Transcript Financial Markets

Financial Markets
• Financial markets refer to the
market and to the
market.
• New variable considered:
• Goals of the chapter:
– To find how
in these markets.
– To find how
to influence the interest rate.
– To introduce the link between the financial
and the goods markets.
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Money versus bonds
There are many forms of financial assets,
from cash to shares.
In this chapter we only consider 2 forms
•
–
–
–
–
the
liquid form
which does not earn
which is used for
and is defined as
–
–
–
–
a
liquid form
which earn
which are not used for
and bonds somehow stand for all the other less liquid forms.
•
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• Question:
wealth can be held
either in bonds
or in money
in what proportion will it be?
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Main variables affecting the decision
1.
–
–
The higher
the
,
the need for money,
but there is a cost in holding money instead of
bonds as money does not earn interest
2.
–
–
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the higher
,
the more
it is to hold wealth in the form
of bonds rather than money.
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The demand for money Md
• The amount of money needed for transaction
depends on
(i.e. on
income).
• The opportunity cost of holding money instead
of interest bearing bonds depends
• so

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M 
d
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The demand for money - graph
Effect of an increase in Y or in P
i
Inversely related to the
rate of interest.
An increase in Y or in P
results in a rightward
shift of the curve.
M
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The demand for bonds Bd
• It is related to the demand for money
through
W
(note that all these variables are nominal)
So Bd =
• It follows that (ceteris paribus):
– If W increases, Bd
– If PY increases, Md
– If i increases, Bd
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by the
amount
and Bd
and Md
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Determination of the interest rate
• Since the interest rate can be considered
it can be determined like any other price
on the money market.
• However as money is defined as
1.
2.
there are 2 suppliers:
1.
2.
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Problem 2: wealth W = $50,000 - income Y = $60,000
Money demand is Md = PY(.35 - i) with P = 1
a. When i = 5%
Md =
=
and Bd = W - Md =
When i = 10% Md =
and
Bd =
b. Md
when i
and Bd
when i
c. i = 10% and Y2 = .5Y1 = $30,000
Since Md is proportional to Y we have Md2 = .5Md1 =
d. i = 5% same story
e. Independent of i (at every level of i, the money demand will
be halved)
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• To simplify, we assume at first that
currency is the only form of money
and the Fed, the only supplier.
• In the second part of the chapter, the
role of the commercial banks in
creating money in the form of deposits
will be explained.
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Supply of money Ms
The Fed determines the
amount of money Ms
(central bank currency in
this section) it supplies to
the economy.
i
So the level of the money
supply does not depend
M
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Equilibrium in the financial markets
• If the money market is in equilibrium, the
bonds market
• Proof: W 
So W =
When the money market is in equilibrium,
so in this case
• As a result we need only focus on one
market equilibrium, the money market,
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Equilibrium in the money market
The interest rate is
determined where the
2 curves intersect i.e.
supply = demand.
i
M
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Note that the quantity
supplied is solely
determined by the
Fed and not by the
equilibrium
supply/demand.
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Shifts in the demand for money
i
An increase in P or in Y,
results in a shift of the
demand curve to the
right and an increase in
the equilibrium interest
rate. There is no change
in supply, but the public
needs more money for
transaction and bid up
the price of money i.
M
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Shifts in the supply of money
i
An increase in the
money supply - due to
expansionary monetary
policy - results in a
rightward shift of the Ms
curve and a drop in the
equilibrium interest rate i
M
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Problem #4 Md = PY(.25 - i) with P = 1 and Y = $100
and Ms = $20
a. In equilibrium Md = Ms i.e.
or
25 - 20 = 100i
i = 5/100 =
b. If the Fed wants to increase i by 10 percentage points to 15%,
it must
the money supply to:
Md =
(or by 20 - 10 = 10)
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Velocity of money
•
•
•
•
Definition: V =
PY is
output - it is a
M is the money supply - a
If PY =
and M =
i.e.
we only have one
bill, we will have to
use the same bill
times to buy all the
goods corresponding to PY during the year,
so the velocity of money is .
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Velocity cont.
• It seems that the velocity of money has
increased historically: i.e. we need less
cash in hand to buy the same amount of
goods.
• This is due to innovations in the financial
markets (ATM, credit cards etc.)
• Empirical studies also show a positive
relation between velocity and interest rates.
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Open market operations
• The Fed can affect the quantity of money in the
economy
• When the Fed wants to increase Ms,
• When the Fed wants to cut Ms, it
(old) bonds
from its bonds holdings to the public and
money from the public:
(i.e. money is taken out of circulation).
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The Fed’s balance sheet
Assets
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Liabilities
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The Fed’s balance sheet
Open market purchase
Assets
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Liabilities
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Relation between the price of bonds
and the interest rate
• Let’s consider a 1 year Treasury Bill that promises
a $100 payment (its face value) at maturity.
• PB is the price paid for the bond now.
• The rate of return on the bond, i.e. the
interest rate is
i
• This is indeed an
relation between the price
of the bond and the interest rate.

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Illustration
$100  PB
i
PB
or
$100
PB 
1 i
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PB
i
$90
%
$80
%
$70
%
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Rational
• If the interest rate on newer bonds is higher,
people will sell their old bonds to take
advantage of the better returns and by doing
so they will depress the prices overall on the
bond market.
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Monetary policy
• Expansionary: Open market
(MS )
The Fed
bonds:
PB
as the demand for bonds Bd
so i
• Contractionary: Open market
(MS )
The Fed
PB
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bonds:
as the supply of bonds Bd
so i
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Interest Rate determination w/ Ms = CU + D
• Let’s now assume that
Money = currency + deposit
• Role of commercial banks: financial intermediaries
– Banks receive funds from the public that they
use to make loans or to buy government bonds
– Public depositing own funds at banks can use
these bank balances to write checks used to
make payments
• Funds in form of checkable deposits are money
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• Banks must also hold reserves so that they
are always able to meet demand (flows in
and out not necessarily equal on a daily
basis)
– By law banks must hold a specific
proportion (10%) of the total deposits
in an account at the Fed
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Balance sheets of Fed and of
commercial banks
Fed
Assets
Commercial banks
Liabilities
Assets
Liabilities
=
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Supply and demand for CB money H
• Supply H : determined by
• Demand Hd: demand for
and for
• S=D determine the equilibrium interest rate i
Demand for money derived above as Md=
corresponds to
We need to know what how much is held as CU and how
much as D or proportion c held as CU
In the US:
c=
So demand for currency: CUd =
demand for deposits: Dd =
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Demand for reserves Rd depends on reserve ratio
requirement  as R =
-Let’s replace D by
demand for reserves: Rd =
Finally the demand for CB money H is
Hd =
=
=
=
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Interest rate determination
• In equilibrium H =
i.e.
H=
Case 1: people only hold CU so c = 1
Equilibrium i determined by H =
-earlier case: no money creationCase 2: people only hold deposits so c = 0
Then H =
and
H represents
of total money supply
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• In general we have 0 < c < 1 and H represents between
10 % and 100% of the total money in the economy.
i
•If either P or Y
increase, the
impact on Hd is
the same as the
impact on Md
Hd=Cud+Rd=[c + (1-c)]PYL(i)
H
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Money multiplier mm
• We derived H = [c + (1-c)]M
with c = CUd/M and  = R/D
so mm =
=
If c = 40% and  =10%
the money multiplier is ---------------- = 2.17
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Money multiplier: step by step
Open market purchase of $100 assuming
 = .1 and c = 0 (no currency, only deposits)
- Fed pays $100 to Mr A who deposits the
money in his account in Bank X
- Bank X redeposits $10 as reserve in its Fed
account and lends $90 to Ms B
- Ms B deposits $90 in her account in Bank Y
- Bank Y redeposits $9 as reserve in its Fed
account and lends $81 to Sir C
Etc…
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How much money has been added in the
economy up to now?
$100 +
Total increase in the money supply is:
100
= 100
= 100
Fed
A
Bonds
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L
Comm. Banks
A
L
Loans
Reserves
Reserves
Deposit
s
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