CHAPTER 4 Financial Markets Prepared by Fernando Quijano

4 -1 The Demand for Money § 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. Money market funds receive funds from people and use these funds to buy bonds. § The proportions of money and bonds you wish to hold depend on your level of transactions and the interest rate on bonds. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

Semantic Traps: Money, Income, and Wealth § Income is 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 is that part of after-tax income that is not spent. It is also a flow. § Savings is sometimes used as a synonym for wealth (a term we will not use in this course). © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

Semantic Traps: Money, Income, and Wealth § Your financial wealth, or simply wealth, is 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 a term economists reserve for 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. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

Deriving the Demand for Money § The demand for money: § increases in proportion to nominal income ($Y), and § depends negatively on the interest rate (L(i)). © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

Deriving the Demand for Money 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. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

4 -2 The Determination of the Interest Rate, I § In this section, we assume that only the central bank supplies money, in an amount equal to M, so M = Ms. People hold only currency as money. § The role of banks as suppliers of money (and checkable deposits) is introduced in the next section. § Equilibrium in financial markets requires that money supply be equal to money demand: © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

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). © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

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 leads to an increase in the interest rate. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

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. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

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. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

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. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

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 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. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

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. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

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. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

4 -3 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. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

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

What Banks Do § 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). © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

What Banks Do § Loans represent roughly 70% of banks’ nonreserve assets. Bonds account for the other 30%. § 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 as currency by the public, and as reserves by banks. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

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. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

Determinants of the Demand the Supply of Central Bank Money © 2003 Prentice Hall

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: © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

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: © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

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. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

4 -4 Two Alternative Ways to Think about the Equilibrium § The equilibrium condition that the supply and the demand for bank reserves be equal is given by: § The federal funds market is a market for bank reserves. In equilibrium, demand (Rd) must equal supply (H-CUd). The interest rate determined in the market is called the federal funds rate. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

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: 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. © 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

Key Terms § § § § income, flow, savings, financial wealth, stock, investment, financial investment, money, currency, checkable deposits, bonds, money market funds, open market operation, © 2003 Prentice Hall Business Publishing § expansionary, and contractionary, open market operation, § Treasury bill, T-bill, § financial intermediaries, § (bank) reserves, § reserve ratio, § central bank money, § bank run, § federal deposit insurance, § narrow banking, § federal funds market, federal funds rate, § money multiplier, § high-powered money, § monetary base, Macroeconomics, 3/e Olivier Blanchard