Chapter 4

Financial Markets
 Financial Markets

 What determines interest rates

 How the Federal Reserve System (Fed)

influences interest rates

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #2

 Financial Markets
Some Assumptions

 One bond market

 One interest rate

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #3

 Financial Markets
 Section I: The Demand for Money

 Section II: The determination of the

interest rate when the supply of money is
controlled by the central bank

 Section III: The determination of the

interest rate when both the central bank
and commercial banks influence the
money supply

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #4

 Financial Markets
 Income: A flow of compensation per unit of
time
 Wealth: A stock variable at a given point in
time. Equal to financial assets minus financial
liabilities
 Money: A stock variable equal to financial
assets used for transactions. Is equal to
currency plus checkable deposits
 Investment: The purchase of new capital
goods
Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #5
 The Demand for Money
A Scenario…
Two financial assets to choose from

Money: Used for transactions

(currency and checkable deposits)

Bonds: Cannot be used for

transactions and pays a positive
interest rate (i)

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #6

 The Demand for Money
Md = $YL(i)
(-)
d Demand for money
M
$Y Nominal income
L (i ) The liquidity demand for
Money is a function of i
(-) Md is inversely related to i
Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #7
 The Demand for Money
Money Demand and the Interest Rate: The Evidence

Observations

M 1960 = 27% 1998 = 13%

$Y @ Approximately the same i

$Y
= Velocity of Money
M
1 1
1960 :  3.7 1998 :  7. 6
.27 .13
Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #8
 The Determination of the Interest Rates: I

Money Demand, Money Supply & the Equilibrium Interest

Rate

•The LM relation: M = $YL(i)

•The demand for Liquidity (L) = Supply of Money

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #9

 The Determination of the Interest Rates: I
The Equilibrium Graphically
Ms
Interest Rate, i

A
i1
Equilibrium interest, I, Md = MS

Md ($Y)

M
Money, M

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #10

 The Determination of the Interest Rates: I
The effects of an increase in National Income on i
Ms
• Increase $Y to $Y´
• Md increases to Md´
i2 A´ • Equilibrium moves from A to A´
Interest Rate, i

• i increases from i1 to i2

i1 A

Md´ ($Y´ > $Y)

Md ($Y)

M
Money, M

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #11

 The Determination of the Interest Rates: I
The effects of an increase in the Money Supply on i
Ms Ms´

• Increase Ms to Ms´
Interest Rate, i

• Equilibrium moves from A to A´

• Interest rate falls from i1 to i2
A
i1

A´
i2

Md ($Y)

M M´
Money, M

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #12

 The Determination of the Interest Rates: I

Open Market Operations:

•Buying and selling government bonds by the

central bank
•Buy bonds to increase the money supply
•Sell bonds to decrease the money supply

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #13

 The Determination of the Interest Rates: I

Balance Sheet

Banks Central Bank

Assets Liabilities Buy $1 million in bonds:

Bonds Money • Bonds increase
(Currency)
• Currency decreases at the Central
Bank and increases in the economy

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #14

 The Determination of the Interest Rates: I

Monetary Policy and Open Market Operations

The Price of Bonds and the Interest Rate

Assume: •The bonds pay $100 in one year

•$PB = Price of the bonds (B) today

Therefore: •The return on the bond (i) is:

$100  $ PB
i
$ PB

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #15

 The Determination of the Interest Rates: I

Monetary Policy and Open Market Operations

The Price of Bonds and the Interest Rate

For Example, Assume:

$PB = $95 $PB = $90

$100  $95 $5 $100  $90 $10

i   0.053  5.3% i   0.111  11.1%
$95 95 $90 90

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #16

 The Determination of the Interest Rates: I

Monetary Policy and Open Market Operations

Observation!

The price of a bond and

the interest rate are
inversely related.

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #17

 The Determination of the Interest Rates: I

Monetary Policy and Open Market Operations

Expansionary Open Market Operation: Increase the Money Supply

Step 1: Central bank buys bonds.

Step 2: The central bank injects money (currency)
into the economy to pay for the bonds.
Step 3: The demand for bonds increases, causing
the price of bonds to rise.
Step 4: When the price of bonds increases,
the interest rate falls.

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #18

 The Determination of the Interest Rates: I

A Summary:

• i is determined by MD & MS
• Central bank changes i by changing MS
• Central bank changes MS with open market
operations
• Buying bonds increases the MS and
reduces i
• Selling bonds decreases the MS and
increases i

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #19

 The Determination of the Interest Rates: II

The supply and demand for central bank money

Demand for
money

Demand for Demand for

checkable reserves
deposits (by banks) Demand for Supply of
Central Bank = Central Bank
Money Money
Demand for
currency

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #20

 The Determination of the Interest Rates: II

The demand for reserves

If people hold deposits of Dd, then banks must hold

reserves (R) of Dd.

R  D d

D  (1  c) M
d d

R  (1  c) M
d d

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #21

 The Determination of the Interest Rates: II

The demand for reserves

The Equilibrium

H : Supply of Central Bank Money

CU d  R D : Demand for money
H  CU  R : Equilibrium (Supply of Money
d d

= Demand for Money)

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #22

 The Determination of the Interest Rates: II

The supply and demand for money

Observations:

1
 Money Multiplier
C  (1  C )
•The supply of money is a multiple of the
Central Bank money.
•Central Bank money (monetary base) is
High-powered money (H)

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #23

 The Determination of the Interest Rates: II

Open market operations revisited

If: C=O (People hold only checkable deposits) ,

1 1
The Multiplier = 
C  (1  C ) 

1
If: = .10, The Multiplier =  10
.10

Blanchard: Macroeconomics Chapter 4: Financial Markets Slide #24