Financial Markets

1
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.

2
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.

3

• Question
• wealth can be held
• either in bonds
• or in money
• in what proportion will it be?

4
Main variables affecting the decision

• 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.
• the higher
  ,
• the more it is to hold wealth in
  the form of bonds rather than money.

5
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

6
The demand for money - graphEffect 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
7
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 by the
  amount
• If PY increases, Md and Bd
  
• If i increases, Bd and Md
  

8
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.

9

• Problem 2 wealth W 50,000 - income Y
  60,000
• Money demand is Md PY(.35 - i) with P 1
• When i 5
• Md and
  Bd W - Md
• When i 10 Md and
  Bd
• Md when i and Bd
  when i
• i 10 and Y2 .5Y1 30,000
• Since Md is proportional to Y we have Md2 .5Md1
  
• i 5 same story
• e. Independent of i (at every level of i, the
  money demand will be halved)

10

• 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.

11
Supply of money Ms

• The Fed determines the amount of money Ms
  (central bank currency in this section) it
  supplies to the economy.
• So the level of the money supply does not depend

i
M
12
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,

13
Equilibrium in the money market
The interest rate is determined where the 2
curves intersect i.e. supply demand. Note that
the quantity supplied is solely determined by the
Fed and not by the equilibrium supply/demand.
i
M
14
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
15
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
16

• Problem 4 Md PY(.25 - i) with P 1 and Y
  100
• and Ms 20
• In equilibrium Md Ms i.e.
• or 25 - 20 100i i 5/100
• 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)

17
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 .

18
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.

19
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).

20
The Feds balance sheet
Assets Liabilities
21
The Feds balance sheet Open market purchase
Assets Liabilities
22
Relation between the price of bonds and the
interest rate

• Lets 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
• This is indeed an relation between
  the price of the bond and the interest rate.

23
Illustration

or
24
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.

25
Monetary policy

• Expansionary Open market (MS
  )
• The Fed bonds
• PB as the demand for bonds Bd
• so i
• Contractionary Open market (MS )

The Fed bonds PB as the
supply of bonds Bd
so i
26
Interest Rate determination w/ Ms CU D

• Lets 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

27

• 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

28
Balance sheets of Fed and of commercial banks
Fed
Commercial banks
Assets Liabilities Assets
Liabilities

29
Supply and demand for CB money H

• Supply H determined by
• Demand Hd demand for and for
  
• SD 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

30

• Demand for reserves Rd depends on reserve ratio
  requirement ? as R
• -Lets replace D by -
• demand for reserves Rd
• Finally the demand for CB money H is
• Hd

31
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 creation-
• Case 2 people only hold deposits so c 0
• Then H and
• H represents of total money supply

32

• In general we have 0 lt c lt 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

HdCudRdc ?(1-c)PYL(i)
H
33
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

34
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

35

• How much money has been added in the economy up
  to now?
• 100
• Total increase in the money supply is
• 100 100
• 100
• Fed Comm. Banks
• A L A
  L

Loans Reserves
Bonds
Deposits
Reserves