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Supply and Demand Models of
Financial Markets
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Two Markets
Loanable Funds Market
Determines Interest Rate in Capital Markets
Liquidity Market Determines Money Market Rate
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Loanable Funds Market
Consider the financial market at itsbroadest and most abstract.
an amalgamation of the bond market and thelending market (banks, etc.)
Map the relationship between the interestrate and the quantity of funds that are lent.
Supply curve represents the behavior of
savers & lenders Demand curve represents the behavior ofborrowers
Could represent the global financial
market or a large national market.
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Supply Curve: Loanable Funds
Why does the supply curve slope up? When real interest rates offered by banks
are high, savers are rewarded with morefuture consumption and are likely to beinduced to save more.
Caveat: If some savers are setting a targetfor their level of wealth at retirement, a
higher interest rate reduces the amountthey need to save.
For this reason, many economists believesaving curve is very inelastic.
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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 thehurdle.
Households borrow to finance housing. The
higher are interest rates, the smaller is thehouse that the householders can buy with a
mortgage payment that they can afford.
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Competitive Market Equilibrium:
Loanable Funds Market
(Geometry)S
D
LF
r*
LF*
r
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Example: Investment Boom in
Japan as economy recovers
S
I
LF
r*
LF*
r
r**
I
LF**
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Savings
We divide savingsinto 2 parts:
SGovernment Public Saving/Government Saving
(Budget Surplus)
+ SPrivate Private Saving
(Household + Business Saving)
= S National Saving
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Example: US Government runs a
deficit to finance military spending
S
I
LF
r*
LF*
r
r**
S
LF**
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Example: US Consumers become
thriftier
S
I
LF
r*
LF*
r
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Global Economy
Additional Source of Savings
Loanable Funds Supply = Public Savings +
Net Capital Inflow from Abroad Two Effects
1. Supply Curve Becomes More Elastic
More globalized, more elastic2. Global Financial Markets also a source of
shifts in Supply Curve
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Questions
Compare Investment Boom in a very
globalized economy with one in a less
globalized economy. What happens to
investment & interest rates?
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Money Markets
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Liquid Assets
Two kinds of assets
1. Liquid Assets (Currency, CheckingAccounts, Savings Accounts) that are
useful for transactions which pay zero orbelow market interest rates.
2. Money market assets (Government bills,
commercial paper, jumbo CDs) that paya market rate, i, but which cannot beused for transactions
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Liquidity Demand
Q: Why does the money
demand curve slope
down?
A: The greater is themarket interest rate,
the greater is the
opportunity cost of
holding money.
Q: What shifts the
money demand
curve?
A: An increase in GDPwill increase the need
for money for
transactions shifting
the demand curveout. A reduction in
GDP will shift the
demand curve in.
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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.
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Money Market
i
Money Demand
i*
Money Supply
M
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Equilibrium in the Money Market
If interest rates are too high, excess supply ofmoney:
people will want to buy interest paying assets likebank accounts or treasury bills.
Bond dealers and banks can reduce the interestrates they are willing to offer
If interest rates are too low, excess demand for
money: people will want to sell interest paying assets likebank accounts or treasury bills to get moreliquidity.
Bond dealers and banks must raise interest rates.
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Changes in Money Market Rates
During Business Cycles
Money Demand Shocks: What happens to
interest rates when GDP (either prices or
real GDP rises)?
What happens when GDP falls?
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Operating Targets: Target Interest
Rates
Most big country CBs target interbank interest
rates, the rate at which banks lend reserves to
one another (in HK, this is called what?)
Fed Federal Funds Rate
BoJ Uncollateralized Call Money Rate
ECB Main Refinancing RateBoK Overnight Call Rate
UK Official Bank Rate
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Target Rates Affect Money Market
Rates
Money Market Rates USA
0
1
2
3
4
5
6
7
Sep-97
Mar-98
Sep-98
Mar-99
Sep-99
Mar-00
Sep-00
Mar-01
Sep-01
Mar-02
Sep-02
Mar-03
Sep-03
Mar-04
Sep-04
Mar-05
Sep-05
Mar-06
C.P. Rate Fed Funds T-Bill 3 Mo
CEIC Database
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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?
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Money Market at ZIRP
Money Demand Money Supply
0
1
2 3
i
i**
i*
M
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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 ofmoney markets to examine the effect of changes
in the economy on money market rates and;
Characterize the effects of changes in monetary
policy