Chapter 4: Financial Markets

4-1 The Demand for Money

 Assumptions:
o There are only two in the financial market: and

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

 Money: what can be readily used to pay for transactions (‫)المعامالت التجاريّة‬. It is highly liquid
)‫ (عالي السيولة‬but pays no interest
 Money = Currency (‫ (عملة‬+ Checkable bank deposits)‫(الودائع المصرفية‬

 Bonds: pays interest but cannot be used for transactions
 Income: a flow)‫ (تدفق‬concept: What is earned from working+interest+dividends(‫)توزيعات ارباح‬
 Saving: a flow concept: part of after-tax income that is not spent
 Savings: a stock (‫ )مخزون‬concept: value of what have been accumulated over time
 Wealth (‫)ثروة‬: a stock concept = Ʃ financial assets – Ʃ financial liabilities
Wealth = Md + Bondd
 Investment (in economy): purchase of new capital goods (‫)السلع الرأسمالية‬, from machines to
plants to office buildings
 A person’s choice: hold currency or to buy bonds? (tradeoff: liquidity vs. return)
 Money demand depends on:
o level of transactions (‫)مستوى المعامالت‬
o interest rate on bonds (‫)الفائدة على السندات‬
o other factors like transaction (brokerage) cost (‫ )تكلفة الوساطة‬and liquidity of bonds

 Money market mutual funds (‫)صناديق االستثمار في أسواق المال‬: pool together (‫ )تجمع معا‬the funds
of many people, which are then used to buy bonds (typically government bonds). These funds pay
an interest rate that is slightly below (‫ )أقل قليال‬the interest rate on the bonds they hold (due to
administrative costs (‫ )التكاليف اإلدارية‬and profit margins (‫))هوامش الربح‬
 The demand for money (Md) in the economy as a whole is the sum of all the individual
demands for money by the people in the economy.

with the function denoted by L(i)  The demand for money increases in proportion to nominal income  The demand for money depends negatively on the interest rate: An increase in the interest rate decreases the demand for money. as people put more of their wealth into bonds. (FED in US). M: Money) M = $Y L(i) . The quantity supplied of money is independent of interest rate. 4-2 The Determination of Interest Rate I  Assumption: checkable deposits do not exist—that the only money in the economy is currency.  Money supply M = MS  Equilibrium in financial markets requires that money supply be equal to money demand Money supply = Money demand (LM Relation.  Money supply determined by central bank (‫ )البنك المركزي‬in most countries. Money demand function: Md = $Y L(i)  The demand for money Md is equal to nominal income $Y (‫ )الدخل االسمي‬times a function of the interest rate i. L: Liquidity.

. An increase in the interest rate is needed to decrease the amount of money people want to hold and to reestablish equilibrium (‫)إعادة التوازن‬. An increase in nominal income leads to an increase in the interest rate: At the initial interest rate (iA). the demand for money exceeds the supply.

 The balance sheet (‫ )ورقة الموازنة‬of a bank (or firm. or individual) is a list of its assets and liabilities (‫ )التزامات‬at a point in time. o The assets are the sum of what the bank owns and what is owed to it by others. The liabilities of the central bank are the stock of money in the economy. The assets of the central bank are the bonds it holds in its portfolio. it sells bonds and removes from circulation the money it receives in exchange for the bonds (Contractionary OMP ‫)انكماشية‬.  Open Market Operations (‫)عمليات السوق المفتوحة‬: if a central bank wants to increase the amount of money in the economy. it buys bonds and pays for them by creating money (Expansionary OMP ‫)توسعية‬.  An increase in the supply of money by the central bank leads to a decrease in the interest rate. . o The liabilities are what the bank owes to others.  The central bank can change money supply by conducting open market operations (OMO). If it wants to decrease the amount of money in the economy. Open market operations lead to equal changes in assets and liabilities. The decrease in the interest rate increases the demand for money so it equals the now larger money supply.

bonds issued by the government promising payment in a year or less are called Treasury bills or T-bills.  Nominal interest (‫ )الفائدة االسمية‬rate and the bond price are inversely related. interest rate (or rate of return) on this bond is given by (? – $?? ) o i= $?? ? o $PB =(1+?)  In the United States. which increases the interest rate. it increases the demand for them and tends to increase their price. it increases the supply for them and tends to decrease their price. Then. o When the central bank purchases bonds. Considers open market operations in terms of their effect on bond prices. $PB is the current price of bonds.  Modern central banks. 4-3 The Determination of Interest Rate II  Assumption: money includes currency and checking accounts in banks . Suppose a bond promises a payment of F (face value) in one year. and then move the money supply so as to achieve it. typically think about the interest rate they want to achieve. o When the central bank sells bonds. which reduces the interest rate. including the Fed.

 Financial intermediaries (‫)وسطاء الماليين‬: institutions that receive funds from people and firms (liabilities) and use these funds to buy financial assets or to make loans to other people and firms (assets). o Banks are subject to reserve requirements according to a reserve ratio. there is no reason for the inflows and outflows of cash to be equal. What the bank. as a result of these transactions.  Balance sheet of central banks and banks:  Demand for central bank money (Hd) = demand for currency (CUd) + demand for reserves by banks (Rd) .  Banks hold reserves for 3 reasons: o While some depositors withdraw cash from their checking accounts while others deposit cash into their accounts. However. o People with accounts at the bank write checks to people with accounts at other banks. so the bank must keep some cash on hand. which require them to hold reserves in some proportion of their checkable deposits. which they can draw on when they need to. and people with accounts at other banks write checks to people with accounts at the bank.  Banks receive funds from depositors (individuals and firms) and allow their depositors to write checks against (or withdraw) their account balances  Reserves (‫)االحتياطيات‬: some of the funds received by banks that they held partly in cash and partly in an account at the central bank. owes the other banks can be larger or smaller than what the other banks owe to it. For this reason. the bank needs to keep reserves.

 Supply of money is controlled by the central bank (H: supply of central bank money)  Central bank money is sometimes called high-powered money. Equilibrium: H= CUd + Rd  Demand for currency (CUd) o Recall Md = $Y L(i). and are therefore “high-powered.  The equilibrium interest rate is such that the demand and the supply for central bank money are equal. people hold money in the form of currency (CUd) by a fraction (‫ )جزء‬of c and in the form of checkable deposit (Dd) by a fraction of (1 – c) where 0<c<1. o The term high-powered (‫ )عالي القوة‬reflects the fact that increases in H lead to more than one-for-one increases in the overall money supply.” o The term monetary base reflects the fact that the overall money supply depends ultimately on a “base”—the amount of central bank money in the economy. or the monetary base ( ‫القاعدة‬ ‫)النقدية‬. CUd =cMd and Dd = (1 – c) Md .

. o Md = CUd + Dd = cMd + (1 – c) Md  Demand for reserves (Rd) o The reserve ratio (Ɵ) (‫)نسبة االحتياطي‬: the amount of reserves banks hold per dollar of checkable deposits. o Demand for reserves: Rd = Ɵ D = Ɵ (1– c) Md  The demand for central bank money o Hd = CUd + Rd o Hd = cMd + Ɵ (1– c) Md o Hd = [c + Ɵ (1 – c)] $Y L(i)  According to the equilibrium condition. the supply of central bank money (H) is equal to the demand for central bank money (Hd) o H = Hd o H = [c + Ɵ (1 – c)] $Y L(i)  A higher interest rate implies a lower demand for central bank money for two reasons: o The demand for currency by people goes down o The demand for checkable deposits by people also goes down.

For this reason.. its inverse—[c + Ɵ (1 – c)] —is greater than one.  The purchase puts more money in the hands of the non-bank public and hence creates more checkable deposits. The remainder of the deposit increase is used to purchase bank assets (e. Banks that have excess reserves (‫ )االحتياطيات الفائضة‬at the end of the day lend them to banks that have insufficient (‫ )غير كافية‬reserves.g. Thus. 4-4 Two Alternative Ways of Looking at the Equilibrium*  The supply and demand for reserves: Fed fund market o The federal funds market (‫)سوق المواد المالية االحتياطية الفيدرالي‬: an actual market for bank reserves.  This leads to lower demand for reserves by banks. an increase in central bank money leads to a larger increase in the overall money supply o The Fractional reserve banking and the money multiplier  A given increase in currency deposits creates only a fractional increase in bank reserves. where the interest rate (federal funds rate) adjusts to balance the supply and demand for reserves. and so on. bonds). o At equilibrium: H = Hd = CUd + Rd o H – CUd = Rd o Supply of reserves (H – CUd) = Demand for reserves (Rd)  Money Multiplier (‫)مضاعف األموال‬ o We think about the equilibrium in terms of the equality of the overall supply and the overall demand for money (currency and checkable deposits). this constant term is called the money multiplier. o H = [c + Ɵ (1 – c)] $Y L(i) (We divide both sides by [c + Ɵ (1 – c)]) 1 o H = $Y L(i) [c + Ɵ (1 – c)] o Supply of money = Demand for money 1 o Because [c + Ɵ (1 – c)] is less than one. .

.o Multipliers can often be interpreted as the result of successive rounds of decisions and derived as the sum of a geometric series.