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Financial Markets What determines interest rates How the Federal Reserve System (Fed) influences interest rates
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Chapter 4Chapter 4Financial MarketsFinancial Markets
Chapter 4: Financial Markets Slide #2Blanchard: Macroeconomics
Financial MarketsFinancial Markets
What determines interest rates
How the Federal Reserve System (Fed) influences interest rates
Chapter 4: Financial Markets Slide #3Blanchard: Macroeconomics
Financial MarketsFinancial Markets
One bond market
One interest rate
Some Assumptions
Chapter 4: Financial Markets Slide #4Blanchard: Macroeconomics
Financial MarketsFinancial 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
Chapter 4: Financial Markets Slide #5Blanchard: Macroeconomics
Financial MarketsFinancial 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
Chapter 4: Financial Markets Slide #6Blanchard: Macroeconomics
The Demand for MoneyThe Demand for Money
Money: Used for transactions (currency and checkable deposits)
Bonds: Cannot be used for transactions and pays a positive interest rate (i)
A Scenario…
Two financial assets to choose from
Chapter 4: Financial Markets Slide #7Blanchard: Macroeconomics
The Demand for MoneyThe Demand for Money
dM Demand for money
Md = $YL(i) (-)
Y$The liquidity demand forMoney is a function of i
)(iLNominal income
(-) Md is inversely related to i
Chapter 4: Financial Markets Slide #8Blanchard: Macroeconomics
The Demand for MoneyThe Demand for MoneyMoney Demand and the Interest Rate: The Evidence
Observations
YM$
1960 = 27% 1998 = 13% @ Approximately the same i
MY$
= Velocity of Money
7.327.1:1960 6.7
13.1:1998
Chapter 4: Financial Markets Slide #9Blanchard: Macroeconomics
•The LM relation: M = $YL(i)
•The demand for Liquidity (L) = Supply of Money
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
Money Demand, Money Supply & the Equilibrium InterestRate
Chapter 4: Financial Markets Slide #10Blanchard: Macroeconomics
Md ($Y)
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
Money, M
Inte
rest
Rat
e, i
M
Ms
i1 Equilibrium interest, I, Md = MS
A
The Equilibrium Graphically
Chapter 4: Financial Markets Slide #11Blanchard: Macroeconomics
Md ($Y)
Md´ ($Y´ > $Y)
• Increase $Y to $Y´ • Md increases to Md´
M
Ms
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
Money, M
Inte
rest
Rat
e, i
i1A
The effects of an increase in National Income on i
A´i2• Equilibrium moves from A to A´• i increases from i1 to i2
Chapter 4: Financial Markets Slide #12Blanchard: Macroeconomics
Md ($Y)
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
The effects of an increase in the Money Supply on i
Money, M
Inte
rest
Rat
e, i
Ms
M
i1
A
Ms´
• Increase Ms to Ms´
M´
• Equilibrium moves from A to A´
A´i2
• Interest rate falls from i1 to i2
Chapter 4: Financial Markets Slide #13Blanchard: Macroeconomics
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
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
Chapter 4: Financial Markets Slide #14Blanchard: Macroeconomics
Balance Sheet
Central Bank
Buy $1 million in bonds:
• Bonds increase
• Currency decreases at the Central Bank and increases in the economy
Assets Liabilities
Bonds Money(Currency)
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
Banks
Chapter 4: Financial Markets Slide #15Blanchard: Macroeconomics
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:
B
B
PPi
$$100$
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
Chapter 4: Financial Markets Slide #16Blanchard: Macroeconomics
Monetary Policy and Open Market Operations
The Price of Bonds and the Interest Rate
For Example, Assume:
$PB = $95
%3.5053.095
5$95$
95$100$
i %1.11111.0
9010$
90$90$100$
i
$PB = $90
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
Chapter 4: Financial Markets Slide #17Blanchard: Macroeconomics
The price of a bond andthe interest rate are
inversely related.
Monetary Policy and Open Market Operations
Observation!
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
Chapter 4: Financial Markets Slide #18Blanchard: Macroeconomics
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.
Monetary Policy and Open Market Operations
Expansionary Open Market Operation: Increase the Money Supply
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
Chapter 4: Financial Markets Slide #19Blanchard: Macroeconomics
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
The Determination of the Interest Rates: IThe Determination of the Interest Rates: I
Chapter 4: Financial Markets Slide #20Blanchard: Macroeconomics
The supply and demand for central bank money
The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II
Demand for money
Demand forcheckabledeposits
Demand for Central Bank
MoneyDemand for
currency
Supply of Central Bank
Money=
Demand for reserves
(by banks)
Chapter 4: Financial Markets Slide #21Blanchard: Macroeconomics
The demand for reserves
The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II
If people hold deposits of Dd, then banks must holdreserves (R) of Dd.
dd
dd
d
McR
McD
DR
)1(
)1(
Chapter 4: Financial Markets Slide #22Blanchard: Macroeconomics
The demand for reserves
The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II
The Equilibrium
MoneyBankCentralofSupply:H
moneyfor Demand :Dd RCU
:dd RCUH Equilibrium (Supply of Money = Demand for Money)
Chapter 4: Financial Markets Slide #23Blanchard: Macroeconomics
The supply and demand for money
The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II
Observations:
MultiplierMoney )1(
1
CC•The supply of money is a multiple of theCentral Bank money.•Central Bank money (monetary base) is High-powered money (H)
Chapter 4: Financial Markets Slide #24Blanchard: Macroeconomics
Open market operations revisited
The Determination of the Interest Rates: IIThe Determination of the Interest Rates: II
1
)1(1
CC
If: C=O (People hold only checkable deposits) ,
The Multiplier =
If: = .10, The Multiplier = 1010.1