Transcript Document

Supply and Demand Models of
Financial Markets
Chapter 21, 26, 29 30
Three Markets
• Loanable Funds Market
– Determines Interest Rate in Capital Markets
• Liquidity Market
– Determines Money Market Rate
• Forex Market
– Determines Foreign Exchange Rate
Money Markets
Interest Rates
• What are some major interest rates in
financial markets? Be as specific as
possible.
Bond Yields and Interest Rate
• Bank accounts typically have very simple
interest rates.
Balancet+1 = (1+i) ∙ Depositt
• Short-term bills have equivalent rates
called yields.
Face Valuet+1 = (1+i) ∙ Pricet
• Simple loans could also be written
Repaymentt+1 = (1+i) ∙ Principalt
Liquid Assets
Two kinds of assets
1. Liquid Assets (Currency, Checking
Accounts, Savings Accounts) that are
useful for transactions which pay zero or
below market interest rates.
2. Money market assets (Government bills,
commercial paper, jumbo CD’s) that pay
a market rate, i, but which cannot be
used for transactions
Liquidity Demand
Q: Why does the money
demand curve slope
down?
A: The greater is the
market interest rate,
the greater is the
opportunity cost of
holding money.
Q: What shifts the
money demand
curve?
A: An increase in GDP
will increase the need
for money for
transactions shifting
the demand curve
out. A reduction in
GDP will shift the
demand curve in.
Money Supply
•
Supply of monetary assets governed by
central bank.
1. Prints currency
2. Makes reserves available to banks
3. Governs fraction of deposits that banks
must keep.
Money Market
Money Demand
Money Supply
i
i*
M
Equilibrium in the Money Market
• If interest rates are too high, excess supply of
money:
– people will want to buy interest paying assets like
bank accounts or treasury bills.
– Bond dealers and banks can reduce the interest
rates they are willing to offer
• If interest rates are too low, excess demand for
money:
– people will want to sell interest paying assets like
bank accounts or treasury bills to get more
liquidity.
– Bond dealers and banks must raise interest rates.
Money Market: GDP Rises
Money Demand
i
i**
Money Supply
2
i*
1
Money Demand’
M
Operating Targets: Target Interest
Rates
• Most big country CB’s target interbank interest
rates, the rate at which banks lend reserves to
one another (in HK, this is called what?)
Fed
BoJ
ECB
BoK
UK
Federal Funds Rate
Uncollateralized Call Money Rate
Main Refinancing Rate
Overnight Call Rate
Official Bank Rate
Target Rates Affect Money Market
Rates
Money Market Rates USA
7
6
5
4
3
2
1
C.P. Rate
CEIC Database
Fed Funds
T-Bill 3 Mo
Mar-06
Sep-05
Mar-05
Sep-04
Mar-04
Sep-03
Mar-03
Sep-02
Mar-02
Sep-01
Mar-01
Sep-00
Mar-00
Sep-99
Mar-99
Sep-98
Mar-98
Sep-97
0
Money Supply
• Government can control the money supply
and can shift the curve in or out by
decreasing or increasing money supply.
• What does the central bank need to do to
money supply to increase the interest
rate?
Monetary Policy: Money Supply Shrinks
Money Demand
i
i**
Money Supply
2
i*
1
Money
Supply’
M
Japan and the Liquidity Trap
• BBC Story Download
• During the 1990’s and this decade Bank of
Japan reduced their interest rate ultimately
implementing ZIRP – Zero Interest Rate
Policy
• Interest rate cannot be set at a rate below
zero because of the existence of an
alternative financial instrument that always
pays better than negative rates.
Money Market at ZIRP
Money Demand
Money Supply
i
i*
i**
0
1
2
3
M
ZIRP: Japan
JP: Call Rate: Uncollaterized: Overnight
% pa
10
9
8
7
6
5
4
3
2
1
0
Jul-1985
Jul-1988
Jul-1991
Jul-1994
Jul-1997
Jul-2000
Jul-2003
Jul-2006
Loanable Funds Market
Nominal and Real Interest Rates
• Nominal return represents how much
money you will receive after 1 year for
giving up 1 dollar of money today
• Real return represents how many goods
you can buy if you give up the opportunity
to buy 1 good today.
• Nominal interest rate is money interest
rate. Real interest rate is goods interest
rate.
• Imagine a 1 year loan [T =1]: The lender gives up
some goods to make a loan and will buy goods in the
future with the repayment.
Repaymentt+1
1  it 
Principalt
• If the price of goods at time t is Pt, the foregone
current goods are
Principalt
Pt
• The goods value of the future repayment is
Repaymentt+1
Pt+1
Real Interest Rate
• The real interest rate on the loan is
defined as the future goods received
relative to current goods foregone
Repaymentt+1
1  rt 
Principalt
Pt+1
Repaymentt+1

Pt
1  it
1  rt 
 rt  it   t 1
1   t 1
Pt+1
Principalt
Pt
Measuring the Real Interest Rate
• Two alternatives
1. Use nominal interest minus consensus
inflation forecast
2. Use the yield on inflation protected
securities.
TIPS Bond
• The US Treasury offers bonds whose
principal and coupon payments increase
with the inflation rate.
• Investors are paid off in terms of real
purchasing power.
• Yield is equivalent to a real interest rate.
Additional Information from U.S. Treasury
Real & Nominal Interest Rates
8.00
7.00
6.00
5.00
Yield 4.00
π5 Year Forecast
3.00
2.00
1.00
0.00
2003
2004
TIPS
2005
5 year Treasury
2006
Loanable Funds Market
• Consider the financial market at its
broadest and most abstract.
– an amalgamation of the bond market and the
lending market (banks, etc.)
• Map the relationship between the interest
rate and the quantity of funds that are lent.
– Supply curve represents the behavior of
savers & lenders
– Demand curve represents the behavior of
borrowers
• Could represent the global financial
market or a large national market.
Supply Curve: Loanable Funds
• Why does the supply curve slope up?
– When real interest rates offered by banks
are high, savers are rewarded with more
future consumption and are likely to be
induced to save more.
– Caveat: If some savers are setting a target
for their level of wealth at retirement, a
higher interest rate reduces the amount
they need to save.
• For this reason, many economists believe
saving curve is very inelastic.
Demand Curve: Loanable Funds
• Why does the demand curve slope down?
– Firms borrow to finance investment projects. If
the return on investment falls below the interest
rate, the project is not worthwhile. The higher
the interest rate, the fewer projects fall below the
hurdle.
– Households borrow to finance housing. The
higher are interest rates, the smaller is the
house that the householders can buy with a
mortgage payment that they can afford.
Competitive Market Equilibrium:
Loanable Funds Market
(Geometry)
r
S
I
r*
LF*
LF
Example: Investment Boom in
Japan as economy recovers
r
S
I
I´
r**
r*
1
LF*
LF**
LF
Savings
• We divide savings
into 2 parts:
SGovernment
+
SPrivate
= S
Public Saving/Government Saving
(Budget Surplus)
Private Saving
(Household + Business Saving)
National Saving
Example: US Government runs a
deficit to finance military spending
r
S´
S
I
r**
r*
1
LF**
LF*
LF
Example: US Consumers become
thriftier
r
S
I
r*
LF*
LF
Example: US Consumers become
thriftier
r
S
S’
I
1
r*
r**
LF*
LF**
LF
Global Economy
• Additional Source of Savings
Loanable Funds Supply = S+KA =
National Savings + Net Capital Inflow from
Abroad (+/-)
• Two Effects
1. Supply Curve Becomes More Elastic
More globalized, more elastic
2. Global Financial Markets also a source of
shifts in Supply Curve
Competitive Market Equilibrium:
Loanable Funds Market
(Global Economy)
r
S
I
S+KA
r*
KA
LF*
LF
Questions
• Compare Investment Boom in a very
globalized economy with one in a less
globalized economy. What happens to
investment & interest rates?
• What happens to a a globalized economy
when there is an increase in overseas
rates (or an increase in the rate premium).
Government Deficits
(Globalized Economy)
[r Doesn’t Rise by as Much, I doesn’t fall as much
r
S’
I
S
S’+KA
2
S+KA
r**
r*
1
LF*
LF**
LF
Investment Boom
(Globalized Economy)
[r Doesn’t Rise by as Much, I Rises by More]
r
I
S
S+KA
r**
r*
2
I’
1
LF*
LF**
LF
Foreign Interest Rate Rises
(Global Economy)
r
I
r**
r*
S+KA’
2
S+KA
1
LF*
LF
Savings Glut
• Theory put forth by Fed Chairman
explaining the U.S. trade deficit.
• Washington Post Article Download
Recent TIPS Bond
Capital Account
• Model can be used to derive equilibrium
real interest rates and national saving and
investment as well as capital inflows
(designated KA).
• Trade balance is opposite of the capital
account.
• Trade balances are temporary.
Net Capital Outflows =
‘Goods & Income Outflows
•
•
•
•
•
Private Savings = Y + NFI -Tax – C
Public Savings = Tax – G
S = Y+ NFI – C – G
-KA = S – I = NFI + (Y – C – G – I)
-KA = NFI + NX = CA
US Current Account
1.00%
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
0.00%
-1.00%
-2.00%
-3.00%
-4.00%
-5.00%
-6.00%
-7.00%
NX
NFI
CA
Ex Ante Rate and the Fisher Effect
• Savings and investment decisions must be
made before future inflation is known so
they must be made on the basis of an ex
ante (predicted) real interest rate.
• Fisher Hypothesis: Ex ante real interest
rate is determined by forces in the
financial market. Money interest rate is just
the real ex ante rate plus the market’s
consensus forecast of inflation.
it  rt
EA

FORECAST
t 1
Great Inflation of the 1970’s
US Inflation Rates & Interest Rates
18.00
16.00
14.00
%
12.00
10.00
Interest Rates
Inflation
8.00
6.00
4.00
2.00
Mar-03
Mar-00
Mar-97
Mar-94
Mar-91
Mar-88
Mar-85
Mar-82
Mar-79
Mar-76
Mar-73
Mar-70
Mar-67
Mar-64
Mar-61
Mar-58
Mar-55
0.00
Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/
Exchange Rate Model
Exchange Rates are Volatile
Jan-06
Jan-04
Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
280.00
260.00
240.00
220.00
200.00
180.00
160.00
140.00
120.00
100.00
80.00
Jan-84
Yen per Dollar
Yen-Dollar Rate
Why do exchange rates change?
• Relative values of two currency
determined by supply and demand by
traders of the two currencies.
• People trade currencies to engage in
foreign trade and international investment.
• Monetary policy is a prime driver of
exchange rates.
– And vice versa, Some economies structure
monetary policy around exchange rate.
Forex Market: Supply & Demand
Consider the spot foreign exchange market.
• Price of US$: S is the price of US$ in terms of DCU.
• Supply of US$: Foreign people who want to acquire
DCU to buy domestic goods or assets.
– When US$ becomes expensive, domestic goods
or assets get cheap and foreign investors are
attracted to domestic currency.
• Demand for US$: Domestic people who want to
acquire US$ for foreign purchases or overseas
investment.
– When US$ get cheap, US$ goods or assets get
cheap and demand for US$ rises
Equilibrium in Forex Market
Supply Equals Demand
S
Supply
S*
Demand
Increase in Desired Capital Outflows by
Domestic Investors/
Desired Purchases of Foreign Goods
S
S**
2
S*
Domestic
Currency
Depreciates
1
Supply
Demand '
Demand
Increase in Desired Capital Inflows by
Foreign Investors/
Desired Purchases of Domestic Goods
S
Supply
Supply'
Domestic
Currency
Appreciates
1
S*
S**
2
Demand
US Monetary Policy Causes
US$ Interest Rates Go Up
Relative Demand for US$ Goes Up
S
2
S**
Domestic
Currency
Depreciates
S*
1
Supply'
Supply
Demand '
Demand
Domestic Monetary Policy Causes
D.C. Interest Rates Go Up
Relative Demand for US$ Goes Down
S
Supply
Supply'
1
S*
Domestic
Currency
Appreciates
S**
2
Demand
Demand '
Monetary Policy & Exchange Rates
• The central impact of the foreign currency
intervention is on domestic interest rates.
• Monetary policy that shifts domestic interest
rates will also shift exchange rates
regardless of whether it occurs through
currency intervention, OMO, or some other
change in quantity of bank reserves.
• Monetary policy that does not shift interest
rates will not shift exchange rates.
Foreign Currency Intervention
• Foreign currency purchase:
– Central bank purchases foreign currency
– Credit reserve accounts of counterparty commercial bank
– More reserves pushes down interest rates
• Increases demand for and reduces supply of US$ in
forex market
• Foreign currency sale
–
–
–
–
Central bank sells foreign currency
Debit reserve accounts of purchasing bank
Less reserves pushes up interest rates
Reduces demand for and increases supply of US$ in
forex market
Excess Demand for Foreign Currency
1. Domestic
Currency Faces
Depreciation
Pressure
S
A
S*
Supply
Demand '
Demand
Forex Sale
Supply
S
A
S*
B
Supply'
1. Central Bank
does Forex
Sale
maintaining
Exchange
Rate Stability
2. Shrinking
money
Demand supply and
higher
domestic
Demand '
interest rates
Excess Supply of Foreign Currency
1. Domestic
Currency Faces
Appreciation
S
S*
A
Supply
Demand
Forex Purchase
S
B
S*
Supply'
Supply
A
1. Central Bank
does Forex
Purchase
maintaining
Exchange
Rate Stability
2. Growing
money
supply and
Demand ' lower
domestic
interest rates
Demand
Iron Triangle of International
Finance
Open to
International
Capital Flows
Monetary
Policy that
Controls The
Interest Rate
Pick 2 items from this menu
Fixed
Exchange
Rates
Uncovered Interest Parity
• Bloomberg News Download
Learning Outcomes
• Students should be able to:
• Use the Loanable Funds model to analyze
the effects of external events on savings,
investment, and real interest rates in capital
markets and;
• Compare capital markets in globalized
economies with those in closed economies.
• Use the money supply and demand model
of money markets to examine the effect of
changes in the economy on money market
rates and;
Learning Outcomes Pt. 2
• Use the Supply-Demand model of the
forex model to explain:
– the effect of international trade conditions on
the exchange rate.
– the impact of interest rates and other financial
market conditions on exchange rates.
– Government policy efforts to stabilize the
exchange rate.
Discussion Question
•
In the past 3 years, the US dollar has been
weak against a number of currencies including
the British pound, Euro, Australian dollar, etc.
–
–
Discuss what types of firms in a country might
benefit from a strong currency and what types will
benefit from a weak country. What aspects of a
firm's balance sheets and income statements can
you imagine might be affected?
Use the exchange rate model/money market model
to help understand what would happen to the
domestic economy if the government decided to
weaken the currency. Which types of firms might
benefit and which would lose.