Macroeconomics Prof. Juan Gabriel Rodríguez Chapter 3 The Financial Market

Macroeconomics

Prof. Juan Gabriel Rodríguez

Chapter 3

The Financial Market

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. Investment is a function of the interest rate, so output is affected by the interest rate.

[Nominal income is taken as given, so there is no need to consider

simultaneous equilibrium of goods and financial markets.]

FINANCIAL ASSETS

Main characteristics:

– EXPECTED RETURN: The larger, the better– RISK: Riskier assets must have a higher expected

return– LIQUIDITY: The easier to exchange, the more

attractive

Functions of Money

- MEDIUM OF EXCHANGE: Trade at less cost- UNIT OF ACCOUNT: Needs price stability- STORE OF VALUE: Way of storing wealth

The Demand for Money

Money (use for transactions) pays no interest.

Types of money:

Currency: coins and bills (banknotes)

Checkable deposits: the bank deposits on which you can write checks.

Bonds pay a positive nominal interest rate, i, but they cannot be used for transactions.

The proportions of money and bonds you wish to hold depend mainly on two variables:

Your level of transactions

The interest rate on bonds


The demand for money:– increases in proportion to nominal income (€Y)– depends negatively on the interest rate

Money market funds pool together the funds of many people. The funds are then used to buy bonds—typically government bonds.

dMThe demand for money, , is equal to nominal income, €Y, times a function L of the interest rate, i:

)(iLYM d €


For a given level of nominal income, a lower interest rate increases the demand for money. At a given interest rate, an increase in nominal income shifts the demand for money to the right.

M (Money)

I (I

nter

est

rate

)

i

Md (€Y)

M M’

Md’ (€Y’)

According to household surveys, in 2006, U.S. household held in total $170 billion in currency. However, the Federal Reserve Board knows the amount of currency in circulation was much higher, $750 billion.

Taking into consideration that some currency was held by firms and some was held by those involved in the underground economy (or in illegal activities) leaves 66% of the total unaccounted for…

The fact that foreigners hold such a high proportion of the dollar bills in circulation (see the cases of Argentina and Russia!) has two main macroeconomic implications.

- The rest of the world, by being willing to hold U.S. currency, is making in effect an interest-free loan to the United States of $500 billion.

- U.S. money demand depends not only on the interest rate and the level of transactions but also on other factors…International insecurity…

The Dollar as the World’s reserve currency

The Determination of the Interest Rate

Equilibrium in financial markets requires that money supply be equal to money demand, or that Ms = Md. The equilibrium condition is:

This equilibrium relation is called the LM relation.

)(iLYM s €


In equilibrium, the interest rate must be such that the supply of money (which is independent of the interest rate -it is exogenous) is equal to the demand for money (which does depend on the interest rate -it is endogenous).

M (Money)

I (I

nter

est

rate

)

i

Md (€Y)

M

Ms


An increase in nominal income leads to an increase in the interest rate.

M

I

i

Md (€Y)

M

Ms

i’

Md’ (€Y’)An increase in the supply of money leads to …


Open-market operationsThey take place in the “open market” for bonds and are the standard method central banks use to change the money stock.

If the central bank buys bonds, this operation is called an expansionary open market operation because the central bank increases (expands) the supply of money.

If the central bank sells bonds, this operation is called a contractionary open market operation because the central bank decreases (contracts) the supply of money.


B

B

PP

i100

The relationship between the interest rate and bond prices:

– Treasury bonds are issued by the government promising payment in a year or less. If you buy the bond today and hold it for a year, the rate of return (or interest) on holding a €100 bond for a year is (€100 - €PB)/ €PB.

– If we are given the interest rate, we can figure out the price of the bond using the same formula.

i

PB

1100


The central bank changes the supply of money through open market operations, which are purchases or sales of bonds for money:

– Open market operations in which the central bank increases the money supply by buying bonds lead to an increase in the price of bonds and a decrease in the interest rate.

– Open market operations in which the central bank decreases the money supply by selling bonds lead to a decrease in the price of bonds and an increase in the interest rate.

So far only two assets: money and bonds.

This is a much simplified version of actual economies, with their many financial assets and many financial markets.

Nevertheless, we will consider only the money market because of the Walras Law:

Money Market Equilibrium implies

Bond Market Equilibrium



0

sd

sd

ii

bbMLY

bMbLY

SD

N MARKETS

N-1 in equilibrium IMPLIES N in equilibrium

Supply Value equals Demand Value:

But money is not only currency…

FINANCIAL INTERMEDIARIES

BORROWERSFIRMS

HOUSEHOLDSPUBLIC SECTOR

COMMERCIALBANKS

SAVERSFIRMS AND PEOPLE

INSURANCE COMPANIESPENSION FUNDS

Receive Funds

Make Loans

The Determination of Interest Rate

Financial intermediaries are institutions that receive funds from people and firms, and use these funds to buy bonds or stocks, or to make loans to other people and firms.

■ Banks receive funds from people and firms who either deposit funds directly or have funds sent to their checking accounts. The liabilities of the banks are therefore equal to the value of these checkable deposits.

■ Banks keep as reserves some of the funds they receive.

Banks hold reserves for three reasons:

1. On any given day, some depositors withdraw cash from their checking accounts, while others deposit cash into their accounts.

2. In the same way, on any given day, people with accounts at the bank write checks to people with accounts at other banks, and people with accounts at other banks write checks to people with accounts at the bank.

3. Banks are subject to reserve requirements. The actual reserve ratio – the ratio of bank reserves to bank checkable deposits – is about 2% in the European Union today.


Bank Runs

Rumors that a bank is not doing well (loans are not repaid) will lead people to close their accounts at that bank. If enough people do so, the bank will run out of reserves—a bank run.

To avoid bank runs, the governments provide deposit insurances.

An alternative solution is narrow banking, which would restrict banks to holding liquid, safe, government bonds.


Loans represent roughly 70% of banks’ non-reserve assets. Bonds count for the rest, 30%.

The assets of the central bank are the bonds it holds. The liabilities of the central bank are the money it has issued, central bank money. The new feature is that not all of central bank money is held as currency by the public. Some of it is held as reserves by banks.



Let’s think in terms of the supply and the demand for central bank money.

■ The demand for central bank money is equal to the demand for currency by people plus the demand for reserves by banks.

■ The supply of central bank money is under the direct control of the central bank.

■ The equilibrium interest rate is such that the demand and the supply for central bank money are equal.



The demand for money involves two decisions:

- People must decide how much money to hold. - They must decide how much of this money to hold in currency and how much to hold in checkable deposits.

d dCU c MD c Md d ( )1

The demands for currency and checkable deposits are given by:

Assuming that overall money demand is given by the same equation as before:

)(iLYM d


R D

The larger the amount of checkable deposits, the larger the amount of reserves the banks must hold, for both precautionary and regulatory reasons.

The relation between reserves (R) and deposits (D):

Therefore, the demand for reserves by banks is given by:

1d dR c M


1 1d d d dH cM c M c c M

H CU Rd d d

The demand for central bank money is equal to the sum of the demand for currency and the demand for reserves:

Hence,

That is:

HiLYccH d )()1(

H: Monetary Base


M (Money)

I (I

nter

est

rate

)

i

Hd=CUd+Rd

H

Supply of Central Bank Money

The equilibrium interest rate is such that the supply of central bank money is equal to the demand for central bank money.

Other alternative interpretations

The supply and the demand for bank reserves are equal in equilibrium:

H CU Rd d

■ The overall supply of money is equal to central bank money times the money multiplier:

■ High-powered money: the overall supply of money depends in the end on the monetary base or amount of central bank money (H).

)()1(

1iLYH

cc

STEP BY STEP MONEY CREATION

cH (1-c)H (1-c)H pH

cpH (1-c)pH (1-c)pH p2H

cp2H (1-c)p2H (1-c)p2H p3H

Currency Deposits Reserves Loans

¿p?

Money Multiplier

pppp

1

1...1 32

We have the sum of a geometric series:

In equilibrium:

])1([1

1

11

HcHcp

DCUMi

di

i

di

d

Hcc

M d

)1(

1

What are the limits of the Multiplier w.r.t. c and ?

Other alternative interpretations

We can also think of the ultimate increase in the money supply as the result of successive rounds of purchases of bonds—the first started by the Central Bank in its open market operation, the following rounds by banks.

Equilibrium in real terms?


Excess supply M = Excess demand BPrice increase and interest rate decrease

Excess demand M = Excess supply BPrice decrease. Interest rate increase

i

L

M/PY·L(i)

E

i is the bonds yieldi is the money opportunity cost

Leverage

Example:

Assets Liabilities Capital Leverage

Bank 1 100 80 20 5

Bank 2 100 95 5 20

Capital

AssetsratioLeverage What happens if the value of the assets

falls from 100 to 80?

Bank 2 becomes insolvent: it is bankrupt!A high leverage ratio is risky

Leverage

Nevertheless, banks like having a high leverage ratio:

Assets yield a return of 10%. Therefore,Bank 1: return on its capital of 50% (10/20)Bank 2: return on its capital of 200% (10/5)

As long as house prices were rising, by keeping their leverage high banks could earn huge profits and none failed. When this honeymoon came to an end, many banks were bankrupt.

Why the US government did not intervene, imposing a limit on leverage? - Widening the number of US citizens who own a home was a political

objective - Bankers often translated into campaign contributions to politicians who

then lobbied for lax rules on leverage.

Leverage

Over time the situation of banks spread to other financial institutions like insurance companies…a huge volume of risky investments were held on a tiny pedestal of capital.

When the value of their assets fell, some banks with high leverage went bust, which stopped lending.The rest of banks had used almost all their capital, alive but weak. To strength their position:

- Raise more capital, but a crisis is not a good time to … - Reduce the amount of loans they were holding- Sell liquid assets (mostly stocks)

Credit Freeze (any investment?)Fire sale in the stock market (lower value of household wealth….consumption!)

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Macroeconomics Prof. Juan Gabriel Rodríguez Chapter 3 The Financial Market