Download demand for money

Financial Markets
Lecture 18 – academic year 2014/15
Introduction to Economics
Fabio Landini
Questions of the day
What is it that determine the interest rate paid
in financial market?
How can the interest rate be influenced by the
authorities that are responsible for monetary
policies (Central Bank)?
How does the Central Bank operate?
What we will do today?
• Allocation of financial wealth and construction
of the demand for money
• Determination of the equilibrium in financial
markets
• Analysis of the factors that changes the
equilibrium interest rate
• Analysis of open market operations carried out
by the Central Bank
Construction of the demand for money
Preliminary distinction: income/wealth
The wealth of an individual is what he/she owns in a
given moment
The income of an individual is what he/she earns in a
given period of time
Example:
• Annual salary = income
• Financial assets that are owned today = wealth
Construction of the demand for money
In the analysis of financial markets we focus on
the financial wealth of an individual
Financial wealth is the difference between the
financial assets (shares, bonds, etc.) and
liabilities (shares, bonds, etc.)
Construction of the demand for money
Example:
• A large company issues bonds (liabilities) and
purchases shares of another company and
Government bonds (assets)
• The government issues bonds (liabilities) and buys
shares of some companies (assets)
• An household owns the shares of some companies
(assets) and take out a mortgage (liabilities)
Construction of the demand for money
Let’s assume that there exist only two financial activities
(money and bond)
Problem under investigation: How to optimally split the
financial wealth (W) between money and bonds
MD
W
BD
where, MD is the money desired by people (demand for
money) and BD is the quantity of bond desired by people
(demand for bond)
Construction of the demand for money
Why do people demand money and/or bonds?
a) Advantage of detaining money -> liquidity
• Money is used to purchase goods
• Bonds must be sold before they can be sued to purchase
goods
Money is detained for transaction purposes
Construction of the demand for money
b) Advantage of detaining bonds = remuneration
• On the bonds that are owned an interest rate is paid
• Money does not ensure any return
Bonds are detained in order to earn the assets’
financial remuneration
Construction of the demand for money
On the basis of what we saw before:
•Given the financial wealth W, MD depends positively on
the amount of transactions
•Given the financial wealth W, MD depends negatively on
the interest rate (i)
The amount of transactions is difficult to measure
It can be approximated by the nominal income (€Y)
(the larger the nominal income, the greater the
number of transactions)
Construction of the demand for money
An adequate functional form is
MD = €YL(i)
-
It implies that:
•Demand for money is proportional to the nominal income
•Demand for money decreases with the interest rate
Let’s consider the nominal income as exogenous
(constant value) -> MD as a function of i (given €Y)
Construction of the demand for money
Graphically: Decreasing relationship between MD and i
i
MD
Determination of the equilibrium
To identify the equilibrium in financial markets we need
to consider the standard condition:
Money demand = Money supply
Let’s assume that the Central Bank (CB) perfectly controls
the supply of money (MS) -> CB decides the value of MS
The assumption is analogous to the one concerning G and
T in the goods market
•G, T = choice variable for the fiscal policy
•MS = choice variable for the monetary policy
Determination of the equilibrium
Since MS is an autonomous choice of the Central Bank we
can assume it exogenous, i.e. it does not depend on i
Graphically: MS is a vertical line
i
MS
MS
Determination of the equilibrium
The equilibrium in financial markets is obtained by imposing
MS = MD =€YL(i)
The equilibrium is the point E where i=iE
i
iE
MD
MS
E
MD
Determination of the equilibrium
iE is the interest rate for which, given the nominal income,
the demand for money equals the exogenous value of the
money supply
i
MD
iE
MS
E
MD
Variations of the interest rate
What does it happen if we vary the exogenous
variables €Y and MS ?
1) Increase in nominal income €Y
• €Y -> people carry out more transactions ->
Demand for money (for any level of i) -> the
curve MD shifts rightward
Initial position of the curve
€Y -> the curve MD shifts rightward
€Y -> E -> E’ ->
MD
i
MD ’
i in equilibrium
MS
E’
iE’
iE
E
MD
Variations of the interest rate
2) Increase in the amount of money supplied by the
Central Bank
MS -> The line MS shifts rightward
Initial position of the curve
MS -> the curve MS shifts rightward
MS -> E -> E’ ->
i
iE
iE’
MD
i in equilibrium
MS
E
MS’
E’
MD
Variations of the interest rate
In conclusion:
• An increase in nominal income -> iE
• An increase in money supply -> iE
Open market operations
We examined the effects of a variation of MS
How does the Central Bank changes MS?
The Central Bank can operate in two ways:
• MS -> Introduce new money into the system
• MS -> Take money out of the system
To do so the Central Bank buys and sells bonds on the
open market -> “Open market operations”
Open market operations
To increase MS the Central Bank buys bonds on the
open market paying them with newly printed money
•
•
stock of bonds owned by private parties
money available in the economy
To decrease MS the Central Bank sells bonds on the
open market collecting money
•
•
stock of bonds owned by private parties
money available in the economy
Open market operations
The open market operations carried out by the
Central Bank affect the supply of money but also
the demand and supply of bond
What does it happen on the bond market when
the Central Bank carries out some open market
operations?
Open market operations
Let’s examine the bond market. Let’s assume:
•Issued at the price PT
•Repaid at time T for the nominal value V
What is the interest rate paid on the bond?
The interest rate is equal to the proportion between
the earning and the initial price
i=
V - PT
PT
Open market operations
Important: the interest rate i depends on the time
span from today until T (e.g. 1 month, 3 month, 1
year, etc.)
In Blanchard V=100€
i1=00 - PT
PT
from which we get
PT 1=00
1 i
100

-1
PT
Open market operations
This implies that there exist a negative relationship
between the interest rate and the price of a bond
i <-> PT
Intuition: Given a certain repayment value (100€), if
the price that is paid to but the bond is high, the
interest rate is low
When the newspaper says “the market went up”, it
means that bond prices raised and interest rate fell
Open market operations
What happens when the Central Bank changes MS?
If the Central Bank MS ->
The Central Bank buys bond ->
Demand for bonds ->
Price of bonds -> i
If the Central Bank MS ->
The Central Bank sells bond ->
Supply of bonds ->
Price of bonds -> i
Open market operations
In conclusion:
•
MS -> CB buys bonds ->
•
MS -> CB sells bonds ->
PT ->
PT ->
i
i
The effects are the same obtained in the
previous graphical analysis
The effects of a variation of MS on i can be
observed both on the money market and on
the bond market