Financial Markets 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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Financial Markets Income: A flow of compensation per unit of time
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 - PowerPoint PPT Presentation
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Financial MarketsFinancial MarketsIncome: 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…A Scenario…
Two financial assets to choose from
The Demand for MoneyThe Demand for MoneyA Summary:A Summary:
The demand for money (Md) depends on:
•The level of transactions which are proportional to nominal income ($Y)
•The interest rate on bonds
The Demand for MoneyThe Demand for Money
dM Demand for money
Md = $YL(i) (-)
Md = $YL(i) (-)
Y$The liquidity demand forMoney is a function of i
)(iLNominal income
(-) Md is inversely related to i
Md (for $Y´ > $Y)Md
(for nominalIncome $Y)
The Demand for MoneyThe Demand for Money
Money, M
Inte
rest
Rat
e, i
M
i
M´
Graphically Md = $YL (i)
Md ($Y)
The Demand for MoneyThe Demand for Money
Money, M
Inte
rest
Rat
e, i
M
ia
c
M1
i1
bi2
• Md and i are inversely related• Given $Y at i, M = M (P*, A)
i2, M = M2
i1, M = M1
M2
The Demand for MoneyThe Demand for Money
Money, M
Inte
rest
Rat
e, i
Md
($Y)
M M´
i
Graphically Md = $YL (i)
Md´
($Y´ > $Y)
a b
• Increase $Y to $Y´; Md shifts to Md´• M increases from M to M´ (a to b)
The Demand for MoneyThe Demand for Money
The Demand for MoneyThe Demand for MoneyMoney Demand and the Interest Rate: The EvidenceMoney Demand and the Interest Rate: The Evidence
ObservationsObservations
Negative relation between iY
M&
$
Assume: • All money (M) is currency, supplied by the central bank
Money Demand, Money Supply & the Equilibrium InterestRateMoney Demand, Money Supply & the Equilibrium InterestRate
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
•The LM relation: M = $YL(i)
•The demand for Liquidity (L) = Supply of Money
The Determination of the Interest Rates: IThe Determination of the Interest Rates: IMoney Demand, Money Supply & the Equilibrium InterestRateMoney Demand, Money Supply & the Equilibrium InterestRate
Md ($Y)
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
Money, M
Inte
rest
Rat
e, i
M
Ms
i1Equilibrium interest, I, Md = MS
A
The Equilibrium Graphically
Md ($Y)
Md´ ($Y´ > $Y)
• Increase $Y to $Y´ • Md increases to Md´
M
Ms
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
Money, M
Inte
rest
Rat
e, i
i1A
The effects of an increase in National Income on i
A´i2• Equilibrium moves from A to A´
• i increases from i1 to i2
Md ($Y)
The Determination of the Interest Rates: IThe Determination of the Interest Rates: IThe 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
Monetary Policy and Open Market OperationsMonetary Policy and Open Market Operations
The Price of Bonds and the Interest RateThe Price of Bonds and the Interest Rate
Calculating the price of a bond--
Assume a bond with a $100 value in one year
iPB
1
100$
95053.1
100$3.5
BPi
90111.1
100$1.11
BPi
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
The price of a bond andthe interest rate are
inversely related.
The price of a bond andthe interest rate are
inversely related.
Monetary Policy and Open Market OperationsMonetary Policy and Open Market Operations
Observation!Observation!
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
A Summary: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 Determination of the Interest Rates: IThe Determination of the Interest Rates: I
The Determination of the Interest Rates: IIThe Determination of the Interest Rates: IIInterest rates in an economy with currency and checkable depositsInterest rates in an economy with currency and checkable deposits
What banks do:What banks do:
Banks
ReservesLoansBonds
Assets
Bonds
Assets
Checkable deposits
Liabilities
Central Bank Money=Reserves+Currency
LiabilitiesCentral Banks
The supply and demand for central bank moneyThe 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 moneyThe demand for money
The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II
Assume: Assume:
The demand for currency is: CUd
The demand for checkable deposits is: Dd
CUd = cMd: Demand for currency (Central Bank Money)
Dd = (1-c)Md: Demand for Reserves (Central Bank Money)
CUd = cMd: Demand for currency (Central Bank Money)
Dd = (1-c)Md: Demand for Reserves (Central Bank Money)
The demand for reservesThe demand for reserves
The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II
Assume: Assume:
: Represents the reserve ratio (reserves to checkable deposits)
R: Represents the dollar amount of reserves
D: Represents the dollar amount of checkable deposits
Therefore: Therefore:
)1.0%10:( orUSDR
The demand for reservesThe demand for reserves
The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II
If people hold deposits of Dd, then banks must holdreserves (R) of Dd. If people hold deposits of Dd, then banks must holdreserves (R) of Dd.
dd
dd
d
McR
McD
DR
)1(
)1(
The demand for reservesThe demand for reserves
The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II
The Equilibrium The Equilibrium
MoneyBankCentralofSupply:H
moneyfor Demand :Dd RCU
:dd RCUH Equilibrium (Supply of Money = Demand for Money)
The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II
Supply of Central Bank Money = Demand for Central Bank Money
)($)1( iLYccH Assume: People only hold currency: C=1
)($)($11(1 iLYiLYH
Banks do not impact the money supply.
The supply and demand for moneyThe supply and demand for money
The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II
)($)1( iLYccH Recall:Recall:
Therefore:Therefore: Supply of Money = Demand for Money
)($)1(
1iYLH
cC
The supply and demand for moneyThe supply and demand for money
The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II
Observations: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)
The supply and demand for reservesThe supply and demand for reserves
The Determination of the Interest Rates: II
• The Federal Funds Market: The market for bank reserves
• The Federal Funds Rate: The interest rate that equates the supply of Reserves (H-Cud) with demand for reserves (Rd)
• Increases in Central Bank money (Fed buys bonds) decrease the interest rate
• Decreases in Central Bank money (Fed sells bond) increase the interest rate
The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II