BlCh41 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.

BlCh42 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.

BlCh43 Question: wealth can be held either in bonds or in money in what proportion will it be?

BlCh44 Main variables affecting the decision 1. –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.

BlCh45 The demand for money M d 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

BlCh46 The demand for money - graph Effect of an increase in Y or in P i M Inversely related to the rate of interest. An increase in Y or in P results in a rightward shift of the curve.

BlCh47 The demand for bonds B d It is related to the demand for money through W  (note that all these variables are nominal) So B d = It follows that (ceteris paribus): –If W increases, B d by the amount –If PY increases, M d and B d –If i increases, B d and M d

BlCh48 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 there are 2 suppliers: 1. 2.

BlCh49 Problem 2: wealth W = $50,000 - income Y = $60,000 Money demand is M d = PY(.35 - i) with P = 1 a.When i = 5% M d = = and B d = W - M d = When i = 10% M d = and B d = b.M d when i and B d when i c.i = 10% and Y 2 =.5Y 1 = $30,000 Since M d is proportional to Y we have M d 2 =.5M d 1 = d.i = 5% same story e.Independent of i (at every level of i, the money demand will be halved)

BlCh410 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.

BlCh411 Supply of money M s The Fed determines the amount of money M s (central bank currency in this section) it supplies to the economy. So the level of the money supply does not depend M i

BlCh412 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,

BlCh413 Equilibrium in the money market i M 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.

BlCh414 Shifts in the demand for money i M 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.

BlCh415 Shifts in the supply of money i M An increase in the money supply - due to expansionary monetary policy - results in a rightward shift of the M s curve and a drop in the equilibrium interest rate i

BlCh416 Problem #4 M d = PY(.25 - i) with P = 1 and Y = $100 and M s = $20 a.In equilibrium M d = M s i.e. or = 100i i = 5/100 = b.If the Fed wants to increase i by 10 percentage points to 15%, it must the money supply to: M d = (or by = 10)

BlCh417 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.

BlCh418 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.

BlCh419 Open market operations The Fed can affect the quantity of money in the economy When the Fed wants to increase M s, When the Fed wants to cut M s, it (old) bonds from its bonds holdings to the public and money from the public: (i.e. money is taken out of circulation).

BlCh420 The Fed’s balance sheet Assets Liabilities

BlCh421 The Fed’s balance sheet Open market purchase Assets Liabilities

BlCh422 Relation between the price of bonds and the interest rate Let’s consider a 1 year Treasury Bill that promises a $100 payment (its face value) at maturity. P B 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.

BlCh423 Illustration PBPB i $90% $80% $70% or

BlCh424 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.

BlCh425 Monetary policy Expansionary: Open market (M S ) The Fed bonds: P B as the demand for bonds B d so i Contractionary: Open market (M S ) The Fed bonds: P B as the supply of bonds B d so i

BlCh426 Interest Rate determination w/ Ms = CU + D Let’s 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

BlCh427 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

BlCh428 Balance sheets of Fed and of commercial banks Assets Liabilities Fed Commercial banks =

BlCh429 Supply and demand for CB money H Supply H : determined by Demand H d : demand for and for S=D determine the equilibrium interest rate i Demand for money derived above as M d = 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: CU d = demand for deposits: D d =

BlCh430 Demand for reserves R d depends on reserve ratio requirement  as R = -Let’s replace D by - demand for reserves: R d = Finally the demand for CB money H is H d = =

BlCh431 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

BlCh432 In general we have 0 < c < 1 and H represents between 10 % and 100% of the total money in the economy. If either P or Y increase, the impact on H d is the same as the impact on M d i H H d =Cu d +R d = [c +  (1-c)]PYL(i)

BlCh433 Money multiplier mm We derived H = [c +  (1-c)]M with c = CU d /M and  = R/D so mm = = If c = 40% and  =10% the money multiplier is = 2.17

BlCh434 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…

BlCh435 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 Bonds Reserves Loans Reserves Deposit s