Chapter 4 Financial Markets

Chapter 4Chapter 4Financial MarketsFinancial Markets

Chapter 4: Financial Markets Slide #2Blanchard: Macroeconomics

Financial MarketsFinancial Markets

What determines interest rates

How the Federal Reserve System (Fed) influences interest rates


Financial MarketsFinancial Markets

One bond market

One interest rate

Some Assumptions


Financial MarketsFinancial 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 MarketsFinancial 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 MoneyThe Demand for Money

Money: Used for transactions (currency and checkable deposits)

Bonds: Cannot be used for transactions and pays a positive interest rate (i)

A Scenario…

Two financial assets to choose from


The Demand for MoneyThe Demand for Money

dM Demand for money

Md = $YL(i) (-)

Y$The liquidity demand forMoney is a function of i

)(iLNominal income

(-) Md is inversely related to i


The Demand for MoneyThe Demand for MoneyMoney Demand and the Interest Rate: The Evidence

Observations

YM$

1960 = 27% 1998 = 13% @ Approximately the same i

MY$

= Velocity of Money

7.327.1:1960 6.7

13.1:1998


•The LM relation: M = $YL(i)

•The demand for Liquidity (L) = Supply of Money

The Determination of the Interest Rates: IThe Determination of the Interest Rates: I

Money Demand, Money Supply & the Equilibrium InterestRate


Md ($Y)


Money, M

Inte

rest

Rat

e, i

M

Ms

i1 Equilibrium interest, I, Md = MS

A

The Equilibrium Graphically


Md ($Y)

Md´ ($Y´ > $Y)

• Increase $Y to $Y´ • Md increases to Md´

M

Ms


Money, M

Inte

rest

Rat

e, i

i1A

The effects of an increase in National Income on i

A´i2• Equilibrium moves from A to A´• i increases from i1 to i2


Md ($Y)


The effects of an increase in the Money Supply on i

Money, M

Inte

rest

Rat

e, i

Ms

M

i1

A

Ms´

• Increase Ms to Ms´

M´

• Equilibrium moves from A to A´

A´i2

• Interest rate falls from i1 to i2


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



Balance Sheet

Central Bank

Buy $1 million in bonds:

• Bonds increase

• Currency decreases at the Central Bank and increases in the economy

Assets Liabilities

Bonds Money(Currency)


Banks


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:

B

B

PPi

$$100$




The Price of Bonds and the Interest Rate

For Example, Assume:

$PB = $95

%3.5053.095

5$95$

95$100$

i %1.11111.0

9010$

90$90$100$

i

$PB = $90



The price of a bond andthe interest rate are

inversely related.


Observation!



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.


Expansionary Open Market Operation: Increase the Money Supply



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 supply and demand for central bank money

The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II

Demand for money

Demand forcheckabledeposits

Demand for Central Bank

MoneyDemand for

currency

Supply of Central Bank

Money=

Demand for reserves

(by banks)


The demand for reserves


If people hold deposits of Dd, then banks must holdreserves (R) of Dd.

dd

dd

d

McR

McD

DR

)1(

)1(


The demand for reserves


The Equilibrium

MoneyBankCentralofSupply:H

moneyfor Demand :Dd RCU

:dd RCUH Equilibrium (Supply of Money = Demand for Money)


The supply and demand for money


Observations:

MultiplierMoney )1(

1

CC•The supply of money is a multiple of theCentral Bank money.•Central Bank money (monetary base) is High-powered money (H)


Open market operations revisited


1

)1(1

CC

If: C=O (People hold only checkable deposits) ,

The Multiplier =

If: = .10, The Multiplier = 1010.1

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Chapter 4 Financial Markets