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CHAPTER

Financial Markets

Prepared by:
Fernando Quijano and Yvonn Quijano

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

4-1

The Demand for Money

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. Money
market funds receive funds from people and
use these funds to buy bonds.
The proportions of money and bonds you wish
to hold depend on your level of transactions
and the interest rate on bonds.
2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Semantic Traps:
Money, Income, and Wealth
Income is what you earn from working plus
what you receive in interest and dividends. It
is a flowthat 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).

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Semantic Traps:
Money, Income, and Wealth
Your financial wealth, or simply wealth, is the value of
all your financial assets minus all your financial
liabilities. Wealth is a stock variablemeasured at a
given point in time.
Financial assets that can be used directly to buy goods
are called money. Money includes currency and
checkable deposits.
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.
2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Deriving the Demand for Money

M d $YL(i )
The demand for money:
increases in proportion to

nominal income ($Y), and


depends negatively on the
interest rate (L(i)).

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Deriving the Demand for Money


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.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

4-2

The Determination of
the Interest Rate, I

In this section, we assume that only the central


bank supplies money, in an amount equal to
M, so M = Ms. People hold only currency as
money.
The role of banks as suppliers of money (and
checkable deposits) is introduced in the next
section.
Equilibrium in financial markets requires that
money supply be equal to money demand:
M $YL(i )
2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Money Demand, Money Supply; and


the Equilibrium Interest Rate
The Determination of the
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).

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Money Demand, Money Supply; and


the Equilibrium Interest Rate
The Effects of an
Increase in
Nominal Income on the
Interest Rate
An increase in nominal
income leads to an
increase in the interest
rate.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

The Demand for Money and the


Interest Rate: The Evidence

The interest rate and the ratio of money to nominal


income typically move in opposite directions.
2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

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Monetary Policy and


Open-Market Operations
The Effects 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.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Monetary Policy and


Open-Market Operations
Open-market operations,
which take place in the
open market for bonds,
are the standard method
central banks use to
change the money stock
in modern economies.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

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Monetary Policy and


Open-Market Operations
The Balance Sheet of the
Central Bank and the Effects 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.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Monetary Policy and


Open-Market Operations
In an expansionary
open market operation,
the central bank buys $1
million worth of bonds,
increasing the money
supply by $1 million.
In a contractionary
open market operation,
the central bank sells $1
million worth of bonds,
decreasing the money
supply by $1 million.
2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Monetary Policy and


Open-Market Operations
Bonds issued by the government, promising a
payment in a year or less, are called Treasury
bills, or T-bills
When the central bank buys bonds, the
demand for bonds goes up, increasing the
price of bonds. Equivalently, the interest rate
on bonds goes down.
$100 $ PB

i
$ PB
2003 Prentice Hall Business Publishing

$100
$ PB
1 i

Macroeconomics, 3/e

Olivier Blanchard

4-3

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 firms.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

The Balance Sheet of Banks and the Balance


Sheet of the Central Bank Revisited

2003 Prentice Hall Business Publishing

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What Banks Do
Banks keep as reserves some of the funds
they have received, for three reasons:
To honor depositors withdrawals
To pay what the bank owes to other banks

To maintain the legal reserve requirement, or

portion of checkable deposits that must be kept as


reserves:
The reserve ratio is the ratio of bank reserves to

checkable deposits (currently about 10% in the United


States).

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

What Banks Do
Loans represent roughly 70% of banks
nonreserve assets. Bonds account for the
other 30%.
The assets of a central bank are the bonds it
holds. The liabilities are the money it has
issued, central bank money, which is held as
currency by the public, and as reserves by
banks.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Bank Runs
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
reservesa bank run.
To avoid bank runs, the U.S. 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.
2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Determinants of the Demand and


the Supply of Central Bank Money

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

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The Demand for Money, Reserves,


and Central Bank Money
Demand for currency: CU d cM d
d
d
Demand for checkable deposits: D (1 c) M

Relation between deposits (D) and reserves (R): R = qD


Demand for reserves by banks: R d = q( 1- c )M d
Demand for central bank money: H d CU d R d
Then: H d = cM d + q( 1- c )M d = [ c + q( 1- c )]M d

Since

M d $YL(i ) Then: H d = [c + q(1- c)]$YL(i )

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

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):
H Hd

Or restated as:
H = [ c + q( 1- c )]$YL( i )

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

The Determination of the Interest Rate


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.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

4-4

Two Alternative Ways to


Think about the Equilibrium

The equilibrium condition that the supply and


the demand for bank reserves be equal is
given by:
d
d
H CU R

The federal funds market is a market for


bank reserves. In equilibrium, demand (Rd)
must equal supply (H-CUd). The interest rate
determined in the market is called the federal
funds rate.

2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

The Supply of Money, the Demand for


Money and the Money Multiplier
The overall supply of money is equal to central
bank money times the money multiplier:
H = [ c + q( 1- c )]$YL( i )

Then:

1
H = $YL( i )
[ c + q( 1 - c )]
Supply of money = Demand for money

High-powered money is the term used to


reflect the fact that the overall supply of money
depends in the end on the amount of central
bank money (H), or monetary base.
2003 Prentice Hall Business Publishing

Macroeconomics, 3/e

Olivier Blanchard

Key Terms

income,
flow,
saving,
savings,
financial wealth, wealth,
stock,
investment,
financial investment,
money,
currency,
checkable deposits,
bonds,
money market funds,
open market operation,

2003 Prentice Hall Business Publishing

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,
Macroeconomics, 3/e

Olivier Blanchard