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Financial Markets
Prepared by:
Fernando Quijano and Yvonn Quijano
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The Demand for Money
The Fed (short for Federal Reserve Bank) is the
. central bank.
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.
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The Demand for Money
The proportions of money and bonds you wish to
hold depend mainly on two variables:
Your level of transactions
The interest rate on bonds
Money market funds pool together the funds of
many people and use these funds to buy bonds –
typically, government bonds.
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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).
Semantic Traps: Money,
Income, and Wealth
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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.
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.
Semantic Traps: Money,
Income, and Wealth
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The demand for money:
increases in proportion to nominal income
($Y), and
depends negatively on the interest rate
(through L(i) ,note the negative sign underneath
L(i) ).
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Deriving the Demand for Money
The Demand for Money
Figure 4 - 1
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.
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The Demand for Money and the
Interest Rate: The Evidence
Using this equation, you can find out how much the
demand for money responds to changes in the
interest rate( through L(i) ).
Because L(i) is a decreasing function of the
interest rate i, this equation says:
When the interest rate is low, then L(i) is high,
so the ratio of money demand to nominal
income should be high.
When the interest rate is high, then L(i) is low,
so the ratio of money demand to nominal
income should be low.
= L(i)M
d
$Y
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Figure 4 - 1
The Ratio of Money
Demand to Nominal
Income and the
Interest Rate since
1960
The ratio of money
to nominal income
has decreased over
time. Leaving aside
this trend, the
interest rate and the
ratio of money to
nominal income
typically move in
opposite directions.
The Demand for Money and the
Interest Rate: The Evidence
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Figure 4 -1 suggests two main conclusions:
The first is that there has been a large decline
in the ratio of money demand to nominal
income since sometimes
refer to the inverse of the ratio of money
demand to nominal income ($Y/Md) as the
velocity of money.
The second conclusion is that there is a
negative relation between year-to-year
movements in the ratio of money demand to
nominal income and year-to-year movements
in the interest rate.
The Demand for Money and the
Interest Rate: The Evidence
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Figure 4 - 2
Changes in the
Interest Rate Versus
Changes in the Ratio
of Money Demand to
Nominal Income
since 1960
Increases in the
interest rate have
typically been
associated with a
decrease in the ratio
of money to nominal
income, decreases in
the interest rate with
an increase in that
ratio.
A scatter diagram is a figure in which
one variable is plotted against another.
Each point in the figure shows the values
of these two variables at a point in time.
The Demand for Money and the
Interest Rate: The Evidence
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The Determination of
the Interest Rate. i
In this section, we assume that checkable
deposits do not exist – that the only money in the
economy is currency.
The role of banks as suppliers of money (and
checkable deposits) is introduced in the next
section.
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Money Demand, Money Supply,
and the Equilibrium Interest Rate
EquilibriumEquilibrium in financial markets requires that in financial markets requires that
money supply be equal to moneymoney supply be equal to money demanddemand, or , or
that that Ms = Md. Then using this equation, the
equilibrium condition is:
Money Supply = Money demand
This equilibrium relation is called the LM
relation.
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Money Demand, Money Supply,
and the Equilibrium 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).
The Determination of
the Interest Rate
Figure 4 - 2
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Money Demand, Money Supply,
and the Equilibrium Interest Rate
An increase in
nominal income leads
to an increase in the
interest rate.
The Effects of an
Increase in
Nominal Income on
the Interest Rate
Figure 4 - 3
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Money Demand, Money Supply,
and the Equilibrium Interest Rate
Figure 4 - 4
An increase in the
supply of money leads
to a decrease in the
interest rate.
The Effects of an
Increase in the
Money Supply on the
Interest Rate
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Open Market Operations
In modern economies ,the way central banks change the
supply of money is by buying or selling bonds in the
bonds market,these actions are called Open-market
operations, because they take place in the “open market”
for bonds, it is the standard method central banks use to
change the money stock in modern economies.
If the central bank buys bonds, this operation is called an
expansionary open market operation because the
central bank increases (expands) the supply of money.
If the central bank sells bonds, this operation is called a
contractionary open market operation because the
central bank decreases (contracts) the supply of money.
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Figure4-5 is the balance sheet of the cental bank .The
asset of the cental bank are bonds it hold in its
portfolio(资产组合).Its liabilities are the stock of money
in the economy . Open market operations lead to equal
but contrary change in assets and liabilities.
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Bond Prices and Bond Yields
The Balance Sheet of the
Central Bank and the Effects
of an Expansionary Open
Market Operation
Figure 4 - 5
(a) The assets of the central
bank are the bonds it
holds. The liabilities are
the stock of money in the
economy.
(b) An open market operation
in which the central bank
buys bonds and issues
money increases both
assets and liabilities by the
same amount.
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Bond Prices and Bond Yields
You must understand the relation between the
interest rate and bond prices:
Treasury bills, or T-bills are issued by the
. government promising payment in a
year or less.
In fact, what is determined in bonds markets
is not interest rates,but prices; the interest
rate on a bond can be infered from the price
of the bond .
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If you buy the bond today and hold it for a
year, the rate of return (or interest) on
holding a $100 bond for a year is ($100 -
$PB)/$PB.
If we are given the interest rate, we can
figure out the price of the bond using the
same formula.
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Choosing Money or
Choosing the Interest Rate?
A decision by the central bank to lower the interest rate from i to i
’ is equivalent to increasing the money supply(through open
market operations which purchase bonds and at same time
increase the amount of money in the economy. ).
Figure 4 - 4
Typically ,the
cental bank first
thinks about the
interest rate it
want to achieve
and then change
the money supply
in the economy so
as to achieve it .
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SUMMARIZATION:
The interst rate is determined by the equality of supply
of money and the demand for money. .
By changing the supply of money ,the central bank can
affect the interest rate.
The central bank changes the supply of money
through open-market operations in bonds market,
which are purchases or sales of bonds for money.
open-market operations are the basic tools used by
morden central bankes to affect rates .
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In bonds markets what is determined is not interest
rates,but prices;the interest rate on a bond can be
infered from the price of the bond .
Open-market operations in which the central bank
increases the money supply by buying bonds lead
to an increase in the price of bonds –equivalently, a
decrease in the interest rate.
Open-market operations in which the central bank
decreases the money supply by selling bonds lead
to an decrease in the price of bonds –equivalently,
an increase in the interest rate.
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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
assets of these institutions consists of the stocks
and bonds they own and loans they have made .Their
liabilities are what they owe to the people and firms from
whom they have received funds.
Banks receive funds from people and firms who either
deposit funds directly or have funds sent to their
checking accounts. The liabilities of the banks are
equal to the value of these checkable deposits.
(note :this is just a simplied version ,bank have other types of liabilities in
addition to checkabe deposits. ).
Banks keep as reserves some of the funds they
hold them partly in cash and partly in an
account the banks have at the the central bank .
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What Banks Do
Banks hold reserves for three reasons:
1. On any given day, some depositors withdraw
cash from their checking accounts, while
others deposit cash into their accounts.
2. In the same way, on any given day, people
with accounts at the bank write checks to
people with accounts at other banks, and
people with accounts at other banks write
checks to people with accounts at the bank.
3. Banks are subject to reserve requirements.
The actual reserve ratio – the ratio of bank
reserves to bank checkable deposits – is
about 10% in the United States today.
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The Balance Sheet of Banks and the Balance Sheet
of the Central Bank Revisited
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What Banks Do
Loans represent roughly 70% of banks’
nonreserve assets. Bonds account for the
rest (30%).
The assets of the central bank are the bonds
it holds. The liabilities of the central bank are
the money it has issued, central bank money.
The new feature is that not all central bank
money is held as currency by the public. Some of
its is held as reserves by banks(partly in cash and partly
in their cenrtral bank accounts.)
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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 . 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.
Bank Runs
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The Supply and the Demand
for Central Bank Money
Let’s think in terms of the supply and the demand
for central bank money.
The demand for central bank money is equal
to the demand for currency by people plus the
demand for reserves by banks .
The supply of central bank money is under
the direct control of the central bank.
The equilibrium interest rate is such that the
demand and the supply for central bank
money are equal.
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The Demand for Money
Demand for currency:
Demand for checkable deposits:Demand for checkable deposits:
When people can hold both currency and
checkable deposits, and demand for money by
people is for both checkable deposits and
currency.
The demand for money involves two decisions.
First, people must decide how much money to
hold. Second, they must decide how much of this
money to hold in currency and how much to hold
in checkable deposits
.
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The Demand for Reserves
Relation between deposits (D) and reserves (R):Relation between deposits (D) and reserves (R):
Demand for reserves by banks:Demand for reserves by banks:
The larger the amount of checkable deposits,
the larger the amount of reserves the banks
must hold, both for precautionary and for legal
reasons.
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The Demand for Central Bank Money
Demand for central bank money:Demand for central bank money:
Then:Then:
SinceSince Then:Then:
The demand for central bank money is equal
to the sum of the demand for currency and
the demand for reserves.
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The Supply and the Demand
for Central Bank Money
Figure 4 - 7 Determinants of the Demand and the Supply of Central
Bank Money
]
]
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SUMMARIZATION:
for money by people is for both checkable
deposits and currency.
banks have to hold reserves against
checkable deposits ,the demand for checkable
deposits leads to a demand for reserves by banks;
, the demand for central bank money is
equal to the sum of the demand for currency and
the demand for reserves
supply of central bank money is determined by
the central bank.
equilibrium ,the demand and the supply of central
money must be equal.
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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:Or restated as:
Please Consider the different means when
c=0,c=1,0<c<1,and ө=0 ?
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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.
Equilibrium in the
Market for Central
Bank Money, and the
Determination of the
Interest Rate
Figure 4 - 8
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The demand for central bank money,CUd+Rd,is drawn for a
given level of nominal income .A higher interest rate
implied a lower demand for central bank money for two
reason:
(1)The demand for currency by people goes down :
(2)The demand for checkable deposits by people also
goes down. This also leads to lower demand for
reserves by banks.
Both leads to lower demand for central bank money.
The changes in nominal income and in the supply of
central bank money can both lead to the shift of the
demand and supply curve of central bank money.
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Two Alternative Ways to
Think about the Equilibrium*
In addition to the equilibrium in terms of the equality of
demand and supply of central money, there are two other
way of looking at the equilibrium .
Firstly , the equilibrium that the supply and the demand for
bank reserves be equal:
The The federal funds market is a market for bank reserves is a market for bank reserves
rate,where the interest rate moves up and down to balance
the supply and demand for that have excess .Banks that have excess
reserves at the end of the day lend them to banks that have reserves at the end of the day lend them to banks that have
insufficent reserves . In equilibrium, demand (insufficent reserves . In equilibrium, demand (RRdd) must equal ) must equal
supply (supply (H-CUH-CUdd). The interest rate determined in the market is ). The interest rate determined in the market is
called the called the federal funds rate which is typically thougt of as
the main indicator of . monetary policy.
4-4
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The Supply of Money, the Demand for
Money and the Money Multiplier
The second equilibrium is that the overall supply of
money is equal to the overall demand for money
(including currency and checkable deposits) .
This equilibrium condition can be derived from the
equilibrium equation of the supply and demand of
central bank money:
Supply of money = Demand for moneySupply of money = Demand for money
Supply of central bank money = Demand for Supply of central bank money = Demand for
central bankcentral bank money:money:
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Because (c+θ(1-c))<1,so 1/(c+θ(1-c))>1,so as a
constant 1/(c+θ(1-c)) is called the money
overall supply of money is
,therefore , equal to central bank money (H) times
the money multiplier. This means that a given
change in central bank money has a larger effect on
the money supply---and, in turn ,a larger effect on
the interest rate .
High-powered money is the term used to reflect the is the term used to reflect the
fact that the overall supply of money depends in the fact that the overall supply of money depends in the
end on the amount of central bank money (end on the amount of central bank money (HH), or ), or
monetary base,in the economy..
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Understanding the Money Multiplier
We can think of the ultimate increase
in the money supply as the result of
successive rounds of purchases of
bonds—the first started by the Fed in
its open market operation, the
following rounds by
successive round leads to an increase
in the money supply .
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Key Terms
Federal Reserve Bank (Fed)
Income,
Flow,
Saving,
Savings,
Financial wealth, wealth,
Stock,
Investment,
Financial investment,
Money,
Currency,
Checkable deposits,
Bonds,
Money market funds,
M1
Velocity
Scatter diagram
Open market operation,
LM relation
Open market operation
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,
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