Download Chapter 9 financial markets, interest rates, and the monetary

Chapter Nine
Financial Markets, Interest Rates, and
Monetary Transmission Mechanism
Macroeconomics by Curtis, Irvine and Begg
Canadian Edition, McGraw-Hill Ryerson, 2007
Slides are prepared by Dr. Amy Peng, Ryerson University
Learning Outcomes
This chapter explains:
• Portfolio choices between money and other
assets
• Bond prices and interest rates
• The demand for money balances
• Money market equilibrium and interest rates
• How interest rates affect planned
expenditures
• The monetary transmission mechanism
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9
2
Portfolio Choices between Money
and Other Assets
•
The structure of a financial portfolio
reflects
1. The returns paid by different financial assets
2. The risk arising from changes in the market
prices of assets
•
•
Money holdings are important part of the
portfolio
Other financial assets differ from money
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.1
3
Bond Prices and Interest Rates
• Bond
Example: Government of Canada, 4.25, 2009-sep-01
– Marketable 4.25 percent bond with a maturity date
September 1, 2009.
– 4.25 is called coupon value, it pay its holder $4.25 for
each $100 face value. $100 is the principal.
• Present Value of the Bond (PV)
– The present value is the discounted value of future
payments
– At 5%, the PV of $1000 to be received one year from
now is $1000/1.05 = $952.38
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.2
4
Bond Price and Interest Rate
Government of Canada, 4.25, 2009-Sep-01
– Purchase on September 1, 2006.
1. Assume interest rate at 4.25%
4.25
4.25
104.25
PV 


2
(1.0425) (1.0425) (1.0425) 3
 4.077  3.911  92.013  100
2. Assume the Market interest rate is 5%
4.25
4.25
104.25


(1.05) (1.05) 2 (1.05) 3
 4.048  3.855  90.055  97.758
PV 
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.2
5
Bond Price and Interest Rates
•
A higher current interest rate leads to a lower
bond price, and vice versa.
3. Assumer interest rate at 3.5%
4.25
4.25
104.25


(1.035) (1.035) 2 (1.035) 3
 4.106  3.967  94.028  102.10
PV 
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.2
6
Bond Prices, Yields, and Interest Rates
•
The fall in Canadian interest rates over the
past few years have been good for
bondholders.
Issuer
Coupon
Maturity
Bid price
Ask price Bid yield
Ask yield
Canada
7.25
07/06/01
104.23
104.27
3.91
3.88
Canada
5.75
29/06/01
121.86
122.00
4.26
4.25
Royal Bank 6.30
11/04/12
108.15
108.58
4.51
4.42
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.2
7
The Demand for Money Balance
• Motives for Holding Money
– The Transaction Motive
– The Precautionary Motive
– The asset Motive
Quantity
Demanded
Nominal
Money
Real Money
Effect of Rise in
Price Level
Real Income
Interest Rate
Rise in
proportion
Unaffected
Rises
Falls
Rises
Falls
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.3
8
The Demand for Money Balance
Money Demand is
negatively related to
the interest rate
Nominal Interest Rates
• The demand for money balances: prices, real
income, and interest rates
L = kY - hi
L = kY0 - hi
i2
i1
L2
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.3
L1
kY0
9
Holding of M1 and M2 in Canada, 1995 and 2005
Index of:
Nominal M1
Nominal M2
Consumer prices
Real M1
Real M2
Real GDP
Interest Rate Spread (%, between
3-5 year bonds and band deposits)
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.3
1995
2005
100
100
100
291
151
123
100
100
100
237
123
140
6.01
3.80
10
Financial Market Equilibrium
and Interest Rates
•
Money supply
•
•
Real money supply, M/P
Money demand
M
(1  cr )
H
(rr  cr )
L  kY  hi
•
Money market equilibrium
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.4
11
Equilibrium in the Money Market
Nominal Interest Rate i
M0/P0
At lower interest rate
i0
There is an excess
Bond price
fall, for
raising
bond yields
demand
money
and the
opportunity cost of holding
balances
money balance
There must be a
Revertcorresponding
to the equilibrium
excess
supply of bond
E
i1
Excess Demand
for money balance
M0/P0
©2007 McGraw-Hill Ryerson Ltd.
L1
Chapter 9.4
L(Y0)
Real Money Balances
12
Change in Financial Market Equilibrium
Nominal Interest Rate i
M1/P M0/P
Fall in Money Supply
 Excess demand for money
i1
 Sell bond, bond price falls
i0
 Equilibrium is restored at higher
interest rate
L(Y0)
M1/P
©2007 McGraw-Hill Ryerson Ltd.
M0/P
Chapter 9.4
Real Money Balances
13
Change in Financial Market Equilibrium
Nominal Interest Rate i
M0/P
Rise in Real Income
 Increase in demand for money
i2
 Sell bond, bond price falls
i0
 Equilibrium is restored at higher
interest rate
L(Y1)
L(Y0)
M0/P
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.4
Real Money Balances
14
Money, Aggregate Demand,
and National Income
• Transmission mechanism
– Links money, interest rates and financial
markets to output and employment and prices
• Money supply and demand affect
consumption and investment through the
real interest rate
r=i-
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.5
15
Money, Aggregate Demand,
and National Income
• Consumption Expenditure Revisited
– Wealth effect
– Durables and Consumer Credit
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.5
16
r1
r2
Δr
ΔC
C0
C1
C2
Consumption
Real Interest Rates
Interest Rates and
Consumption Expenditure
C2
C1
C1 + cY
Y
C
Real GDP and Income
Autonomous Consumption
©2007 McGraw-Hill Ryerson Ltd.
ΔC
C2 + cY
Chapter 9.5
17
Money, Aggregate Demand,
and National Income
• Investment Expenditure
– Investment in Fixed Capital
– Inventory Investment
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.5
18
r2
r1
Δr
Investment
Real Interest Rates
Interest Rates and
Consumption Expenditure
ΔI
I(r0)
ΔI
I(r1)
I = I0
I1
I0
Y
I
Planned Investment Expenditure
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.5
Real GDP and Income
19
Money, Aggregate Demand,
and National Income
• Net Exports
• Transmission mechanism
r  C  I 
M  i  


er


NX


 AE  multiplier  AD  Y
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.5
20
The Transmission Mechanism
1. With prices constant, changes in money supply
change nominal and real interest rates
2. Changes in real interest rates change
consumption expenditure
3. Change in real interest rate also cause
changes in planned investment expenditure
4. Changes in nominal interest rate also cause
changes in exchange rates, which change the
price competitiveness and profitability of trade.
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.5
21
The Monetary Transmission Mechanism
Nominal Interest Rate i
(a) Money Market
M0
i1
M1
Δi
i2
L(Y0)
M0
M1
Real Money Balances
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.5
22
The Monetary Transmission Mechanism
Real Interest Rates
(b) Expenditure and Real Interest Rate
r1
r2
Δr
ΔA
C0 + I0 + NX0
A(r1)
A(r2)
C
Autonomous Expenditure
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.5
23
The Monetary Transmission Mechanism
(c) Aggregate Expenditure and Output
AE(r2)
AE(r1)
A0(r2)
ΔA
ΔY
A0(r1)
Y1
Y2
Real Output and Income
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.5
24
The Monetary Transmission Mechanism
(d) Aggregate Demand and Supply
P
ΔAD
P0
ΔY
AD1
AD2
Y1
Y2
Real Output and Income
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.5
25
Business Cycles, Output Gaps
and Policy Issues
• Fluctuations in money supply and financial
conditions are an important source of
business cycle fluctuations in output and
employment
• Discretionary monetary policy would
attempt to manage money supply or
interest rates or financial condition more
broadly
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9.5
26
Chapter Summary
• Bond price and interest rate are inversely
related.
• Demand for money
L = kY – hi
• Nominal interest rate and real interest rate
• Transmission mechanisms
– Consumption
– Investment
– Net Export
©2007 McGraw-Hill Ryerson Ltd.
Chapter 9
27