Transcript (i) is: The Determination of the Interest Rates

Chapter 4
Financial Markets
Financial Markets
 What determines interest rates
 How the Federal Reserve System (Fed)
influences interest rates
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Chapter 4: Financial Markets
Slide #2
Financial Markets
Some Assumptions
 One bond market
 One interest rate
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Chapter 4: Financial Markets
Slide #3
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
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Chapter 4: Financial Markets
Slide #4
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
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Chapter 4: Financial Markets
Slide #5
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)
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Chapter 4: Financial Markets
Slide #6
The Demand for Money
Md = $YL(i)
(-)
M
d
Demand for money
$Y
Nominal income
L (i )
The liquidity demand for
Money is a function of i
Md is inversely related to i
(-)
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Chapter 4: Financial Markets
Slide #7
The Demand for Money
Money Demand and the Interest Rate: The Evidence
Observations
M
$Y
$Y
M
1960 = 27% 1998 = 13%
@ Approximately the same i
= Velocity of Money
1
1960 :
 3 .7
.27
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1
1998 :
 7.6
.13
Chapter 4: Financial Markets
Slide #8
The Determination of the Interest Rates: I
Money Demand, Money Supply & the Equilibrium Interest
Rate
•The LM relation: M = $YL(i)
•The demand for Liquidity (L) = Supply of Money
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Chapter 4: Financial Markets
Slide #9
The Determination of the Interest Rates: I
The Equilibrium Graphically
Interest Rate, i
Ms
A
i1
Equilibrium interest, I, Md = MS
Md ($Y)
M
Money, M
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Chapter 4: Financial Markets
Slide #10
The Determination of the Interest Rates: I
The effects of an increase in National Income on i
Interest Rate, i
Ms
A´
i2
• Increase $Y to $Y´
• Md increases to Md´
• Equilibrium moves from A to A´
• i increases from i1 to i2
A
i1
Md´ ($Y´ > $Y)
Md ($Y)
M
Money, M
Blanchard: Macroeconomics
Chapter 4: Financial Markets
Slide #11
The Determination of the Interest Rates: I
The effects of an increase in the Money Supply on i
Interest Rate, i
Ms
Ms´
• Increase Ms to Ms´
• Equilibrium moves from A to A´
• Interest rate falls from i1 to i2
A
i1
A´
i2
Md ($Y)
M
M´
Money, M
Blanchard: Macroeconomics
Chapter 4: Financial Markets
Slide #12
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
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Chapter 4: Financial Markets
Slide #13
The Determination of the Interest Rates: I
Balance Sheet
Banks
Assets
Bonds
Central Bank
Liabilities
Money
(Currency)
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Buy $1 million in bonds:
• Bonds increase
• Currency decreases at the Central
Bank and increases in the economy
Chapter 4: Financial Markets
Slide #14
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:
$100  $ PB
i
$ PB
Blanchard: Macroeconomics
Chapter 4: Financial Markets
Slide #15
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
$100  $95 $5
i

 0.053  5.3%
$95
95
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i
$100  $90 $10

 0.111  11.1%
$90
90
Chapter 4: Financial Markets
Slide #16
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.
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Chapter 4: Financial Markets
Slide #17
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.
Blanchard: Macroeconomics
Chapter 4: Financial Markets
Slide #18
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
Blanchard: Macroeconomics
Chapter 4: Financial Markets
Slide #19
The Determination of the Interest Rates: II
The supply and demand for central bank money
Demand for
money
Demand for
checkable
deposits
Demand for
currency
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Demand for
reserves
(by banks)
Demand for
Central Bank
Money
Chapter 4: Financial Markets
=
Supply of
Central Bank
Money
Slide #20
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.
R  D
d
D  (1  c) M
d
d
R  (1  c) M
d
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d
Chapter 4: Financial Markets
Slide #21
The Determination of the Interest Rates: II
The demand for reserves
The Equilibrium
H : Supply of Central Bank Money
CU d  R D : Demand for money
H  CU  R : Equilibrium (Supply of Money
d
d
= Demand for Money)
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Chapter 4: Financial Markets
Slide #22
The Determination of the Interest Rates: II
The supply and demand for money
Observations:
1
 Money Multiplier
C  (1  C )
•The supply of money is a multiple of the
Central Bank money.
•Central Bank money (monetary base) is
High-powered money (H)
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Chapter 4: Financial Markets
Slide #23
The Determination of the Interest Rates: II
Open market operations revisited
If: C=O (People hold only checkable deposits) ,
The Multiplier =
1
1

C  (1  C ) 
If: = .10, The Multiplier =
Blanchard: Macroeconomics
1
 10
.10
Chapter 4: Financial Markets
Slide #24