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Financial Markets
 What determines interest rates
 How the Federal Reserve System (Fed)
influences interest rates
Econ 302
Financial Markets
Slide #1
Financial Markets
Some Assumptions
 One bond market
 One interest rate
Econ 302
Financial Markets
Slide #2
The Demand for Money
A Scenario…
Two financial assets to choose from
Money: Used for transactions
(currency and checkable deposits)
Bonds: Cannot be used for
transactions and pays a positive
interest rate (i)
Econ 302
Financial Markets
Slide #3
The Demand for Money
A Scenario…
Your financial wealth = $12,000
Choice: How to allocate the $12,000
between money and bond
Econ 302
Financial Markets
Slide #4
The Demand for Money
A Scenario…
The proportion of money and bonds
depend on:
 Your level of transactions
 The interest rate on bond
Econ 302
Financial Markets
Slide #5
The Demand for Money
A Scenario…
The proportion of money and bonds depend on
the interest rate on bonds:
The interest rate on bonds:
•When the interest rate (i) increases the incentive to hold
bonds increases
•At high i, you may choose to reduce your money
holdings to two weeks or $500 (spending = $1000/month)
and increase bond holdings to $11,500
Question: If i=0, how much would you hold
in bonds?
Econ 302
Financial Markets
Slide #6
The Demand for Money
A Summary:
The demand for money (Md) depends on:
•The level of transactions which are
proportional to nominal income ($Y)
•The interest rate on bonds
Econ 302
Financial Markets
Slide #7
The Demand for Money
Md = $YL(i)
(-)
M
Demand for money
$Y
Nominal income
L (i )
The liquidity demand for
Money is a function of i
Md is inversely related to i
(-)
Econ 302
d
Financial Markets
Slide #8
The Demand for Money
Interest Rate, i
Graphically Md = $YL (i)
i
Md
Md (for
$Y´ > $Y)
(for nominal
Income $Y)
M´
M
Money, M
Econ 302
Financial Markets
Slide #9
Interest Rate, i
The Demand for Money
i2
• Md and i are inversely related
• Given $Y at i, M = M
i2, M = M2
i1, M = M1
b
a
i
c
i1
Md ($Y)
M2
M
M1
Money, M
Econ 302
Financial Markets
Slide #10
The Demand for Money
Graphically Md = $YL (i)
• Increase $Y to $Y´; Md shifts to Md´
Interest Rate, i
• M increases from M to M´ (a to b)
a
i
b
Md
($Y)
Md´
($Y´ > $Y)
M´
M
Money, M
Econ 302
Financial Markets
Slide #11
The Demand for Money
Money Demand and the Interest Rate: The Evidence
M  $YL(i)
d
d
Divide both sides by $Y
M
 L(i )
$Y
d
M
$Y
Econ 302
= ratio of money to nominal
income
Financial Markets
Slide #12
The Demand for Money
Money Demand and the Interest Rate: The Evidence
d
M
& i should be inversely
$Y
related
Econ 302
Financial Markets
Slide #13
The Demand for Money
Econ 302
Financial Markets
Slide #14
The Demand for Money
Money Demand and the Interest Rate: The Evidence
Observations
M
$Y
$Y
M
Econ 302
1960 = 27% 1998 = 13%
@ Approximately the same i
= Velocity of Money
1
1960 :
 3. 7
.27
Financial Markets
1
1998 :
 7.6
.13
Slide #15
The Demand for Money
Money Demand and the Interest Rate: The Evidence
What do you think?
What caused the velocity to double between
1960 and 1998?
Econ 302
Financial Markets
Slide #16
The Demand for Money
Money Demand and the Interest Rate: The Evidence
Observations
Negative relation between
Econ 302
Financial Markets
M
&i
$Y
Slide #17
The Determination of the Interest Rates: I
Money Demand, Money Supply & the Equilibrium Interest
Rate
Assume:
• All money (M) is currency, supplied
by the central bank
• Financial Market Equilibrium Occurs
when:
Money Supply = Money Demand
M
=
$YL(i)
Econ 302
Financial Markets
Slide #18
The Determination of the Interest Rates: I
Money Demand, Money Supply & the Equilibrium Interest
Rate
•The LM relation: M = $YL(i)
•The demand for Liquidity (L) = Supply of Money
Econ 302
Financial Markets
Slide #19
The Determination of the Interest Rates: I
The Equilibrium Graphically
Interest Rate, i
Ms
A
i1
Equilibrium interest, I, Md = MS
Md ($Y)
M
Money, M
Econ 302
Financial Markets
Slide #20
The Determination of the Interest Rates: I
The effects of an increase in National Income on i
Interest Rate, i
Ms
A´
i2
• Increase $Y to $Y´
• Md increases to Md´
• Equilibrium moves from A to A´
• i increases from i1 to i2
A
i1
Md´ ($Y´ > $Y)
Md ($Y)
M
Money, M
Econ 302
Financial Markets
Slide #21
The Determination of the Interest Rates: I
The effects of an increase in the Money Supply on i
Interest Rate, i
Ms
Ms´
• Increase Ms to Ms´
• Equilibrium moves from A to A´
• Interest rate falls from i1 to i2
A
i1
A´
i2
Md ($Y)
M
M´
Money, M
Econ 302
Financial Markets
Slide #22
The Determination of the Interest Rates: I
Open Market Operations:
•Buying and selling government bonds by the
central bank
•Buy bonds to increase the money supply (and
lower the interest rate)
•Sell bonds to decrease the money supply (and
raise the interest rate)
Econ 302
Financial Markets
Slide #23
The Determination of the Interest Rates: I
Balance Sheet
Banks
Assets
Bonds
Econ 302
Central Bank
Liabilities
Money
(Currency)
Buy $1 million in bonds:
• Bonds increase
• Currency decreases at the Central
Bank and increases in the economy
Financial Markets
Slide #24
The Determination of the Interest Rates: I
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:
$100  $ PB
i
$ PB
Econ 302
Financial Markets
Slide #25
The Determination of the Interest Rates: I
Monetary Policy and Open Market Operations
The Price of Bonds and the Interest Rate
For Example, Assume:
$PB = $95
$PB = $90
$100  $95 $5
i

 0.053  5.3%
$95
95
Econ 302
i
Financial Markets
$100  $90 $10

 0.111  11.1%
$90
90
Slide #26
The Determination of the Interest Rates: I
Monetary Policy and Open Market Operations
Observation!
The price of a bond and
the interest rate are
inversely related.
Econ 302
Financial Markets
Slide #27
The Determination of the Interest Rates: I
Monetary Policy and Open Market Operations
The Price of Bonds and the Interest Rate
Calculating the price of a bond-Assume a bond with a $100 value in one year
100
$ PB 
1 i
Econ 302
100
i  5.3 $ PB 
 95
1  .053
100
i  11.1 $ PB 
 90
1  .111
Financial Markets
Slide #28
The Determination of the Interest Rates: I
Monetary Policy and Open Market Operations
Expansionary Open Market Operation: Increase the Money Supply and
Lower the interest rate
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.
Econ 302
Financial Markets
Slide #29
The Determination of the Interest Rates: I
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
Econ 302
Financial Markets
Slide #30
The Determination of the Interest Rates: II
Interest rates in an economy with currency and checkable deposits
What banks do:
Banks are financial intermediaries-• They receive funds (deposits) which
are liabilities
• They make loans and buy bonds which
are assets
Econ 302
Financial Markets
Slide #31
The Determination of the Interest Rates: II
Interest rates in an economy with currency and checkable deposits
What banks do:
Banks
Assets
Liabilities
Reserves
Loans
Bonds
Assets
Checkable deposits
Central Banks
Central Bank Money
=Reserves
+Currency
Bonds
Econ 302
Liabilities
Financial Markets
Slide #32
The Determination of the Interest Rates: II
Why do banks hold reserves?
1. To cover the cash withdrawls by depositors.
2. To cover the payment of checks which are
deposited in other banks.
3. To maintain the legal reserve requirement
(10%) set by the Fed (Reserve ratio =
Reserves  checkable deposits).
Econ 302
Financial Markets
Slide #33
The Determination of the Interest Rates: II
The supply and demand for central bank money
Demand for
money
Demand for
checkable
deposits
Demand for
reserves
(by banks)
Demand for
currency
Econ 302
Financial Markets
Demand for
Central Bank
Money
=
Supply of
Central Bank
Money
Slide #34
The Determination of the Interest Rates: II
The demand for money
• The overall demand for money Md is unchanged with
checkable deposits:
Md  $YL (i )
( )
However, people must choose between currency
and checkable deposits.
Econ 302
Financial Markets
Slide #35
The Determination of the Interest Rates: II
The demand for money
Assume:
•C represents the fixed proportion of money
people hold as currency (US: C=.4)
•1-C is the proportion of money held as
checkable deposits.
Econ 302
Financial Markets
Slide #36
The Determination of the Interest Rates: II
The demand for money
Assume:
The demand for currency is: CUd
The demand for checkable deposits is: Dd
CUd = cMd:
Demand for currency (Central Bank Money)
Dd = (1-c)Md: Demand for Reserves (Central Bank Money)
Econ 302
Financial Markets
Slide #37
The Determination of the Interest Rates: II
The demand for reserves
Assume:
:
Represents the reserve ratio (reserves to checkable deposits)
R: Represents the dollar amount of reserves
D: Represents the dollar amount of checkable
deposits
Therefore:
R  D (US :   10% or 0.1)
Econ 302
Financial Markets
Slide #38
The Determination of the Interest Rates: II
The demand for reserves
If people hold deposits of Dd, then banks must hold
reserves (R) of Dd.
R  D
d
D  (1  c) M
d
d
R   (1  c) M
d
Econ 302
Financial Markets
d
Slide #39
The Determination of the Interest Rates: II
The demand for reserves
The Equilibrium
H : Supply of Central Bank Money
CU d  R D : Demand for money
H  CU  R : Equilibrium (Supply of Money
d
d
= Demand for Money)
Econ 302
Financial Markets
Slide #40
The Determination of the Interest Rates: II
Equilibrium:
H  CU d  R d
CU d   (1  c) M d
H  cM d   (1  c)M d  c   (1  c)M d
d
M  $YL(i)
H  c   (1  c)$LY (i)
Econ 302
Financial Markets
Slide #41
The Determination of the Interest Rates: II
Supply of Central Bank Money = Demand for Central Bank Money
H
 c   (1  c)$LY (i)
Special Case: Assume, people only hold currency: C=1
H  1   (1 1)$LY (i)  $LY (i)
Then banks do not impact the money supply.
Econ 302
Financial Markets
Slide #42
The Determination of the Interest Rates: II
Assume: People hold only checkable deposits: C=O
H  O   (1  0)$LY (i)   $LY (i)
Assume:
  .10 &.10$LY (i)
= Central Bank
Money Demand
The demand for central bank money =  or 1/10Md
If C<1, demand for central bank money <Md,
Econ 302
Financial Markets
Slide #43
The Determination of the Interest Rates: II
The Equilibrium Graphically
Interest Rate, i
Supply
Equilibrium
A
i1
Demand
Cud + Rd ($Y)
H
Central Bank Money, H
Econ 302
Financial Markets
Slide #44
The Determination of the Interest Rates: II
The supply and demand for reserves
Recall:
Supply of Central Bank Money = Demand for Central Bank Money
 c   (1  c)$LY (i)
Therefore:
H
H  CU d
And:
H  CU  R
d
=Supply of Reserves
d
Supply of Reserves = Demand for Reserves
Econ 302
Financial Markets
Slide #45
The Determination of the Interest Rates: II
The supply and demand for reserves
 The Federal Funds Market: The market
for bank reserves
 The Federal Funds Rate: The interest
rate that equates the supply of
Reserves (H-Cud) with demand for
reserves (Rd)
Econ 302
Financial Markets
Slide #46
The Determination of the Interest Rates: II
The supply and demand for money
Recall:
Therefore:
H  c   (1  c)$LY (i)
Supply of Money = Demand for Money
1
H  $YL (i)
c   (1  c)
Econ 302
Financial Markets
Slide #47
The Determination of the Interest Rates: II
The supply and demand for money
c   (1  c)  1
Therefore:
1
1
c   (1  c)
Econ 302
Financial Markets
Slide #48
The Determination of the Interest Rates: II
The supply and demand for money
Observations:
1
 Money Multiplier
c   (1  c)
•The supply of money is a multiple of the
Central Bank money.
•Central Bank money (monetary base) is
High-powered money (H)
Econ 302
Financial Markets
Slide #49
The Determination of the Interest Rates: II
Open market operations revisited
If: C=O (People hold only checkable deposits) ,
The Multiplier =
1
1

c   (1  c) 
If: = .10, The Multiplier =
Econ 302
Financial Markets
1
 10
.10
Slide #50
The Determination of the Interest Rates: II
Open market operations revisited
An example of the multiplier
Assume:
 = .10 & the Fed buys $100 worth of
bonds
• Seller1 deposits $100 in bank A and Central Bank money
increases
• Bank A puts $10 (.10x100) in reserve and buys $90 in bonds
• Seller2 deposits $90 (.10x90) in Bank B and checkable deposits
increase $90
• Bank B puts $9(.10x90) in reserve and buys $81 in bonds
• Seller3 deposits $81 in bank C and checkable deposit increases
$81
Econ 302
Financial Markets
Slide #51
The Determination of the Interest Rates: II
Open market operations revisited
An Example
Questions:
• How much money has been created after
seller 3 deposits the $81?
• How much money could be created from the
Fed’s original $100 purchase?
Hint: The Multiplier =
Econ 302
Financial Markets
1
&   .10

Slide #52
The Determination of the Interest Rates: II
A Summary:
 Increases in Central Bank money (Fed
buys bonds) decrease the interest rate
 Decreases in Central Bank money (Fed
sells bond) increase the interest rate
 Cashless economy? What is the role of
the Central Bank?
Econ 302
Financial Markets
Slide #53