Chapter 4: Financial Markets

4-1 The Demand for Money

Assumptions:
o There are only two in the financial market: and

o Price is fixed and Y is given, that is nominal GDP is given

Money: what can be readily used to pay for transactions () . It is highly liquid
) ( but pays no interest
Money = Currency ( (+ Checkable bank deposits)(

Bonds: pays interest but cannot be used for transactions

Income: a flow) (concept: What is earned from working+interest+dividends()
Saving: a flow concept: part of after-tax income that is not spent
Savings: a stock ( )concept: value of what have been accumulated over time
Wealth (): a stock concept = financial assets financial liabilities
Wealth = Md + Bondd
Investment (in economy): purchase of new capital goods () , from machines to
plants to office buildings
A persons choice: hold currency or to buy bonds? (tradeoff: liquidity vs. return)
Money demand depends on:
o level of transactions ()
o interest rate on bonds ()
o other factors like transaction (brokerage) cost ( ) and liquidity of bonds

Money market mutual funds () : pool together ( ) the funds

of many people, which are then used to buy bonds (typically government bonds). These funds pay
an interest rate that is slightly below ( ) the interest rate on the bonds they hold (due to
administrative costs ( ) and profit margins ())
The demand for money (Md) in the economy as a whole is the sum of all the individual
demands for money by the people in the economy.
 Money demand function: Md = $Y L(i)
The demand for money Md is equal to nominal income $Y ( ) times a
function of the interest rate i, with the function denoted by L(i)
The demand for money increases in proportion to nominal income
The demand for money depends negatively on the interest rate: An increase in the
interest rate decreases the demand for money, as people put more of their wealth into
bonds.

4-2 The Determination of Interest Rate I

Assumption: checkable deposits do not existthat the only money in the economy is
currency.
Money supply determined by central bank ( ) in most countries. (FED in US). The
quantity supplied of money is independent of interest rate.
Money supply M = MS
Equilibrium in financial markets requires that money supply be equal to money demand
Money supply = Money demand (LM Relation, L: Liquidity, M: Money)
M = $Y L(i)
 An increase in nominal income leads to an increase in the interest rate: At the initial interest
rate (iA), the demand for money exceeds the supply. An increase in the interest rate is
needed to decrease the amount of money people want to hold and to reestablish equilibrium
() .
 An increase in the supply of money by the central bank leads to a decrease in the interest
rate. The decrease in the interest rate increases the demand for money so it equals the now
larger money supply.
The central bank can change money supply by conducting open market operations (OMO).
Open Market Operations () : if a central bank wants to increase the
amount of money in the economy, it buys bonds and pays for them by creating money
(Expansionary OMP ). If it wants to decrease the amount of money in the economy, it sells
bonds and removes from circulation the money it receives in exchange for the bonds
(Contractionary OMP ). Open market operations lead to equal changes in assets and
liabilities.
The balance sheet ( ) of a bank (or firm, or individual) is a list of its assets and
liabilities ( )at a point in time.
o The assets are the sum of what the bank owns and what is owed to it by others.
The assets of the central bank are the bonds it holds in its portfolio.
o The liabilities are what the bank owes to others. The liabilities of the central bank
are the stock of money in the economy.
 Considers open market operations in terms of their effect on bond prices. Suppose a bond
promises a payment of F (face value) in one year, $PB is the current price of bonds. Then, interest
rate (or rate of return) on this bond is given by
( $ )
o i= $

o $PB =(1+)

In the United States, bonds issued by the government promising payment in a year or less are
called Treasury bills or T-bills.
Nominal interest ( ) rate and the bond price are inversely related.
o When the central bank purchases bonds, it increases the demand for them and
tends to increase their price, which reduces the interest rate.
o When the central bank sells bonds, it increases the supply for them and tends to
decrease their price, which increases the interest rate.

Modern central banks, including the Fed, typically think about the interest rate they want to
achieve, and then move the money supply so as to achieve it.

4-3 The Determination of Interest Rate II

Assumption: money includes currency and checking accounts in banks

 Financial intermediaries () : institutions that receive funds from people and
firms (liabilities) and use these funds to buy financial assets or to make loans to other people and
firms (assets).
Banks receive funds from depositors (individuals and firms) and allow their depositors to
write checks against (or withdraw) their account balances
Reserves (): some of the funds received by banks that they held partly in cash and
partly in an account at the central bank, which they can draw on when they need to.
Banks hold reserves for 3 reasons:
o While some depositors withdraw cash from their checking accounts while others
deposit cash into their accounts. However, there is no reason for the inflows and
outflows of cash to be equal, so the bank must keep some cash on hand.
o 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. What the bank, as a result of these transactions, owes the
other banks can be larger or smaller than what the other banks owe to it. For this
reason, the bank needs to keep reserves.
o Banks are subject to reserve requirements according to a reserve ratio, which
require them to hold reserves in some proportion of their checkable deposits.

Balance sheet of central banks and banks:

Demand for central bank money (Hd) = demand for currency (CUd) + demand for reserves by
banks (Rd)
 Supply of money is controlled by the central bank (H: supply of central bank money)
Central bank money is sometimes called high-powered money, or the monetary base (
).
o The term high-powered ( ) reflects the fact that increases in H lead to
more than one-for-one increases in the overall money supply, and are therefore
high-powered.
o The term monetary base reflects the fact that the overall money supply depends
ultimately on a basethe amount of central bank money in the economy.

The equilibrium interest rate is such that the demand and the supply for central bank money
are equal.
Equilibrium: H= CUd + Rd

Demand for currency (CUd)

o Recall Md = $Y L(i), people hold money in the form of currency (CUd) by a
fraction ( )of c and in the form of checkable deposit (Dd) by a fraction of
(1 c) where 0<c<1.
CUd =cMd and Dd = (1 c) Md
 o Md = CUd + Dd = cMd + (1 c) Md

Demand for reserves (Rd)

o The reserve ratio () () : the amount of reserves banks hold per
dollar of checkable deposits.
o Demand for reserves: Rd = D = (1 c) Md

The demand for central bank money

o Hd = CUd + Rd
o Hd = cMd + (1 c) Md
o Hd = [c + (1 c)] $Y L(i)

According to the equilibrium condition, the supply of central bank money (H) is equal to the
demand for central bank money (Hd)
o H = Hd
o H = [c + (1 c)] $Y L(i)

A higher interest rate implies a lower demand for central bank money for two reasons:
o The demand for currency by people goes down
o The demand for checkable deposits by people also goes down.
 This leads to lower demand for reserves by banks.

4-4 Two Alternative Ways of Looking at the Equilibrium*

The supply and demand for reserves: Fed fund market

o The federal funds market () : an actual market
for bank reserves, where the interest rate (federal funds rate) adjusts to balance
the supply and demand for reserves. Banks that have excess reserves
( ) at the end of the day lend them to banks that have insufficient
( ) reserves.
o At equilibrium: H = Hd = CUd + Rd
o H CUd = Rd
o Supply of reserves (H CUd) = Demand for reserves (Rd)

Money Multiplier ()
o We think about the equilibrium in terms of the equality of the overall supply and
the overall demand for money (currency and checkable deposits).
o H = [c + (1 c)] $Y L(i) (We divide both sides by [c + (1 c)])
1
o H = $Y L(i)
[c + (1 c)]

o Supply of money = Demand for money

1
o Because [c + (1 c)] is less than one, its inverse[c + (1 c)] is greater than

one. For this reason, this constant term is called the money multiplier. Thus, an
increase in central bank money leads to a larger increase in the overall money
supply
o The Fractional reserve banking and the money multiplier
A given increase in currency deposits creates only a fractional increase in
bank reserves. The remainder of the deposit increase is used to purchase
bank assets (e.g., bonds).
The purchase puts more money in the hands of the non-bank public and
hence creates more checkable deposits, and so on.
o Multipliers can often be interpreted as the result of successive rounds of decisions
and derived as the sum of a geometric series.