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 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).

© 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 variable—measured 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

 The Determination of
4-2
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 Olivier Blanchard
 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 Olivier Blanchard

 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 $100
i  $ PB 
$ PB 1 i

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 The Determination of
4-3
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 Macroeconomics, 3/e Olivier Blanchard

 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
reserves—a 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 Olivier Blanchard

 The Demand for Money, Reserves,
and Central Bank Money

Demand for currency: CU d  cM d

Demand for checkable deposits: D  (1  c) M

d d

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

Demand for reserves by banks: Rd = 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

 Two Alternative Ways to
4-4
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,  expansionary, and contractionary,
 flow, open market operation,
 saving,  Treasury bill, T-bill,
 savings,  financial intermediaries,
 financial wealth, wealth,  (bank) reserves,
 stock,  reserve ratio,
 investment,  central bank money,
 financial investment,  bank run,
 money,  federal deposit insurance,
 currency,  narrow banking,
 checkable deposits,  federal funds market, federal
 bonds, funds rate,
 money market funds,  money multiplier,
 open market operation,  high-powered money,
 monetary base,
© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard