1. Financial Markets

2. How Is the Interest Rate Determined in the Short Run?
By the condition that the supply of money equals the demand for money.
Here, there are only two assets: bonds and money.
Here, nominal income and prices are given, so there is no need to consider simultaneous equilibrium of goods and financial markets.
Investment is a function of the interest rate, so output is affected by the interest rate.
Monetary policy is, in large part, directed to the determination of the interest rate.

3. The Demand for Money
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Money, which can be used for transactions, pays no interest. There are two types of money: currency and checkable deposits.
Bonds, pay a positive interest rate, i, but they cannot be used for transactions.
Wealth = Money + Bonds
How much of your saving should you hold as money? Depends on your level of
transactions
and the interest rate on bonds.

4. The Demand for Money Transactions Demand for Money
You need money (a financial asset that is an accepted medium of exchange) to buy goods and services on a day to day basis.
Buying food, paying the rent, filling up the tank.
Higher prices increase the demand for money.
Higher income increases the demand for money.
 Md is directly proportional to nominal income.

5. The Demand for Money The interest rate on bonds
People prefer to hold liquid assets, i.e., means of exchange.
To get them to hold bonds (which are not liquid), people must be paid interest.
Money doesn’t pay interest.
If the interest rate is high, the opportunity cost of holding money is higher.
There’s an inverse relation L(i) between the holding of liquid assets and the interest rate.

6. Semantic Traps: Money, Income, and Wealth
what you earn from working plus what you receive in interest and dividends. It is a flow—that is, it is expressed per unit of time.
Saving
that part of after-tax income that is not spent. It is also a flow.

7. Semantic Traps: Money, Income, and Wealth
Financial wealth, or simply wealth,
The value of all your financial assets minus all your financial liabilities. Wealth is a stock variable—measured at a given point in time.
Financial assets that can be used directly to buy goods are called money. Money includes currency and checkable deposits.
Investment
Is the purchase of new capital goods, such as machines, plants, or office buildings.
The purchase of shares of stock or other financial assets is financial investment.

8. Deriving the Demand for Money
increases in proportion to nominal income, $Y, and
depends negatively on the interest rate: L(i).

9. Deriving the Demand for Money
For a given level of nominal income ( for a given Md curve), a lower interest rate increases the quantity demanded of money.
At a given interest rate, an increase in nominal income shifts the demand for money to the right.

10. The Determination of the Interest Rate, Part I
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In this section, we assume that people only hold money in the form of currency.
Then only the central bank supplies money, in an amount equal to M, so M = Ms.
The role of banks as suppliers of money (in the form of checkable deposits) is introduced in the next section.

11. The Determination of the Interest Rate, Part I
Equilibrium in financial markets requires that money supply be equal to money demand:
This is the LM relation.

12. Money Demand, Money Supply; and the Equilibrium Interest Rate
The Determination of the Interest Rate
The interest rate must be such that the supply of money (which is independent of the interest rate) be equal to the demand for money (which does depend on the interest rate).

13. Money Demand, Money Supply; and the Equilibrium Interest Rate
The Effects of an Increase in Nominal Income on the Interest Rate
An increase in nominal income $Y leads to an increase in the interest rate i.
Equivalently, if M/$Y falls, and i will rise.

14. The Demand for Money and the Interest Rate: The Evidence
The interest rate and the ratio of money to nominal income typically move in opposite directions.

15. The Demand for Money and the Interest Rate: The Evidence
There is a “secular trend” in M/$Y: it has been falling for a long time, so it’s not clear that interest rates are the cause.
Is velocity high when the interest rate is low? Not necessarily.
Econometric point: “Detrending” time series that have a trend

16. The Demand for Money and the Interest Rate: The Evidence
So, instead, we look at the relation between the change in i and the change in M/$Y.
Figure 2 shows that there’s an inverse relation between the changes:
If i rises, M/$Y falls.
If i falls, M/$Y rises.

17. The Demand for Money and the Interest Rate: The Evidence

18. This graph would seem to support the thesis that higher GDP growth leads to higher money demand, which the Central Bank (or the banks accommodate.

19. Monetary Policy and Open-Market Operations
The Effects of an Increase in the Money Supply on the Interest Rate
An increase in the supply of money leads to a decrease in the interest rate.
This is the basis for monetary policy

20. Monetary Policy and Open-Market Operations
Open-market operations, which take place in the “open market” for bonds, are the standard method central banks use to change the money stock in modern economies.

21. Monetary Policy and Open-Market Operations
The Balance Sheet of the Central Bank and the Effects of an Expansionary Open Market Operation
The assets of the central bank are the bonds it holds. The main liability is the stock of currency in the economy. An open market operation in which the central bank buys bonds and issues currency increases both assets and liabilities by the same amount.

22. Monetary Policy and Open-Market Operations
In an expansionary open market operation, the central bank buys $1 million worth of bonds, increasing the money supply by $1 million.
In a contractionary open market operation, the central bank sells $1 million worth of bonds, decreasing the money supply by $1 million.

23. Monetary Policy and Open-Market Operations
When the central bank buys bonds (and issues currency), the demand for bonds goes up: the price of bonds rises.
There is an inverse relation between the price of bonds and the interest rate.
See next slide, or take ECO 342.
Therefore, an expansionary open market operation raises the demand for bonds and their price and lowers interest rates.

24. Monetary Policy and Open-Market Operations
The inverse relation between prices of bonds and the interest rate:
Suppose you buy a US government bond (i.e., a debt of the US government) at $PB and hold it until the government pays you back the full amount (say, $100).
Then your return is:

25. The Determination of the Interest Rate, II
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Central Bank Money
In reality, money is not just currency.
We can also use our checking deposits as means of exchange, stores of value, and units of account.
Checking deposits, however, are not issued by the Central Bank, but by banks.
We must study financial intermediaries, institutions that
receive funds from people and firms, and
use these funds to buy bonds or stocks, or to make loans to other people and firms.

26. The Determination of the Interest Rate, II
Deposits are, to a degree, unpredictable:
they depend on the public’s desire to hold currency rather than deposits and
the banks’ desire to lend their funds.
But deposits are influenced by Central Banks through the Reserve Requirement.
So instead of studying money, we study Central Bank money.

27. What Banks Do
Banks receive deposits from individuals and make loans with the funds.
Banks keep as reserves some of the funds they have received, for three reasons:
To honor depositors’ withdrawals.
To pay what the bank owes to other banks.
To maintain the legal reserve requirement, or portion of checkable deposits that must be kept as reserves:
The reserve ratio is the ratio of bank reserves to checkable deposits (currently about 10% in the United States).

28. What Banks Do
Demand for Reserves by Banks = q · Demand for Deposits by public
q < 1
Banks demand reserves for legal and prudential reasons.
Imagine that reserves are currency held in banks’ vaults:
they are liabilities of the CB, but they are not held by the public.
They can also be held as deposits in the CB or as very liquid government bonds.

29. The Balance Sheet of Banks and the Balance Sheet of the Central Bank Revisited

30. What Banks Do Banks’ assets (loans and bonds) and liabilities:
Loans represent roughly 70% of banks’ nonreserve assets.
Bonds account for the other 30%.
Deposits are Banks’ liabilities.
Central Banks’ assets and liabilities:
The assets of a central bank are the bonds it holds.
The liabilities are the money it has issued, central bank money, which is held either:
as currency by the public,
and as reserves by banks.

31. Bank Runs
Rumors that a bank is not doing well and some loans will not be repaid, will lead people to close their accounts at that bank. If enough people do so, the bank will run out of reserves—a bank run.
To avoid bank runs, the U.S. government provides federal deposit insurance.
An alternative solution is narrow banking, which would restrict banks to holding liquid, safe, government bonds, such as T-bills.

32. Determinants of the Demand for Central Bank Money
Rd=qDd
q is determined by banks’ behavior and by the Central Bank.
Central Bank money = Held as Currency by the public + Held as Reserves by banks

33. The Demand for Money, Reserves, and Central Bank Money
Demand for currency:
Demand for checkable deposits:
Relation between deposits (D) and reserves (R):
Demand for reserves by banks:
Demand for central bank money:
Then:
Since
, then:

34. The Determination of the Interest Rate
In equilibrium, the supply of central bank money (H) is equal to the demand for central bank money (Hd):
Or restated as:

35. The Determination of the Interest Rate
Equilibrium in the Market for Central Bank Money, and the Determination of the Interest Rate
The equilibrium interest rate is such that the supply of central bank money is equal to the demand for central bank money.

36. Two Alternative Ways to Think about the Equilibrium
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Alternative 1: Banks can obtain reserves through the Federal Funds Market.
The equilibrium condition that the supply and the demand for bank reserves be equal is given by:
Supply of Reserves
Demand for Reserves R
Reserves, R
In equilibrium, demand (Rd) must equal supply (H-CUd). The interest rate determined in the market is called the federal funds rate.

37. The Supply of Money, the Demand for Money and the Money Multiplier
Alternative 2: The overall supply of money is equal to central bank money times the money multiplier:
Then:
Supply of money = Demand for money
High-powered money is the term used to reflect the fact that the overall supply of money depends in the end on the amount of central bank money (H), or monetary base.

38. What did I learn in this chapter?
Tools and Concepts
Stock versus flow variables; wealth (a stock) versus income (a flow).
Monetary policy and open market operations.
The use of balance sheets for the central bank and private banks.
Various terms and concepts associated with the banking system: currency, checkable deposits, reserves, central bank money (high powered money, the monetary base), the federal funds market and the federal funds rate, and the money multiplier.