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CHAPTER4
Financial Markets
Prepared by:
Fernando Quijano and Yvonn Quijano
Macroeconomics, 4/e
Olivier
4-1
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Semantic Traps:
Money, Income, and
Wealth
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).
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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 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.
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$ Y L (i)
( )
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Figure 4 - 1
The Demand for Money
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4-2
The Determination of
the Interest Rate. i
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M $ Y L (i)
This equilibrium relation is called the LM
relation.
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Md = L(i)
$Y
Using this equation, you can find out how much the
demand for money responds to changes in the
interest rate.
Because L(i) is a decreasing function of the
interest rate i, this equation says:
When the interest rate is low, then L(i) is high,
so the ratio of money demand to nominal
income should be high.
When the interest rate is high, then L(i) is low,
so the ratio of money demand to nominal
income should be low.
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Figure 4 - 1
The Ratio of Money
Demand to Nominal
Income and the
Interest Rate since
1960
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Figure 4 - 2
Changes in the
Interest Rate Versus
Changes in the Ratio
of Money Demand to
Nominal Income
since 1960
Increases in the
interest rate have
typically been
associated with a
decrease in the ratio
of money to nominal
income, decreases in
the interest rate with
an increase in that
ratio.
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Figure 4 - 2
The Determination of
the Interest Rate
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Figure 4 - 3
The Effects of an
Increase in
Nominal Income on
the Interest Rate
An increase in nominal
income leads to an
increase in the interest
rate.
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Figure 4 - 4
The Effects of an
Increase in the
Money Supply on the
Interest Rate
An increase in the
supply of money leads
to a decrease in the
interest rate.
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$ PB
$100
1 i
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Choosing Money or
Choosing the Interest Rate?
Figure 4 - 4
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4-3
The Determination of
the Interest Rate, II
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What Banks Do
Figure 4 - 6
The Balance Sheet of
banks, and the Balance
Sheet of the Central
Bank Revisited.
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What Banks Do
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What Banks Do
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Bank Runs
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(1 c ) M
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(1 c ) M
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cM
(1 c ) M
$ Y L ( i ) Then: H
()
CU
[ c (1 c )] M
d
d
[ c (1 c )]$ Y L (i )
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The Determination of
the Interest Rate
H H
Or restated as:
H [ c (1 c )]$ Y L (i )
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The Determination of
the Interest Rate
Figure 4 - 8
Equilibrium in the
Market for Central
Bank Money, and the
Determination of the
Interest Rate
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4-4
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Then:
1
H $ Y L (i)
[ c (1 c )]
Supply of money = Demand for money
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Key Terms
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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