1. Chapter 4
Financial Markets

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

3. Financial Markets
Some Assumptions
One bond market
One interest rate

4. 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

5. 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

6. 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)

7. 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

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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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:

16. 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

17. 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.

18. 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.

19. 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

20. 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

21. 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.

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

23. 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)

24. 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 =