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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.