Financial Markets

• Two assets Money and Bonds

• One price, interest rates

• The market for money and the market for

bonds are two sides of the same coin, for
simplicity we only approach the market for
money
 Money Market
• DEMAND FOR MONEY - LIQUIDITY PREFERENCE
– TRANSACTIONS DEMAND & PRECAUTIONARY BALANCES
• Explain a positive correlation between nominal balances and nominal income
– SPECULATIVE BALANCES
• Gives interest a role in the determination of the desired holdings of nominal
balances

• Money Supply
– We assume that the money supply is completely
controlled by the federal reserve
 Money Market Equilibrium
• The equilibrium interest rate will come
from combining the money demand with
the money supply.
• Since interest rates correlates negatively
with the desire of holding money the
money demand will have a negative slope
• At this point money supply remains
unaffected by changes in the interest rates
 Money Market Equilibrium
(Its equilibrium corresponds to the bond market equilibrium)
Effects of an increase in nominal income
Effects of a Decrease in money supply
 How the Fed to controls money
supply?
• Money multiplier
– Monetary Base vs. Money supply

• The federal funds market and the federal

funds rate

• Monetary policy tools

 Money Multiplier
• Monetary base (H) = CU+R
-Private agents want to hold a proportion c of money in currency and
the rest (1-c) in liquid deposits : Cud = c*Md and Dd = (1-c)*Md
-Banks will keep a proportion of their deposits in the form of liquid
reserves: Rd=θ*Dd= θ*(1-c)*Md
Hd = Cud + Rd = (c+ θ(1-c))Md
1
Money supply = H =Money Demand
c + θ (1 − c)
 Federal Funds Market
• Monetary base (high power money)
– H=CU+R
• Market for Federal Funds (reserves)
determines the federal funds rate
• In this market banks lend to each other
and borrow from the federal reserve at the
federal funds rate
• The federal funds rate is a good indicator
of our “general” interest rate
The Federal Funds Market
 Monetary Policy
Federal Reserve monetary policy tools
• The Federal Reserve can apply monetary
policy (control over money supply and
interest rates) through three tools.
– Discount Rate

– Reserve requirements

– Open Market Operations (OMO)

 Example Expansionary OMO
Events:
• Fed Purchases Bonds to
banks in exchange for
crediting their reserves
account at the fed
• Monetary base expands
• Federal funds decreases
• Money supply increases
through the money multiplier
• Interest rates decrease
• Investment grows
• Both output and
employment expand
 The IS-LM Model

Combined Equilibrium in the

Goods and Financial Markets
 The Interest rate Connection
• In any economy the “real” and financial
sectors are always interconnected

• In our framework the connection takes

place through interest rates

• Interest rates represents the cost of new

investment. This new “real investment” is
financed through the financial sector
 The Goods Market revisited
A more realistic look at Investment
• Firms adjust production through new
investment (new machines, etc)
• Increases in demand and thus in
equilibrium output forces firms to increase
investment: Investment is positively
correlated with aggregate output
• Investment from this point becomes an
endogenous variable
 The Goods Market revisited
A more realistic look at Investment
• Firms finance their new investment in the
financial markets
• The price to borrow funds is the market
interest rate
• Higher prices will imply a higher cost for
new investment so: Interest rates are
negatively correlated with new
investment
 The Goods Market revisited
• With I = I (Y , i ) the new aggregate demand
+ −

will depend on interest rates and output

In Equilibrium (Aggregate supply = Aggregate

Demand)

 1 
Y =  (c0 − c1T + b0 − b2i + G )
 1 − c1 − b1 