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)

14 & 15.3.2012 (Tutorial 5)

Chapter 4 Financial Markets

**The demand for money
**

Assumptions:

There are only two assets in the financial market: money and bonds

Price is fixed and Y is given, that is nominal GDP is given

Wealth = Md + Bondd

Money: high liquidity, but pays no interest (currency and checkable deposits)

Bond: pays interest but cannot be used for transactions

A person’s choice: hold currency or to buy bonds

Trade off between holding money and bonds: liquidity and return

** Money demand depends on: (1) level of transactions, (2) interest rate on bonds, (3) other
**

factors, like transaction cost and liquidity of bonds.

Money demand function: Md = PL(i, Y) (Overall Money Demand)

Money demand positively depends on Y and negatively depends on i.

**The determination of interest rate
**

(1) The supply and demand for currency: Ms = PL(i, Y)

(2) The supply and demand for central bank money: H = CUd + Rd

(3) The supply and demand for reserves (Fed fund market): H – CUd = Rd

H

(4) Money Multiplier: PL (i, Y )

[c (1 c)]

1

Suppose a bond promises a payment of F (face value) in one year. For example. Y changes) Md (given Y) M M* 2 . i* Change in equilibrium (e. (expansionary) If the central bank wants to reduce money supply. PB is the current price of bonds. Money market equilibrium The money market equilibrium is determined by the demand and supply of money. which reduces the interest rate. The central bank can change money supply by conducting open market operations (OMO).g. Money demand function: Md = PL(i. Md = Ms Equilibrium interest rate = i*. Then. If the central bank wants to increase money supply.The determination of interest rate (I): Supply and demand for currency Assume all money is currency. so there are no checking accounts or banks. (contractionary) Balance sheet for the central bank: Assets Liabilities Bonds Currency Considers open market operations in terms of their effect on bond prices. (FED in US). it will sell bonds. Y) Money supply: M = Ms Money supply determined by central bank in most countries. it will buy bonds. i Ms In the money market equilibrium. when the central bank purchases bonds. it increases the demand for them and tends to increase their price. interest rate (or rate of return) on this bond is given by i = (F – PB ) / PB PB =F /(1+ i) Nominal interest rate and the bond price are inversely related. The quantity supplied of money is independent of interest rate.

Md = CUd + Dd = cMd + (1 – c)Md Demand for currency: CUd = cMd Demand for reserves (Rd) 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 by a fraction of of their deposits. people hold money in the form of currency by a fraction of c and in the form of checkable deposit by a fraction of (1 – c) where 0 < c < 1.The determination of interest rate (II): Supply and demand for Central bank money (H) Assume money includes currency and checking accounts in banks Banks receive funds from depositors (individuals and firms) and allow their depositors to write checks against (or withdraw) their account balances Balance sheet of banks: Assets Liabilities Bonds Checkable deposits Loans Reserves Balance sheet of central bank: Assets Liabilities Bonds Central bank money = Reserve + Currency Demand for central bank money = demand for currency + demand for reserves by banks Supply of money is controlled by the central bank (H: supply of central bank money) Equilibrium: H= CUd + Rd Demand for currency (CUd) Recall Md = $YL(i). (reserve ratio) Demand for reserves: Rd = D = (1– c) Md The demand for central bank money H = Hd = CUd + Rd H = Hd = cMd + (1– c) Md H = Hd = [c + (1 – c)]PL(Y. Hd = CUd + Rd H H 3 . i) The supply of central bank money is equal to the demand for central bank money i H In the money market equilibrium. H= CUd + Rd * i Equilibrium interest rate = i*.

hold $c(1 – )(1 – c) and deposits $(1 – c)(1 – )(1 – c) in a checkable account in Bank B Bank B keeps $ (1 – c)(1 – )(1 – c) in reserves and buys bonds with $(1 – )(1 – c)(1 – )(1 – c) from Seller 3 … … Seller 3 gets $[(1 – )(1 – c)]2 Total increase in money supply = $1 + $(1 – )(1 – c) + $[(1 – )(1 – c)]2 … … 1 = $1 [c (1 c)] H Total increase in money supply = (overall money supply) [c (1 c)] 4 . hold $c as currency and deposit $(1 – c) in a checkable account in Bank A Bank A keeps $ (1 – c) in reserves and buys bonds with $(1 – )(1 – c) from Seller 2 Seller 2 gets $(1 – )(1 – c). money multiplier > 1 An increase in central bank money leads to a larger increase in the overall money supply The Fractional reserve banking and the money multiplier A given increase in currency deposits creates only a fractional increase in bank reserves. Y ) where is the money multiplier [c (1 c)] [c (1 c)] The money supply equals central bank money times the multiplier the central bank can control the money supply by controlling H c and are assumed to be fixed.. i) H 1 MS PL (i. The remainder of the deposit increase is used to purchase bank assets (e. reserve ration is Suppose central bank increases H by $1 by buying bonds from Seller 1 Seller 1 gets $1.The supply and demand for reserves: Fed fund market Fed fund market: the market for bank reserves. The purchase puts more money in the hands of the non-bank public and hence creates more checkable deposits. 0 < c < 1 and 0 < <1.g. and federal funds rate is determined. and so on. H = CUd + Rd H – CUd = Rd Supply of reserves = demand for reserves Money Multiplier H = [c + (1 – c)]PL(Y. bonds). Assume people hold currency and checkable deposit in the proportion of c and (1 – c) out of the overall demand for money.

(a) What is the interest rate on the bond if its price today is $75? 85? 95? PB (1+ i) = 100 Solving for r When PB = $75. at what level should it set the supply of money? Let the new money supply be (Ms)’. i = 5% (b) What is the relationship between the price of the bond and the interest rate? Negative (c) If the interest is 8%.25 – 0. so c = 0 and = 0.92) +…+100(0.25 – i) where Y is $100. i = 18% When PB = $95. Also.9) +100(0. i = 33% When PB = $85.25 – i) i = 0. (Ms)’ = 100 ( 0.15) (Ms)’ = 10 Question 2 A bond promises to pay $100 in one year.Example: Assume people only hold checking account.9n) = 100 [1/ (1 – 0.9)] = 1000 = H + H (1 – ) + H (1 – ) 2 +…+ H (1 – ) n = H [1/ (1 – (1 – )] = H/ (assume c = 0) Examples and Problems Question 1 Suppose that real money demand is given by Md = $Y(0. suppose that the supply of money (Ms) is $20. what is the price of bond today? PB (1+ i) = 100 PB (1+ 8%) = 100 PB (1+ i) $93 5 . (a) What is the real interest rate? In the equilibrium.1. Ms = Md 20 = 100 (0. Assume equilibrium in financial markets.05 (5%) (b) If the Federal Reserve Bank wants to increase i by 10% (from 5 to 15%). so the money multiplier is 1/ Suppose H increases by 100 by buying bonds from Seller 1 Seller 1 deposit 100 in a checking account in Bank A Bank A keeps 10 in reserves and buys bonds with 90 from Seller 2 Seller 2 deposit 90 in a checking account in Bank B Bank A keeps 9 in reserves and buys bonds with 81 from Seller 3 … … … Total increase in money supply =100 + 100 (0.

but decreases bond demand.’ What is wrong with this sentence? When people earn more income. (c) Suppose that the interest rate is 4%. what happens to the demand for money if her yearly income is reduced by 50%? New income = 40000. which pay interest.Question 3 Suppose that a person’s yearly income is $80000. become more attractive. How does it depends on the interest rate? A 1% increase (decrease) in income leads to a 1% increase (decerease) in real money demnad. (e) Summarize the effect of income on money demand.1. Explain.05. The effect is independent of the interest rate. what happens to the demand for money if her yearly income is reduced by 50%? New income = 40000. Md = 17600 (b) Describe the effect of the interest rate on money demand. they obviously will hold more bonds. An increase in the interest rate of 10% increases bond demand by $6000. Md = 20800.35 – i). (d) “When people earn more money. Question 4 Suppose that a person’s wealth is $50000 and that her yearly income is 60000.35 – i). 6 . (d) Suppose that the interest rate is 8%. In percentage terms. Also suppose that her money demand funciton is given by Md = Y(0. What is the effect of an increase in the interest rate by 10% on the demand for bonds? BD = 50000 – 60000(0. An increase in income increases money demand. Thus. Md = 10400. (a) Derive the demand for bonds. Also suppose that her money demand funciton is given by Md = $Y(0. that is demand for money drops by 50%. which depends on income. they increase their demand for money and decrease their demand for bonds. this does not change their wealth right away. (b) What are the effects of an increase in wealth on money and on bond demand? Explain. An increase in wealth increases bond demand. Money demand decreases when interest rate increases becauses bonds.3 – i). that is the real demand for money falls by 50%. Md = 8800. but has no effect on money demand. (c) What are the effects of an increase in income on money and on bond demand? Explain. since we implicitly hold wealth constant. When i = 0. In percentage term. (a) What is her demand for money when the interest rate is 4%? 8% When i = 0.

i) + G = ZZ I = I (Y. MPI IS curve is flatter with higher MPC and MPI 7 . In the goods market equilibrium. Other factors affecting investment Suppose there is an increase in interest ZZ 45 rate (cost of borrowing for ZZ investment) A Investment decreases (For i) Demand decreases D ZZ’ Y decreases C (For i’) Equilibrium in goods market implies B that the higher the interest rate. T. the lower the equilibrium level of output IS curve is downward sloping Y Y** Y* When i increases Firms borrow less and invest less i Fall in I. I0…etc Factors affecting the slope of IS curve: MPC. C0.Chapter 5 Good and Financial Markets: The IS-LM Model The IS curve: Goods market equilibrium IS curve: it captures the relationship between output and the interest rate such that the goods market is in equilibrium. since Y = C + I + G. i): Investment positively depends on Y and negatively depends on i. Aggregate supply of Goods = Aggregate demand for goods/ Total saving = Investment Y = C (Y – T) + I (Y. T…etc) Excess supply of goods (Point C) Y Y** Y* Factors shifting the IS curve: change in G. therefore Y falls B C Movement along the IS curve i’ Points on the left of IS ED for goods ES of goods Excess demand for goods (point D) i Points n the right of IS D A IS (G.

Ms/P. and equilibrium interest rate rises. In the money market equilibrium. and i= 20% (Point D) Factors shifting the LM curve: change in Md/P (due to factors other than Y). and i= 20% (Point E) All points on the right of LM Excess demand for money At Y3 = 3000. The LM curve: Financial market equilibrium LM curve: it captures the relationship between output and the interest rate such that the financial market is in equilibrium. Real money demand = Real money supply Ms/P = YL(i) i Ms1/P i ES of money ED for money LM(Ms1/P) i= 30% i =30% C C B i = 20% E B i = 20% E D D A A i =10% i =10% Md/P(Y3=3000) Md/P(Y1=1000) Md/P(Y2=2000) M/P Y Y1=1000 Y3=3000 Y2=2000 At a higher level of Y. people demand more money at every interest rate The demand curve for money shifts out when Y increases. Y and i are positively related All points on the left of LM Excess supply of money At Y1 = 1000. introduction of credit card…etc Factors affecting the slope of LM: sensitivity of money demand to income and sensitivity of money demand to interest LM curve is flatter when sensitivity of money demand to income is lower and sensitivity of money demand to interest is higher 8 .

Md/P increases Y1 Y2 Effectiveness of fiscal and monetary policy It depends on the slope of IS and LM curves Policy Mix: Combination of fiscal and monetary policy 9 . I may increase or decrease.Goods market and financial market equilibrium i LM(Ms/P) When the goods market and the financial market are simultaneous in equilibrium. I increases. Taxes ) C increases. IS (G. interest rate and output is determined by i1 the intersection point of IS and LM curve. I increases and Y increases] IS (G. Taxes ) Crowding out effect Y Y1 Y2 i LM( ( Ms1 / P) Monetary policy: change in Ms/P Suppose Ms/P increases LM’( Ms 2 / P ) LM curve shifts out Interest rate falls and Y increases i1 i2 [Ms/P increases. i1 IS’ ( G2 . T) Y Y1 i Fiscal policy: change in G or T LM( ( Ms / P) Suppose G increases IS curve shifts out i2 Interest rate and Y increases. T) Y C increases. When i falls. Md/P remains unchanged IS ( G1 . then i falls.

1/ (1 – c1 – b1 + b2d1 / d2) is greater than 1/ (1 – c1) if (b1 – b2d1 / d2) >0. is the effect of a change in autonomous spending bigger than what it was in part (a)? Why? (Assume c1 + b1 < 1. money demand is very sensitive to Y. money demand is not very sensitive to Y. investment is very sensitive to i. and money demand. if investment is very sensitive to Y. What is the value of the multiplier? In the goods market equilibrium. G and T are given. Y = c0 + c1(Y – T) + I + G = ZZ Y = [1/ (1 – c1)] [c0 + I + G + c1T] The multiplier is 1/ (1 – c1) Now. b2 is large. 10 . d1 is large. and/or d2 is large. That is. M/P = d1Y – d2i.) In the goods market equilibrium. (Hint: Eliminate the interest rate from the IS and LM relations. An increase in autonomous spending now leads to an increase in investment as well as consumption. (a) Solve for the equilibrium output. if investment is not very sensitive to Y. b2 is small. That is. i = (d1Y – M/P) / d2 Substitute i = (d1Y – M/P) / d2 into Y = c0 + c1Y – c1T + b0 + b1Y – b2i + G Y = c0 + c1Y – c1T + b0 + b1Y – b2 [(d1Y – M/P) / d2] + G Y = [1/ (1 – c1 – b1 + b2d1 / d2)] [c0 – c1T + b0 + (b2 M/P)/d2 + G] The multiplier is 1/ (1 – c1 – b1 + b2d1 / d2) (d) Is the multiplier you obtained in part (c) smaller or larger than the multiplier you derived in part (a)? Explain how your answer depends on the parameters in the behavioral equations for consumption. The multiplier in this part will be larger if b1 is large. rearrange the terms.Examples and Problems Question 1 Consider first the goods market model with constant investment that we saw in Chapter 3: C = c0 + c1YD and I. money demand is very sensitive to i. investment. 1/ (1 – c1 – b1 + b2d1 / d2) is smaller than 1/ (1 – c1) if (b1 – b2d1 / d2) < 0. d1 is small. money demand is not very sensitive to i. Comparing 1/ (1 – c1) and 1/ (1 – c1 – b1 + b2d1 / d2). At a given interest rate. Next. Y = c0 + c1(Y – T) + I + G = Z Y = c0 + c1Y – c1T + b0 + b1Y – b2i + G Y = [1/ (1 – c1 – b1)] [c0 – c1T + b0 – b2i + G] The multiplier is 1/ (1 – c1 – b1) 1/ (1 – c1 – b1) > 1/ (1 – c1) Effect of a change in autonomous spending is bigger than in part (a). investment is not very sensitive to i. and/or d2 is small. The multiplier in this part will be smaller if b1 is small. let investment depend on both sales and the interest rate: I = b0 + b1Y – b2i (b) Solve for equilibrium output.) Derive the multiplier (the effect of a change of one unit in autonomous spending on output). write the LM relation as follows: M/P = d1Y – d2i (c) Solve for the equilibrium output.

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