Financial Markets The financial market is the market where the equilibrium level of interest rate is determined by the condition that demand for money equal to its supply. Although the supply of money is directly controlled by the central bank, banks operates as another suppliers of money. The demand for money is determined by the level of nominal income (positively) and the rate of interest (negatively).

Some Definitions Income is what you earn from working plus what you receive in interest and dividends from your financial assets. Financial wealth, is the value of all your financial assets minus all your financial liabilities.. Money, that can be used directly to buy goods, includes currency and checkable deposits, and pay no interest. Bonds, pay a positive interest rate, i, but they cannot be used for transactions.

You keep your financial wealth in terms of money and bond proportionately. If you hold all your wealth in the form of bonds, you will earn interest on the full amount. But you will have to call your broker frequently whenever you need money. Buying or selling bonds implies some cost. On the other hand, holding all your wealth in the form of money is clearly very convenient. You won’t ever need to call a broker or pay transaction fees. But it also means you will receive no interest income.

The Demand for Money The proportions of money and bonds you wish to hold depend on the interest rate on bonds and your level of transactions (determined by the level of income). Md =$YL(i) First the demand for money increases in proportion to nominal income. If nominal income doubles, increasing from $Y to $2Y, then the demand for money also doubles, increasing from $Y L(i) to $2Y L(i). Second, the demand for money depends negatively on the interest rate. This is captured by the function L(i). An increase in the interest rate decreases the demand for money.

In other words; The higher the nominal income, the higher the demand for money, and the lower the incentive to hold more bonds. On the contrary, the lower the nominal income, the lower the demand for money, and the higher the willingness to hold bonds. The higher the interest rate, the lower the demand for money, and the higher the incentive to hold more bonds. On the contrary, the lower the interest rate, the higher the demand for money, and the lower the willingness to hold bonds.

The Demand for Money For a given level of nominal income, a lower interest rate increases the demand for money. At a given interest rate, an increase in nominal income shifts the demand for money to the right.

The Determination of the Interest Rate, i For now, we assume that only the central bank supplies money, in an amount equal to M, so M=Ms . We will also assume that the only money is currency. (The role of banks as suppliers of money and checkable deposits is introduced later.) Equilibrium in financial markets requires that money supply be equal to money demand. The interest rate adjusts to clear the market: Ms = Md (i)

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).

The Effects of an Increase in Nominal income on the Interest Rate An increase in nominal income leads to an increase in the interest rate.

The Effects of an Increase in the Money Supply on the Interest Rate An increase in the supply of money, through open market operations, leads to a decrease in the interest rate.

Monetary Policy and Open-Market Operations When the central bank expands the money supply, it buys bonds with the money that it supplies. In the UK, bonds issued by the government are called gilts, in the US, Treasury bills, in general ‘sovereign bonds’ or just ‘bonds’. The payment is fixed: Say it is €100. Let the price of the bond today be € PB. To be just indifferent between €100 in one year and some amount today requires:

Monetary Policy and Open-Market Operations The assets of the central bank are the bonds it holds. The liabilities are the stock of money in the economy. An open market operation in which the central bank buys bonds and issues money increases both assets and liabilities by the same amount.

Monetary Policy and Open-Market Operations In an expansionary open market operation, the central bank buys bonds, increasing the money supply by the same amount. If the central bank buys, say, $1 million worth of bonds, the amount of bonds it holds is higher by $1 million, and so is the amount of money in the economy. In a contractionary open market operation, the central bank sells bonds, decreasing the money supply by the same amount. If the central bank sells $1 million worth of bonds, both the amount of bonds held by the central bank and the amount of money in the economy are lower by $1 million.

Monetary Policy and Open-Market Operations Bonds issued by the government, promising a payment in a year or less, are called Treasury bills, or T-bills When the central bank buys bonds, the demand for bonds goes up, increasing the price of bonds. Equivalently, the interest rate on bonds goes down. 𝑖 = $100 −$ 𝑃 𝐵 𝑃 𝐵 and $𝑃 𝐵 = $100 1+𝑖

Example: 1. Consider a bond that promises to pay €100 in one year.  a. What is the interest rate on the bond if its price today is €75?, €85? and €95? b. What is the relation between the price of the bond and the interest rate? c. If the interest rate is 8%, what is the price of the bond today?

The Determination of the Interest Rate, II Financial intermediaries are 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. Examples include: Banks Pension funds Hedge funds

What Banks Do? Banks receive funds from people and firms who either deposit funds directly or have funds sent to their checking accounts. They keep some of these funds as reserves and, use the rest to buy bonds and to provide loans to the other firms/individuals. Loans represent roughly 70% of banks’ non reserve assets. Bonds account for the rest, 30%. The distinction between bonds and loans is unimportant to understand how the money supply is determined. For the simplicity, we assume that banks do not make loans, that they hold only reserves and bonds as assets.

Banks hold reserves for three reasons: Some depositors withdraw cash from their checking accounts while others deposit cash into their accounts. The inflows and outflows of cash does not have to be equal, so the bank must keep some cash on hand. Account holders write checks to people with accounts at other banks and people with accounts at other banks write checks to people with accounts at the bank. As a result of these transactions, banks owes the other banks. In addition to these, banks are typically subject to reserve requirements, which require them to hold reserves in some proportion of their checkable deposits.

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.

Determinants of the Demand and the Supply of Central Bank Money

The Demand for Money, Reserves, and Central Bank Money Demand for currency: 𝐶𝑈 𝑑 = 𝑐𝑀 𝑑 Demand for checkable deposits: 𝐷 𝑑 = 1−𝑐 𝑐𝑀 𝑑 Relation between deposits (D) and reserves (R): R =θD Demand for reserves by banks: 𝑅 𝑑 =θ(1 −c ) 𝑐𝑀 𝑑 Demand for central bank money: 𝐻 𝑑 = 𝐶𝑈 𝑑 + 𝑅 𝑑 Then: 𝐻 𝑑 = 𝑐𝑀 𝑑 +θ(1−c ) 𝑀 𝑑 = [ c+θ(1−c )] 𝑀 𝑑 Since 𝑀 𝑑 = $YL (i) Then: 𝐻 𝑑 = [ c+θ(1−c )] $YL (i)

The Determination of the Interest Rate In equilibrium, the supply of central bank money (H) is equal to the demand for central bank money (𝐻 𝑑 ): 𝐻= 𝐻 𝑑 Or restated as: 𝐻 𝑑 = [ c+θ(1−c )] $YL (i)

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.

Alternative way to think about the equlibrium: The Supply of Money, the Demand for Money and the Money Multiplier The overall supply of money is equal to central bank money times the money multiplier: 𝐻 𝑑 = [ c+θ(1−c )] $YL (i) Then: 1 [ c+θ(1−c )] H =$YL (i) 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.