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The Financial Market
In this presentation, we take a closer look at how the interest rate is determined in the
financial market.
The financial market consists of a demand for money, which is a positive function of the
level of output and a negative function of the interest rate, and an exogenously
determined money supply.
The interest rate is determined through the interaction of the demand and supply of
money and the equilibrium interest rate is set at such a level that the demand for money
is equal to the supply of money.
Note that on the vertical axis the interest rate is measured and on the horizontal axis the
amount of money demanded and supplied is measured. Let’s take a closer look at the
demand for money.
The demand for money is influenced by two factors - namely the level of output Y and
the interest rate i. Between the demand for money and the level of output, a positive
relationship exists. If the level of output increases, the demand for money increases as
well, and if the level of output decreases, the demand for money decreases.
The Financial Market
UNISA Economics Department
Between the demand for money and the interest rate, a negative or inverse relationship
exists. An increase in the interest rate decreases the quantity of money demanded, and a
decrease in the interest rate increases the quantity of money demanded.
Let’s first deal with the relationship between the level of output and the demand for
money.
The level of output and income also represents the number of transactions that are
taking place in the economy. And to do transactions people need money. An increase in
the level of output implies an increase in the number of transactions, and consequently
an increase in the demand for money takes place. As the income of households and firms
increase, they can afford to do more transactions – for instance, an increase in the
income of households implies that they can afford to buy more goods and services - and
therefore need more money to finance their increased spending.
Between the level of output and the demand for money, a positive relationship therefore
exists. An increase in the level of output and income increases the demand for money and a decrease in the level of output decreases the demand for money.
This relationship between output Y and the demand for money Md plays an important role
in the IS-LM model, as it provides the link between the goods market (where Y is
determined) and the financial market (where the interest rate is determined). Keep this
relationship in mind when you deal with the IS-LM model.
Let’s turn our attention to the relationship between the demand for money and the
interest rate.
In this financial market model, there are two ways in which financial wealth can be kept namely in bonds (for instance treasury bills) and/or money.
By keeping your financial wealth in the form of bonds, you will earn interest on it.
Keeping it in the form of money you earn no interest at all. The opportunity cost of
holding your financial wealth in the form of money is therefore the interest that you could
have earned by keeping it in bonds.
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The higher the interest rate, the higher the opportunity cost of holding money and the
less money people would wish to hold as an asset. At a high interest rate, people will
switch from money to bonds - and they therefore demand a lower quantity of money.
A negative or inverse relationship therefore exists between the interest rate and the
quantity of money demanded. The higher the interest rate, the lower the quantity of
money demanded and the lower the interest rate, the higher the quantity of money
demanded.
Now that you know what the factors are that influence the demand for money, it is time
to present it with the aid of a diagram.
On the vertical axis the interest rate is measured, and on the horizontal axis the quantity
of money demanded.
The demand for money curve is downward sloping - indicating that a negative
relationship exists between the interest rate and the quantity of money demanded. An
increase in the interest rate from i1 to i2 causes a decrease in the quantity of money
demanded from Md2 to Md1 as people switch from money to bonds, while a decrease in
the interest rate causes an increase in the quantity of money demanded as people switch
from bonds to money.
In other words - a change in the interest rate causes a movement along a given demand
for money curve.
The position of the demand for money curve is determined by the level of output and
income. For a given level of income, for instance Y1, there is a corresponding demand for
money curve MD1 (for Y1). An increase in the level of output and income causes an
increase in the demand for money and the demand for money curve Md1 shifts to the
right to Md2. At each and every interest rate, people are demanding more money for
transaction purposes.
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The Financial Market
UNISA Economics Department
A decline in the level of output and income causes a decrease in the demand for money
and the demand for money curve shifts to the left. At each and every interest rate, less
money is now demanded.
It is important to distinguish between a movement along a demand for money curve and
a shift of the demand for money curve. A movement along a demand for money curve
takes place if the interest rate changes - while a shift is caused by a change in the level
of output and income.
With the demand for money behind us, it is time to take a closer look at the money
supply.
In this financial market model, we will follow the traditional approach to the supply of
money. This implies that the money supply is controlled by the central bank. In South
Africa, the Central Bank is the South African Reserve Bank. An exogenously controlled
money supply also implies that the money supply is not influenced by the interest rate.
The money supply curve Ms is therefore presented graphically by a vertically straight line
which is entirely inelastic with regard to the interest rate.
A change in the interest rate from i1 to i2 does not affect the money supply.
An increase in the money supply causes a rightward shift of the money supply curve and at each an every interest rate the supply of money is now higher. A decrease in the
nominal money supply causes a leftward shift - and at each and every interest rate the
money supply is now lower.
With the demand for money and the supply of money behind us, it is time to see how the
equilibrium interest rate is determined.
Given the demand for money Md1 and supply of money Ms, the equilibrium interest is i1.
This is the point where the demand for money is equal to the supply of money and
financial market equilibrium exists. At this equilibrium position, there is portfolio
equilibrium in the sense that at the equilibrium interest rate of i1, people are holding the
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UNISA Economics Department
amount of money and bonds they want and will only change their holdings of money and
bonds if the interest rate or the level of output changes.
Let’s see what happens in the money market if there is a change in the level of output
and income.
An increase in the level of output and income increases the demand for money; the
demand for money curve MD1 shifts upward to Md2 and the equilibrium interest rate rises
to i2. The reason for the increase in the interest rate is as follows: We start from an
equilibrium position in the financial market as presented by point a. At this equilibrium
position people are not only holding money in order to do transactions, but some people
are also holding money as an asset. An increase in income increases the demand for
money for transaction purposes. At the existing equilibrium interest rate i1, an excess
demand for money develops in the economy, as people wish to hold more money for
transaction purposes than before. To get hold of this money for transaction purposes,
bonds are sold and the supply of bonds increases on the bonds market. On the bonds
market, an increase in the supply of bonds decreases the price of bonds and increases
the interest rate. At this higher interest rate i2, there is a decrease in the amount of
money people wish to hold as an asset and money market equilibrium is reestablished at
point b where the demand for money equals the supply of money.
Let us see what happens if the money supply changes.
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An increase in the money supply causes a rightward shift of the money supply curve to
Ms1 and the equilibrium interest declines from i2 to i1.
But how do we get a change in the money supply, and why does an increase in the
money supply cause the equilibrium interest rate to fall?
With the money supply under the control of the central bank, the central bank can make
use of an expansionary monetary policy to increase the supply of money and decrease
the interest rate.
It does this through open market operations - which involves the buying of bonds on the
open market from a broker, a commercial bank or individuals. In exchange for bonds, the
sellers of these bonds receive money from the central bank. Thus the money supply is
increased. This is presented by a rightward shift in the money supply curve.
The reason for the decline in the interest rate is the following: If the central bank wishes
to increase the money supply in order to change the interest rate, it needs to convince
financial market participants to sell their bonds to the central bank. Given the fact that
the financial market participants are in equilibrium - in other words, at the equilibrium
interest rate of i2, they are satisfied with the amount of bonds and money they hold - the
central bank needs to offer to buy the bonds at a higher price than financial market
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participants paid for it. At a higher price for bonds, the interest rate is lower and financial
market participants will be prepared to hold a larger amount of money and fewer bonds
at this lower equilibrium interest rate.
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