Financial Markets Income: A flow of compensation per unit of time

1. Financial Markets • Income:A flow of compensation per unit of time • Wealth:A stock variable at a given point in time. Equal to financial assets minus financial liabilities • Money:A stock variable equal to financial assets used for transactions. Is equal to currency plus checkable deposits • Investment:The purchase of new capital goods

2. The Demand for Money A Scenario… Money: Used for transactions (currency and checkable deposits) Bonds: Cannot be used for transactions and pays a positive interest rate (i) Two financial assets to choose from

3. The Demand for Money A Summary: The demand for money (Md) depends on: • The level of transactions which are proportional to nominal income ($Y) • The interest rate on bonds

4. The Demand for Money Md = $YL(i) (-) Demand for money Nominal income The liquidity demand for Money is a function of i (-) Md is inversely related to i

5. i Md (for $Y´ > $Y) Md (for nominal Income $Y) M´ M The Demand for Money Graphically Md = $YL (i) Interest Rate, i Money, M

6. Md and i are inversely related • Given $Y at i, M = M (P*, A) • i2, M = M2 • i1, M = M1 b i2 a i c i1 Md ($Y) M2 M1 M The Demand for Money Interest Rate, i Money, M

7. The Demand for Money Graphically Md = $YL (i) • Increase $Y to $Y´; Md shifts to Md´ • M increases from M to M´ (a to b) a b i Interest Rate, i Md´ ($Y´ > $Y) Md ($Y) M´ M Money, M

8. The Demand for Money

9. Negative relation between The Demand for Money Money Demand and the Interest Rate: The Evidence Observations

10. The Determination of the Interest Rates: I Money Demand, Money Supply & the Equilibrium Interest Rate Assume: • All money (M) is currency, supplied by the central bank • Financial Market Equilibrium Occurswhen: • Money Supply = Money Demand • M = $YL(i)

11. The Determination of the Interest Rates: I Money Demand, Money Supply & the Equilibrium Interest Rate • The LM relation: M = $YL(i) • The demand for Liquidity (L) = Supply of Money

12. Ms A Interest Rate, i i1 Equilibrium interest, I, Md = MS Md ($Y) M Money, M The Determination of the Interest Rates: I The Equilibrium Graphically

13. Ms • Increase $Y to $Y´ • Md increases to Md´ A´ • Equilibrium moves from A to A´ i2 • i increases from i1to i2 A i1 Md´ ($Y´ > $Y) Md ($Y) M The Determination of the Interest Rates: I The effects of an increase in National Income on i Interest Rate, i Money, M

14. Ms Ms´ • Increase Ms to Ms´ • Equilibrium moves from A to A´ • Interest rate falls from i1to i2 A i1 A´ i2 Md ($Y) M´ M The Determination of the Interest Rates: I The effects of an increase in the Money Supply on i Interest Rate, i Money, M

15. Calculating the price of a bond-- Assume a bond with a $100 value in one year The Determination of the Interest Rates: I Monetary Policy and Open Market Operations The Price of Bonds and the Interest Rate

16. The Determination of the Interest Rates: I Monetary Policy and Open Market Operations Observation! The price of a bond and the interest rate are inversely related.

17. The Determination of the Interest Rates: I A Summary: • i is determined by MD & MS • Central bank changes i by changing MS • Central bank changes MSwith open market operations • Buying bonds increases the MS and reduces i • Selling bonds decreases the MS and increases i

18. Assets Liabilities Reserves Loans Bonds Checkable deposits Assets Liabilities Bonds Central Bank Money =Reserves +Currency The Determination of the Interest Rates: II Interest rates in an economy with currency and checkable deposits What banks do: Banks Central Banks

19. Demand for money Demand for reserves(by banks) Demand for Central Bank Money Supply of Central Bank Money = Demand forcurrency The Determination of the Interest Rates: II The supply and demand for central bank money Demand forcheckabledeposits

20. The Determination of the Interest Rates: II The demand for money Assume: The demand for currency is: CUd The demand for checkable deposits is: Dd CUd = cMd: Demand for currency (Central Bank Money) Dd = (1-c)Md: Demand for Reserves (Central Bank Money)

21. The Determination of the Interest Rates: II The demand for reserves Assume: : Represents the reserve ratio (reserves to checkable deposits) R: Represents the dollar amount of reserves D: Represents the dollar amount of checkable deposits Therefore:

22. The Determination of the Interest Rates: II The demand for reserves If people hold deposits of Dd, then banks must hold reserves (R) of Dd.

23. The Determination of the Interest Rates: II The demand for reserves The Equilibrium Equilibrium (Supply of Money = Demand for Money)

24. The Determination of the Interest Rates: II Supply of Central Bank Money = Demand for Central Bank Money Assume: People only hold currency: C=1 Banks do not impact the money supply.

25. The Determination of the Interest Rates: II The supply and demand for money Recall: Therefore: Supply of Money = Demand for Money

26. The Determination of the Interest Rates: II The supply and demand for money Observations: • The supply of money is a multiple of theCentral Bank money. • Central Bank money (monetary base) is High-powered money (H)

27. The Determination of the Interest Rates: II The supply and demand for reserves • The Federal Funds Market: The market for bank reserves • The Federal Funds Rate: The interest rate that equates the supply of Reserves (H-Cud) with demand for reserves (Rd)

28. The Determination of the Interest Rates: II A Summary: • Increases in Central Bank money (Fed buys bonds) decrease the interest rate • Decreases in Central Bank money (Fed sells bond) increase the interest rate