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Economics 2B
Set 3: Financial Markets Semester 2
Financial Markets Financial markets are intimidating, but they play an essential role in the economy. We will focus on the role of the central bank in a¤ecting interest rates. We learn how the interest rate on bonds is determined, and the role of the central bank (Federal Reserve Bank, or the Fed, in the United States) in this determination.
The Demand for Money Suppose you only have a choice between two assets: money and bonds. Money are used for transactions, but it pays no interest. I Two types of money: currency and checkable deposits. Bonds pay a positive interest rate, i (the rate of interest), but cannot be used for transaction.
The Demand for Money The holding of money and bonds depends on: I The level of transactions I The interest rate on bonds You can hold bonds indirectly through money market funds, or money market mutual funds. In the early 1980s, the interest rate on money market funds reached 14% per year, so people earned more interest by moving their wealth from checking accounts to these funds.
FOCUS: Semantic Traps: Money, Income, and Wealth Money is what can be used to pay for transactions. It is a stock. Income is what you earn, and it is a ow. Saving is the part of after-tax income that you do not spend, and it is also a ow. Savings is the value of what you have accumulated over time. So it is a stock. Financial wealth, or wealth, is the value of all your nancial assets minus all your nancial liabilities, and it is a stock variable. Investment is what economists refer to as the purchase of new capital goods. It is a ow. Financial investment is the purchase of shares or other nancial assets. It is a ow.
The Demand for Money Demand for money (Md ) is equal to nominal income $Y (a measure of level of transactions in the economy) times a decreasing function L (i) of the interest rate i : Md = $Y L(i) () An increase in the interest rate decreases the demand for money, as people put more of their wealth into bonds. Equation above means that the demand for money: I increases in proportion to nominal income, and I depends negatively on the interest rate. The relation between the demand for money and interest rate for a given level of income $Y is represented by the Md curve.
The Demand for Money Fig 1: The Demand For Money 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.
FOCUS: Who Holds U.S. Currency The amount of currency in circulation in 2006 was $750 billion. U.S. households together held $170 billion in currency. U.S. rms held another $80 billion. Foreigners abroad held $500 billion, or 66% of the total, for transactions, especially in countries su¤ering from high ination in the past.
Determining the Interest Rate I Suppose the central bank decides to supply an amount of money equal to M: Ms = M Equilibrium in nancial markets requires that Ms = Md = M Money supply = Money demand M = $YL (i)
Determining the Interest Rate I Fig 2: The Determination of the Interest Rate The interest rate must be such that the supply of money (which is independent of the interest rate) is equal to the demand for money (which does depend on the interest rate).
Determining the Interest Rate I Fig 3: The E¤ects of an Increase in Nominal Income on the Interest Rate Given the money supply, an increase in nominal income leads to an increase in the interest rate.
Determining the Interest Rate I Fig 4: The E¤ects of an Increase in the Money Supply on the Interest Rate An increase in the supply of money leads to a decrease in the interest rate.
Determining the Interest Rate I For a given money supply, an increase in nominal income leads to an increase in the interest rate. An increase in the supply of money by the central bank leads to a decrease in the interest rate. Central banks typically change the supply of money by buying or selling bonds in the bond market open market operations. Expansionary open market operation: the central bank expands the supply of money by buying bonds. Contractionary open market operation: the central bank contracts the supply of money by selling bonds.
Determining the Interest Rate I Fig 5: The Balance Sheet of the Central Bank and the E¤ects of an Expansionary Open Market Operation The assets of the central bank are the bonds it holds. The liabilities are the stock of money in the economy. An open market operation in which the central bank buys bonds and issues money increases both assets and liabilities by the same amount.
Determining the Interest Rate I Suppose a bond such as a Treasury bill, or T-bill, promises to pay $100 a year from now. If the price of the bond today is $PB , then the interest rate on the bond is: i = $100 $PB $PB = $100 $PB 1 The higher the price of the bond, the lower the interest rate. The higher the interest rate, the lower the price today.
Determining the Interest Rate I Rather than the money supply, the central bank could have chosen the interest rate and then adjusted the money supply so as to achieve the interest rate it had chosen. Choosing the interest rate, instead of the money supply, is what modern central banks, including the Fed, typically do: The Fed decided to increase the interest rate today, and never The Fed decided to decrease money supply today.
Determining the Interest Rate II We now try to understand what determines interest rate in an economy with both currency and checkable deposits. For this, we need to understand what banks do.
Determining the Interest Rate II Financial intermediaries: Institutions that receive funds from people and rms and use these funds to buy nancial assets or to make loans to other people and rms. Banks are nancial intermediaries that have money, in the form of checkable deposits, as their liabilities. Banks keep as reserves some of the funds they receive. I Depositers withdraw and deposit every day, inow and outow are not equal I people pay other people with accounts in di¤erent banks, a bank may owe other banks more than they owe it I there are reserve requirements The liabilities of the central bank are the money it has issued, called central bank money. Bank assets are typically loans (about 70%), bonds (about 30%) and reserves (small amount)
Determining the Interest Rate II Fig 6: The Balance Sheet of Banks, and the Balance Sheet of the Central Bank Revisited
Determining the Interest Rate II Assume people hold no currency so the demand for money by people is the demand for checkable deposits: Md = $YL(i) () The demand for reserves (not neceserrily with the Central Bank) by banks depends on the amount of checkable deposits: Hd = θMd = θ$YL(i) θ is the reserve ratio, and Hd is demand for high-power money or the monetary base. Let H denote the supply of central bank money (=reserves, forget about currency for a moment), then the equilibrium condition: H = Hd = θ$YL(i) An increase in H leads to a decrease in the interest rate, and a decrease in H leads to an increase in the interest rate.
Determining the Interest Rate II Fig 7: Equilibrium in the Market for Central Bank Money and 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.
Determining the Interest Rate II How to make an increase in H? I All banks create (have to create) reserve accounts with the Central Bank (think about household deposits with commercial banks) I Central Bank may add money to the account of particular bank, the Central Bank in fact lends (very short-term, overnight) to this bank. I This lending is done at particular interest rate iB I This lending is under collateral, T-bills are used as a collateral. I De facto, Central Bank buys these T-bills from the bank and pays money to the reserve account, and sells T-bills back when the bank returns the short-term loan(REPO agreement) iB a¤ects decision of Banks to hold reserves, and this a¤ects their decision to create loans at interest rate i (i is not equal to iB because of di¤erent risks and maturity). All interest rate rates usually move together, in a sense that if iB changes then i changes too, but may be it changes with a delay and may be by more (or less) than iB . In the rest of the course we assume that we have only one interest rate, labelled i , which the Central Bank can a¤ect.
Determining the Interest Rate II The federal funds market is an actual market for bank reserves. The federal funds rate is the interest rate determined in the federal funds market. The federal funds rate is the main indicator of U.S. monetary policy because the Fed can choose the federal funds rate it wants by changing H.
FOCUS: Will Bitcoins Replace Dollars? Bitcoins are virtual assets that can be used for transactions. As of December 2018 the total value of bitcoin in circulation was $67 billion. US M0 was $5093.1 bn in November 2020. Tax revenue in 2019 was $3.4 trln in US. Bitcoins are not likely to replace dollars for 3 reasons: I Most transactions are quoted in dollars, so price risk (exchange rate) exists. I Verifying bitcoin transactions takes too much electricity (2 months of average household use of electricity). I Governments do not want bitcoin to be the accepted currency since they want to control monetary policy. I Tax avoidance: governments want to control all transactions
The Liquidity Trap Zero lower bound : The interest rate cannot go below zero. The economy is in a liquidity trap when the interest rate is down to zero, monetary policy cannot decrease it further.
The Liquidity Trap Fig 8: Money Demand, Money Supply, and the Liquidity Trap When the interest rate is equal to zero, and once people have enough money for transaction purposes, they become indi¤erent between holding money and holding bonds. The demand for money becomes horizontal. This implies that, when the interest rate is equal to zero, further increases in the money supply have no e¤ect on the interest rate, which remains equal to zero.
The Liquidity Trap When the interest rate is equal to zero, people are indi¤erent between money and bonds. Further increases in the money supply have no e¤ect on the interest rate, which remains equal to zero. If money supply increases on the ZLB we are likely to see increase in money holding (less bonds) of households When the interest rate is equal to zero, banks are indi¤erent between bonds and reserves. If central bank increases money supply, we likely to see an increase in deposits and in bank reserves.
FOCUS: The Liquidity Trap in the United States The large increase in the supply of central bank money between 2008 and 2015 was absorbed by households and banks. Uncertainty caused households increase deposits and demand for reserves went up. Fig 9: Checkable Deposits and Bank Reserves in the US, 2005-2018, $bn.