Chapter 10 Financial Markets and the Economy

Financial Markets are markets in which funds accumulated by one group are made available to another group.

The bond market is a market in which institutions and individuals borrow and lend money. They do this through buying and selling bonds.

For example, the U.S. government wishes to borrow money. They issue a bond like this one. It will have a date of maturity, or when you can turn it back into the government and get your money back

It will also have the amount of money you get paid back, in this case $100. So let’s say the maturity on this bond is one year.

You buy it now and turn give it to the government in one year to be paid $100. You are loaning them your money for one year. What is the interest rate you are getting? That depends on how much you paid for it.

Let’s say you pay $90 for it. In one year, you get back $100. You have lent $90 for a year and got back $100. That is equal to an interest rate of (Face Value – Bond Price)/Bond Price ($100-$90)/$90 = $10/$90 =.1111 = 11.11%

The higher the price you pay for the $100 bond 1 year bond, the lower the interest rate you get. Pay $90, then i = 11.1% Pay $95, then i = 5.3% Pay $99, then i = 1.0%

So now we face a choice. Do we want to think of the bond market as one where people lend and borrow money at a certain interest rate, or buy and sell bonds at a certain price?

Both of these are correct ways of illustrating the same thing happening. Textbook guy uses the 2 nd way. I find the 1 st way much more intuitive.

Here are both ways side-by-side. We will primarily use the diagram on the right.

You’ve seen the 2 nd diagram before back in unit 2, where I called it the supply and demand diagram for the credit market. Interest rate Loanable Funds Supply (savings) Demand (borrowing) iEiE QEQE

Here is one way that a change in interest rates can effect the macroeconomy. Much investment spending done by businesses is financed through borrowing. The higher the interest rate you have to pay on a loan to get the money to build a new factory, the less likely you are to build the factory.

Suppose for some reason there is an increase in the amount available for lending. This is an increase in supply in the credit market. Interest rate Loanable Funds S1S1 D1D1 S2S2 i1i1 i2i2 Q1Q1 Q2Q2 Interest Rates Fall

Q P The extra investment spending will increase AD (GDP=C+I+G) AD 1 SRAS P1P1 QNQN AD 2 This could help get us out of a recession P2P2 Q1Q1 Q2Q2

You have a demand for money. Do you always want more?

What can you do with your purchasing power? 3 things. 1) Buy Goods 2) Buy bonds (or other high interest investments) 3) Hold it as money

1) Why buy goods? That’s obvious. You want them. 2) Why buy bonds? To earn interest. 3) Why hold money? Purchase future goods and services easily. Money is very liquid.

3 Reasons to be holding money 1) Holding money to make expected purchases later is the transactions demand for money. 2) Holding money to protect against unexpected purchases (emergencies) is the precautionary demand for money.

3) The speculative demand for money you expect to invest in bonds or stocks but are waiting for a better price.

If we look just at the choice to hold money or bonds, we can think of the interest rate as the opportunity cost or “price” of holding money. If the money itself earns interest, such as an interest earning checking out, it is the difference in the two interest rates that matters.

The higher the interest rate goes on the bonds you have to give up to hold money, the less money you want to hold. Or the more bonds you want to hold. The two statements are functionally equivalent.

Demand curve for money in terms of interest for bonds.

What else affects the demand for money? 1) Expected inflation – the more you expect prices to rise, the less cash you want to hold (remember the wealth effect?) 2) Confidence in the future – if you fear losing your job or that the bond you buy may not pay off, you wish to hold more cash.

Textbook guy lists a few more, but you do not have to memorize the others on the list.

I fear losing my job.

What about the supply of money. Let’s assume the federal reserve board can create as much or little money as it wishes through open market operations.

Equilibrium in the money market is when people want to hold exactly as much money as the fed has created. Suppose the interest rate is very high. People won’t want to hold much money, they will want to hold bonds instead. If the Fed has created a lot of money, people will have “too much” money.

They will get rid of the excess by saving it into the bond market. They will do this by buying bonds. The interest rate will fall until people no longer feel they have “too much” money.

Do people really think they have too much money? Well, imagine you have a huge cash stash in the cookie jar and read that Ford Auto Co. is paying 100% on Ford bonds. Wouldn’t you say I have too much cash sitting around doing nothing when it could be earning 100%?

If they have “too little” money, they will get more by saving less into the bond market (selling bonds) and interest rates will rise. There will be an interest rate at which people want to hold the exact amount of money created by the Fed.

When we get to that interest rate, there will be equilibrium in the money market.

The money market graph and the credit market graphs are two sides of the same coin. Interest rate Loanable Funds Supply (savings) Demand (borrowing) iEiE QEQE

If the demand curve for money shifts, the interest rate will shift. Suppose people fear a big rise in inflation. More money goes into the bond market and interest rates fall.

If the Fed creates more money, people put some of that money into the bond market and interest rates fall.

Here we see what is simultaneously happening in the credit market. Interest rate Loanable Funds S1S1 D1D1 S2S2 i1i1 i2i2 Q1Q1 Q2Q2 Interest Rates Fall

Q P Why might the Fed want to do this? AS/AD diagram showing the effect of more investment caused by lower interest rates. AD 1 SRAS P1P1 QNQN AD 2 This could help get us out of a recession P2P2 Q1Q1 Q2Q2

Chapter 11 Monetary Policy and the Fed

What are the Fed’s goals? 1) Low Inflation 2) Low Unemployment 3) High Growth The same 3 variables that we said determine if the macroeconomy is working well back at the beginning of chapter 5.

But what weight does it assign to each goal? In the 1960’s and 70’s, it was lower unemployment. Since then, it has been lower inflation. This comes from the feeling among many bankers and economists that the fed paid to little attention to inflation in the 60’s/70’s.

If it did, it was probably acting on the feeling that the fed paid too little attention to unemployment in the 1930’s. Some economists are arguing that this “don’t make the same mistake we made last time” mentality is causing the fed to pay too much attention to inflation now.

In theory, Congress can legally set the goals for the fed whenever it wants. It has given the fed a dual mandate of low unemployment and low inflation. In practice, this has left the fed almost completely independent.

So what should the fed do? Suppose we are in a recession. In our model, Q is in the recessionary gap. How can we get out of the recession? We could wait until wages adjust, but with sticky wages, that could take years … and years.

Q P A quicker way out would be if the fed could get AD to move right. AD 1 SRAS P1P1 QNQN AD 2 P2P2 Q1Q1 Can they do this?

The short answer is yes. 1) Fed buys government securities. 2) Banks have more funds to loan. 3) Drop in interest rates. 4) People borrow the new money from the banks and buy things. Voila, recession over!

This is known as expansionary monetary policy. The fed creates money and drives down the interest rate to increase buying. AD moves to the right and increases output and lowers unemployment.

We’ve already seen what simultaneously is happening in the credit market. Interest rate Loanable Funds S1S1 D1D1 S2S2 i1i1 i2i2 Q1Q1 Q2Q2 Interest Rates Fall

What about in the money market? And buy this, I don’t mean the financial market sometimes known as the money market. I mean people’s choice of how much money to hold.

Interest rates fall, people want to hold more money and less bonds.

So as the fed increases the money supply, people will hold more in their cash stash. The increase in money to be lent will not be as large as the amount created by the fed, since people will respond by saving less and holding more cash. But it is unlikely this effect will be large enough to cancel out the effect of the fed’s action.

But what if the problem is we are in the inflationary gap part of the diagram. Can we get back to Q N without inflation? Not if we wait for the natural long-run adjustment and the shifting SRAS curve. But what if we move AD to the left?

Q P Out of the inflationary gap without inflation. AD 2 SRAS P2P2 QNQN AD 1 P1P1 Q1Q1

To do this, we use contractionary monetary policy. The fed decreases the money supply, this decreasing AD. After all, what is money used for? So less money, less buying. 1) Sell government securities. 2) raise r. 3 raise the discount rate.

So to sum up: To fight recessions, expansionary monetary policy to move AD right. To fight inflation, contractionary fiscal policy to move AD left.

Well, that sounds easy. In fact, it sounds too easy. If macroeconomics is that simple, why do we have such a hard problem with recessions and inflation?