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The Financial Market

The document provides an overview of financial markets, highlighting their role in the economy, key players, and the functions of money. It discusses the demand and supply of money, equilibrium in the money market, and the impact of monetary policy on interest rates. Additionally, it addresses concepts like fractional reserve banking, liquidity traps, and the limitations of monetary policy at the zero lower bound.

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7 views2 pages

The Financial Market

The document provides an overview of financial markets, highlighting their role in the economy, key players, and the functions of money. It discusses the demand and supply of money, equilibrium in the money market, and the impact of monetary policy on interest rates. Additionally, it addresses concepts like fractional reserve banking, liquidity traps, and the limitations of monetary policy at the zero lower bound.

Uploaded by

luow73492
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Exam Review Notes: The Financial Market

1. Introduction to Financial Markets


• Financial markets play a crucial role in the economy by determining the cost of
funds for firms, households, and governments.

• Two key financial assets:

• Money: Used for transactions but pays no interest.


• Bonds: Earn interest but cannot be used for transactions.
• The financial market equilibrium determines the short-term interest rate,
which affects borrowing and investment decisions.

2. Key Players in Financial Markets


• Households & Firms: Demand financial assets.
• Central Bank: Controls the supply of money.
• Government: Issues bonds to finance spending.
• Commercial Banks: Act as intermediaries, offering deposit accounts and
loans.

3. Money and Its Functions


• Medium of Exchange: Facilitates transactions.
• Unit of Account: Measures economic value.
• Store of Value: Maintains value over time.

4. Demand for Money


• Liquidity Preference Theory: Individuals hold money for transactions and as
a precaution.

• Key Determinants:
• Nominal Income (V): Higher income ➔ higher demand for money.

• Interest Rate (i): Higher interest rates reduce money demand as people
prefer bonds.

Mathematically:
M d == YL( i)

where L(i) is a decreasing function of the interest rate.

5. Supply of Money
• Definition: The total amount of currency and deposits available in the
economy.

• Central Bank's Role: Controls money supply through monetary policy tools.
• Types of Money Supply:
• MO (Monetary Base): Currency+ bank reserves.

• M1: MO + demand deposits.

• M2, M3: Broader measures including time deposits and money market
funds.

6. Equilibrium in the Money Market


• The interest rate is determined by the equilibrium condition:
M s == M d

• Graphical Representation:
• The money demand curve slopes downward.

• The money supply curve is vertical (fixed by the central bank).


7. Monetary Policy & Interest Rates
• Open Market Operations {OMOs):
• Expansionary OMO: Central bank buys bonds ➔ increases money supply
➔ lowers interest rates.

• Contractionary OMO: Central bank sells bonds ➔ reduces money supply


➔ raises interest rates.

• Federal Funds Rate {US): The rate at which banks lend reserves to each
other.

• Refinancing Rate {EU): The rate at which the ECB lends to commercial
banks.

8. The Role of Banks & Money Creation


• Fractional Reserve Banking: Banks hold only a fraction of deposits as
reserves and lend out the rest.

• Money Multiplier:

M ~ l H
c+0(1- c)
where:

• c = cash-to-deposit ratio,

• 0 = reserve ratio,
• H = central bank money.

9. The Liquidity Trap & Zero Lower Bound (ZLB)


• Liquidity Trap: When interest rates reach zero, further increases in money
supply do not reduce rates further.

• Implication: Monetary policy becomes ineffective.


• Example: Post-2008 Quantitative Easing {QE) in the US & EU.

10. Key Takeaways


• In the short run, the central bank determines the interest rate.
• Money demand depends positively on income and negatively on interest
rates.
• An increase in the money supply lowers interest rates, stimulating
spending.
• Banks create money through lending, but are constrained by reserve
requirements.
• At the ZLB, monetary policy may become ineffective, requiring
alternative tools like fiscal policy.

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