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Financial Markets

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5 views

Financial Markets

Uploaded by

alexdratini
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© © All Rights Reserved
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Financial Markets

Interest rate determined by central banks (on bonds). Assume two assets
in the economy, money or bonds.

 Money is used for transactions, but pays no interest (two types:


currency (coins and notes) and deposits (bank deposits on which
you can write cheques))
 Bonds pay a positive interest rate, but can’t be used for transactions
(issues by governments and firms – government and corporate
bonds) Buying a bond makes you a lender
 Holding of money and bonds depends on your level of transactions
and the interest rates of the bond

Aggregate demand for money (Md) equals nominal income $Y (measure of


the level of transactions in the economy) times a decreasing function
L(i) of the interest rate i

Md = $Y L(i)

Increase in interest rate decreases demand for money as people put more
wealth into bonds (opportunity cost of holding money)

Demand for money increases in proportion to nominal income (higher GDP


means more income and more transactions, so more money is needed)
and depends negatively on interest rate. The relationship between
demand for money and interest rate for a given level of income $Y is
represented by the Md curve.

Determining interest rates

Supply of money is determined by the central bank (Ms)

Ms = M (exogenous variable)

Ms = Md

M = $Y L(i) [this is the LM relation]

Money supply is independent of the interest rate because it is set by the


central bank. An increase in nominal income will shift Md curve to the
right and increase interest rate (as there is an excess demand for money
so interest rises to make people buy bonds) An increase in money supply
will shift the Ms curve to the right and decrease interest rate (as there is
an excess supply of money so interest falls to make people sell bonds)

Supply of money is changed through open market operations (buying


or selling bonds in the bond market). Expansionary open market
operations (buying bonds to expand the supply of money). Contractionary
open market operations (selling bonds to contract the supply of money).
Central Bank Balance Sheet: Assets are bonds and liabilities are money
(currency). The balance sheet remains balanced if they buy $1 million
bonds, they add $1 million to money circulation, so the sheet remains
symmetric.

Suppose there is one type of bond (not realistic). If you buy the bond for
£Pb and are promised £100 in the future, interest rate is
$ 100−$ Pb $ 100
I= thus $Pb =
$ Pb 1+i
Higher bond price means lower interest rate. Higher interest rate, lower
the price today.

$Pb(1 + i) = $100 [The $100 is fixed, so if interest rate rises, $Pb MUST
fall and vice versa]

Rather than changing money supply to affect the interest rate, the central
bank could have chosen the interest rate to affect the money supply. The
latter is the typical approach for modern central banks. Generally interest
rates for different economies move together as they affect each other, or
respond to global shocks together.

Liquidity Trap: Where interest rates reach near zero, so people become
indifferent to holding money and holding bonds, and thus demand money
for transactions. (Zero lower bound: the interest rate cannot go below
zero) Monetary policy becomes ineffective in this scenario. Once people
have enough money for transactions, the demand for money becomes
horizontal and further increases to money supply have no effect.

The model we have thus far must be extended in terms of the definition of
money. Money not only consists of currency, but also deposits (such as
bank accounts). Financial intermediaries (commercial banks) receive funds
from people and firms and use these funds to buy bonds or stocks, or to
make loans to other people and firms (as they know people won’t be
asking for money back immediately)

 Banks receive deposits from people and firms. The liabilities of the
banks are equal to the value of these deposits.
 The deposits are used for loans/bonds and also reserves (this level
of reserves is determined by law)
 Bank assets are thus sum of bonds, loans and reserves

Reserves are held for people who withdraw cash, people who write
cheques that the bank needs to pay out, and as a legal requirement (legal
reserve ratio – 10% in US today) The reserves are usually held in the
central bank, and are counted as a liability on the central bank’s balance
sheet (in circulation)
Central Bank Money : Currency and Reserves in circulation

Demand for central bank money is equal to the demand for currency by
people plus the demand for reserves by banks, and supply is set.

New demand for money (currency and deposits) involves two decisions

First, people decide how much money to hold.

Second, they decide how much of this money to hold in currency


and how much money to hold in deposits

Md = $Y L(i)

CUd = cMd (where c is between zero and one)

Dd = (1 – c)Md

Demand for reserves by commercial banks: Larger amount of deposits,


larger amount of reserves held.

R = θD where θ is the reserve ratio

Demand for reserves by banks: Rd = θ(1 - c)Md

Demand for central bank money (total demand for money): H d = CUd + Rd

Hd = cMd + θ(1 – c)Md

= [c + θ(1 – c0)]Md

= [c + θ(1 – c)]$Y L(i)

Negative relationship between demand for central bank money and


interest rate (as L(i) is a decreasing function) so equilibrium graph looks
the same as normal money demand and supply curves

Two Other Equilibriums

 H = Hd (where H is supply of central bank money)


H = [c + θ(1 – c)]$Y L(i)

 Supply of bank reserves = Demand for bank reserves


 H = Hd = CUd + Rd
H – CUd = Rd
H - c$Y L(i) = θ(1 – c)$Y L(i)

 Supply of central bank money = Demand for central bank money


 H = [c + θ(1 – c)]$Y L(i)
H
 =$ Y L ( i )
c+ θ ( 1 – c )

Interest rates can be nominal (in terms of dollars - i) or real (in terms of a
basket of goods - r) We must adjust the nominal interest rate to take
expected inflation into account – it is set by central bank. Nominal is a
value, real is a quantity.

Real interest rate: (1 + rt) good (one good after one year)

rt = it – πt+1e - rtπt+1e

Fisher rule: when expected inflation is zero, nominal and real interest rates
are equal. Expected inflation is generally positive so real < nominal. Real
interest rate (I – πe) is based on expected inflation so is called ex-ante real
interest rate. Realized real interest rate (I – π) is called the ex-post interest
rate. Zero lower bound of nominal interest implies real interest cannot be
lower than the negative of inflation. Real interest rates have declined less
than nominal ones over time (due to inflation)

i => Md

r => C, I

Seminar
Changes in the level of transaction will shift the Md curve (such as
changes in nominal income)

Monetary base = currency in circulation + reserves held by central bank =


H

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