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CHAPTER 4. FINANCIAL MARKETS
I.
MOTIVATING QUESTION
How Is the Interest Rate Determined in the Short Run?
The interest rate is determined by equilibrium in the money market, i.e., by the condition that money
supply equals money demand. Since the text abstracts from all assets other than bonds and money,
equilibrium in the money market is equivalent to equilibrium in the bond market. In this chapter,
nominal income is taken as given, so there is no need to consider simultaneous equilibrium of goods and
financial markets.
II.
WHY THE ANSWER MATTERS
Investment is a function of the interest rate (as will be discussed in Chapter 5), so output is affected by
the interest rate. In addition, the determination of the interest rate is intimately connected with monetary
policy. This chapter takes nominal GDP, which affects money demand, as given, so the financial markets
can be considered in isolation from the goods market. Chapter 5 will address the joint determination of
output and the interest rate in the short run.
III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS
1.
Tools and Concepts
i.
The chapter defines stock and flow variables and distinguishes wealth (a stock) from income (a
flow).
ii.
The chapter introduces monetary policy and describes open market operations.
iii.
The chapter makes use of balance sheets for the central bank and private banks.
iv. The chapter introduces various terms and concepts associated with the banking system. These
include currency, checkable deposits, reserves, the reserve ratio, central bank money (high powered
money, the monetary base), the federal funds market and the federal funds rate, and the money
multiplier.
2.
Assumptions
i.
This chapter assumes that nominal GDP is given. More precisely, the chapter maintains the fixedprice level assumption from Chapter 3 and adds the assumption that real income is given. Chapter 5
considers the joint determination of the interest rate and real income.
ii.
For clarity, the chapter assumes that money and bonds are the only assets available and that money
does not pay interest. Money is divided into currency and checkable deposits in the section of the
chapter that describes the banking system. The assumption that money does not pay interest is
maintained throughout the book. Later chapters introduce other financial assets—stocks and bonds of
different maturities—and physical capital.
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IV. SUMMARY OF THE MATERIAL
1.
The Demand for Money
Suppose the financial markets include only two assets: money, which can be used to purchase goods and
services and pays no interest; and bonds, which cannot be used for transactions, but pay a positive
interest rate i. Financial wealth equals the sum of money and bonds.
Financial wealth is a stock variable, i.e., a variable whose value can be measured at any point in time.
An individual’s financial wealth changes over time by saving or dissaving, but at any given moment,
financial wealth is fixed. Saving is a flow variable, i.e., a variable whose value is meaningful only when
expressed in terms of a time period. Income is also a flow variable. One speaks of income per year or
income per month.
At every moment, households must decide how to allocate their given financial wealth between money
and bonds. Since financial wealth is fixed, once the demand for money is known, so is the demand for
bonds, and vice-versa. Accordingly, the chapter restricts attention to the demand for money.
Money is necessary for transactions. Although it is hard to measure the overall level of transactions in
the economy, it seems reasonable to assume that the level of transactions is proportional to nominal
income, denoted $Y. So, money demand should be proportional to $Y. On the other hand, allocating
wealth to money comes at the cost of forgone interest on bonds. So, money demand should decrease with
the interest rate. Putting these observations together, the chapter specifies money demand as
Md=$YL(i)
(4.1)
where the function L decreases as the interest rate increases.
2. The Determination of the Interest Rate I
Assume all money is currency, so there are no checking accounts or banks. Consider the supply of
money to be fully in the control of the central bank and take nominal income as given. Then, equilibrium
in the money market occurs when the supply of money (M) equals the demand for money (Md) given in
equation (4.1). Figure 4.1 illustrates the solution.
An increase in the money supply shifts the vertical line to the right, resulting in a new equilibrium with a
lower interest rate. In order to induce the private sector to hold more money, bonds must become less
attractive (the interest rate must fall). An increase in nominal income (for a given money supply) shifts
the money demand curve to the right and generates a new equilibrium with a higher interest rate. The
increase in nominal income increases the demand for money at the original interest rate. Since the supply
of money has not changed, something must occur to offset the increase in demand. The increase in the
interest rate makes bonds more attractive, thereby reducing the demand for money and offsetting the
increase in money demand from the increase in income.
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Figure 4.1: Equilibrium in the Money Market
How does the central bank control the money supply? Consider the central bank’s balance sheet.
Currency held by the public constitutes the central bank’s liabilities. The central bank’s assets are any
bonds that it owns. To increase the money supply, the central bank creates currency to purchase bonds,
thus increasing assets (through the additional bonds) and liabilities (through the new currency created
and exchanged for bonds). To reduce the money supply, the central bank sells bonds for existing
currency, thus reducing assets (through the sale of bonds) and liabilities (through the reduction of
currency held by the general public). Purchases and sales of bonds by the central bank are called open
market operations.
The text also considers open market operations in terms of their effect on bond prices. Suppose a bond
promises a payment of $F in one year. Call the current price of the bond $PB. Then, the interest rate (or
rate of return) on this bond is given by
i=($F-$PB )/$PB.
(4.2)
Equation (4.2) can be solved for the bond price:
$PB=$F/(1+i).
(4.3)
Given fixed nominal bond payments, equation (4.2) shows that the nominal interest rate and the bond
price are inversely related. For example, when the central bank purchases bonds, it increases the demand
for them and tends to increase their price, which reduces the interest rate.
3.
The Determination of the Interest Rate II
Now introduce banks into the model. Banks receive funds from depositors (individuals and firms) and
allow their depositors to write checks against (or withdraw) their account balances. These checkable
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deposits are liabilities of banks. On the asset side, banks hold bonds, loans (which are claims against
borrowers), and reserves of some of their deposits. Some bank reserves are held in cash and the rest in
accounts at the central bank. Banks hold reserves in part to protect against daily excesses of withdrawals
(in currency or check form) over deposits and in part because they are required to do so by the central
bank. In the United States, the Federal Reserve may set the required reserve ratio between 7% and 22%
of checkable deposits. The actual reserve - deposit ratio in the United States is about 10%.
Returning to the central bank balance sheet in an economy with banks, the only difference is that central
bank liabilities now consist of currency held by the public plus reserves held by banks. Central bank
liabilities—the money the central bank has created—are called central bank money.
Now consider money market equilibrium in terms of central bank money (H). The demand for money
arises from two sources: currency held by the public and reserves held by banks. The supply of money is
under the control of the central bank. Thus, equilibrium is given by
H=CUd+Rd,
(4.4)
where CUd refers to the demand for currency and Rd to the demand for reserves.
On the demand side, assume that overall money demand is determined as before, i.e., Md=$YL(i), and
that the demand for currency (as opposed to checkable deposits) is a fraction c (where 0<c<1) of overall
money demand. In addition, assume that banks keep a fixed fraction  of checkable deposits as reserves.
Putting these assumptions together with equation (4.4) gives
H= CUd+Rd=cMd+ (1-c)Md=[c+  (1-c)]$YL(i).
(4.5)
Equilibrium can be depicted just as in Figure 4.1, with H substituting for M on the horizontal axis. An
increase in H (through open market operations) leads to a decrease in the nominal interest rate.
4. Two Alternative Ways to Think about the Equilibrium
Equation (4.5), which equates supply and demand for central bank money, describes money market
equilibrium in an economy with banks. There are two ways to think about this equation.
First, consider equilibrium in the market for reserves. Supply of reserves is central bank money minus
currency. Demand for them is Rd. Equating supply and demand for reserves gives
H-CUd=Rd,
(4.6)
which is clearly identical to the equilibrium condition in equation (4.4). The advantage to thinking about
equilibrium in this way is that it facilitates discussion of the federal funds market—the market for bank
reserves—and the federal funds rate—the interest rate that adjusts to clear this market. In the federal
funds market, banks that need reserves at the end of the day borrow them from banks that have excess
reserves.
Second, consider equilibrium in terms of the overall supply and the overall demand for money (currency
and checkable deposits). Reorganize equation (4.5) to read
H/[c+(1-c)]=$YL(i).
(4.7)
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The quantity 1/[c+(1-c)] is called the money multiplier. The money supply equals central bank money
times the multiplier. Since c and  are assumed to be fixed, the central bank can control the money
supply by controlling H. For this reason, central bank money is often called high powered money or the
monetary base.
Note that 0<c<1 and 0< <1 together imply that the money multiplier is greater than one. Thus, a given
increase in central bank money leads to a larger increase in the overall money supply. The source of the
money multiplier is fractional reserve banking. A given increase in currency deposits creates only a
fractional increase in bank reserves. The remainder of the deposit increase is used to purchase bank
assets (e.g., bonds). The purchase puts more money in the hands of the nonbank public and hence creates
more checkable deposits, and so on. Thus, the money multiplier can be described as the limit of a
geometric series, in much the same way as the output multiplier was explained in Chapter 3.
V. PEDAGOGY
1.
Points of Clarification
It is probably wise to assume that many undergraduates have never seen a balance sheet of any kind. A
few words of explanation would be useful. In addition, with respect to the central bank balance sheet, as
a memory aid for students, it may be useful to simplify the discussion of open market operations as
follows: when the central bank increases its assets, it increases the money supply. Thus, when the central
bank buys bonds, it increases the money supply. It might also be useful to consider the Fed buying bonds
directly from a single bank. This simplifies the money supply process considerably.
It may also be useful to reconsider comparative statics in the money market in terms of bond prices. The
text carries out this exercise for open market operations, but instructors could also do the analysis for an
exogenous increase in national income. An increase in income shifts the money demand curve up, which
leads to an increase in the equilibrium interest rate, as is evident from the graph. To tell the bond market
story, note that at the initial interest rate, money demand exceeds supply. In other words, households are
attempting to sell bonds to acquire money. The pressure to sell bonds (effectively a shift to the left of the
bond demand curve) reduces the bond price and hence increases the interest rate. Since the supply curve
is vertical all the adjustment must be price adjustment, i.e., the interest rate must change until the
quantity of money demanded equals the existing money supply.
2.
Alternative Sequencing
Instructors have several options for presenting money market equilibrium. The most straightforward
presentation would rely on Section 4.2 for the cash economy and progress to Section 4.3 if banks and
checkable deposits are introduced. Section 4.3 equates demand and supply for central bank money.
Alternatively, to emphasize the federal funds market, instructors could present equilibrium with banks in
terms of the supply and demand for reserves; to emphasize the money multiplier, instructors could
present equilibrium with banks in terms of the supply and demand for money. These latter approaches
are presented in Section 4.4. Note that Section 4.4 is entirely optional.
The interest rate was not introduced in the discussion of the goods market in Chapter 3. Thus, at this
point in the text, the determination of the interest rate seems to stand apart from the determination of real
output. As discussed in Part V of Chapter 3 of the Instructor’s Manual, an alternative is to introduce the
dependence of investment on the interest rate in Chapter 3 and to assume a fixed interest rate.
Another option is to introduce some of the material in Chapter 25, devoted to monetary policy, in the
discussion of the current chapter. Some of the basic facts about the structure of the Federal Reserve may
be helpful to orient students and to help facilitate discussion of current Fed policy.
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3.
Enlivening the Lecture
Casual empiricism suggests that undergraduates have more immediate interest in material related to
financial markets than in almost any other topic. A discussion relating the material of the chapter to
current Federal Reserve policy (perhaps with a few words about the stock market’s response to Fed
policy) would probably be interesting to students.
Another suggestion is to look at the interest rate section of the financial pages of a major newspaper
during the lecture. Besides making the financial pages a bit more accessible to students, this strategy
might also provide an opportunity to discuss the inverse relationship between prices and interest rates.
Those who have classroom access to the internet will find it easy to get this information from any major
newspaper’s web site or a commercial site, viz. money.msn.com or biz.yahoo.com.
Another suggestion might be tell a joke about our “unlimited demand for money” which, of course, turns
out to be an unlimited demand for income and wealth.
VI. EXTENSIONS
1.
The Balance Sheet Constraint
To clarify the relationship between bond market and money market equilibrium, it may be useful to be
more explicit about the implications of the balance sheet constraint. The constraint implies
Md+Bd=Financial Wealth=M+B,
or
(Md - M)=(B – Bd).
In other words, the excess demand for money must equal the excess supply of bonds. When one market
clears, the other must clear as well. This is, of course, just Walras’ Law.
2.
The Money Demand Function
This chapter assumes a money demand function of the form Md=$YL(i)=PYL(i). A more general
alternative would be Md=L($Y,i). The functional form assumed in the chapter allows for an easy
conversion to real money demand by dividing through by the price level. Introducing the more general
form requires explaining to students that money demand should be homogeneous of degree one in P. On
the other hand, this exercise does make clear what is assumed.
VII. OBSERVATIONS
1.
The Definition of Money Demand
Money demand refers to a portfolio decision, the amount of fixed wealth that the nonbank public desires
to hold in money as opposed to bonds. Money demand does not refer to the demand for income or
wealth.
2.
Government Bonds and the Central Bank
The central bank does not create government bonds, only money. It conducts open market operations
with government bonds. The stock of government bonds outstanding is the government (in popular
usage, national) debt, which is the product of past fiscal deficits. Open market operations apportion this
debt between the central bank and the private sector. You cannot emphasize this point enough. In the
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U.S. the government does not create money. The Fed is not part of the government. The government can
only borrow. It’s up to the Fed to create money.
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