4 Financial Markets

Financial Markets What determines interest rates How the Federal Reserve System (Fed) influences interest rates

Financial Markets Some Assumptions One bond market One interest rate

Financial Markets Section I: The Demand for Money Section II: The determination of the interest rate when the supply of money is controlled by the central bank Section III: The determination of the interest rate when both the central bank and commercial banks influence the money supply

Financial Markets Income: A flow of compensation per unit of time Wealth: A stock variable at a given point in time. Equal to financial assets minus financial liabilities Money: A stock variable equal to financial assets used for transactions. Is equal to currency plus checkable deposits Investment: The purchase of new capital goods

The Demand for Money A Scenario… Two financial assets to choose from Money: Used for transactions (currency and checkable deposits) Bonds: Cannot be used for transactions and pays a positive interest rate (i)

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

The Demand for Money 1960 = 27% 1998 = 13% @ Approximately the same i Money Demand and the Interest Rate: The Evidence Observations 1960 = 27% 1998 = 13% @ Approximately the same i = Velocity of Money

The Determination of the Interest Rates: I Money Demand, Money Supply & the Equilibrium Interest Rate The LM relation: M = $YL(i) The demand for Liquidity (L) = Supply of Money

The Determination of the Interest Rates: I The Equilibrium Graphically M Ms Md ($Y) Money, M Interest Rate, i i1 Equilibrium interest, I, Md = MS A

The Determination of the Interest Rates: I The effects of an increase in National Income on i M Ms Md´ ($Y´ > $Y) Increase $Y to $Y´ Md increases to Md´ Md ($Y) A´ i2 Equilibrium moves from A to A´ i increases from i1 to i2 Interest Rate, i i1 A Money, M

The Determination of the Interest Rates: I The effects of an increase in the Money Supply on i Ms M Ms´ Increase Ms to Ms´ M´ Md ($Y) Equilibrium moves from A to A´ A´ i2 Interest rate falls from i1 to i2 Interest Rate, i i1 A Money, M

The Determination of the Interest Rates: I Open Market Operations: Buying and selling government bonds by the central bank Buy bonds to increase the money supply Sell bonds to decrease the money supply

The Determination of the Interest Rates: I Balance Sheet Banks Central Bank Assets Liabilities Bonds Money (Currency) Buy $1 million in bonds: Bonds increase Currency decreases at the Central Bank and increases in the economy

The Determination of the Interest Rates: I Monetary Policy and Open Market Operations The Price of Bonds and the Interest Rate Assume: The bonds pay $100 in one year $PB = Price of the bonds (B) today Therefore: The return on the bond (i) is:

The Determination of the Interest Rates: I Monetary Policy and Open Market Operations The Price of Bonds and the Interest Rate For Example, Assume: $PB = $95 $PB = $90

The Determination of the Interest Rates: I Monetary Policy and Open Market Operations Observation! The price of a bond and the interest rate are inversely related.

The Determination of the Interest Rates: I Monetary Policy and Open Market Operations Expansionary Open Market Operation: Increase the Money Supply Step 1: Central bank buys bonds. Step 2: The central bank injects money (currency) into the economy to pay for the bonds. Step 3: The demand for bonds increases, causing the price of bonds to rise. Step 4: When the price of bonds increases, the interest rate falls.

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

The Determination of the Interest Rates: II The supply and demand for central bank money Demand for money Demand for checkable deposits Demand for reserves (by banks) Demand for Central Bank Money Supply of Central Bank Money = Demand for currency

The Determination of the Interest Rates: II The demand for reserves If people hold deposits of Dd, then banks must hold reserves (R) of Dd.

The Determination of the Interest Rates: II The demand for reserves The Equilibrium Equilibrium (Supply of Money = Demand for Money)

The Determination of the Interest Rates: II The supply and demand for money Observations: The supply of money is a multiple of the Central Bank money. Central Bank money (monetary base) is High-powered money (H)

The Determination of the Interest Rates: II Open market operations revisited If: C=O (People hold only checkable deposits) , The Multiplier = If: = .10, The Multiplier =