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Supply and Demand Models of Financial Markets

Two Markets
• Loanable Funds Market
– Determines Interest Rate in Capital Markets

• Liquidity Market
– Determines Money Market Rate

) • Map the relationship between the interest rate and the quantity of funds that are lent. .Loanable Funds Market • Consider the financial market at its broadest and most abstract. – Supply curve represents the behavior of savers & lenders – Demand curve represents the behavior of borrowers • Could represent the global financial market or a large national market. etc. – an amalgamation of the bond market and the lending market (banks.

a higher interest rate reduces the amount they need to save. many economists believe saving curve is very inelastic. – Caveat: If some savers are setting a target for their level of wealth at retirement. • For this reason. .Supply Curve: Loanable Funds • Why does the supply curve slope up? – When real interest rates offered by banks are high. savers are rewarded with more future consumption and are likely to be induced to save more.

– Households borrow to finance housing. the fewer projects fall below the hurdle.Demand Curve: Loanable Funds • Why does the demand curve slope down? – Firms borrow to finance investment projects. The higher are interest rates. the project is not worthwhile. If the return on investment falls below the interest rate. The higher the interest rate. . the smaller is the house that the householders can buy with a mortgage payment that they can afford.

Competitive Market Equilibrium: Loanable Funds Market (Geometry) r D S r* LF* LF .

Example: Investment Boom in Japan as economy recovers r I r** r* LF* LF** LF I´ S .

Savings • We divide savings into 2 parts: SGovernment + SPrivate = S Public Saving/Government Saving (Budget Surplus) Private Saving (Household + Business Saving) National Saving .

Example: US Government runs a deficit to finance military spending r I r** r* LF** LF* LF S´ S .

Example: US Consumers become thriftier r I S r* LF* LF .

Supply Curve Becomes More Elastic More globalized. more elastic 2. Global Financial Markets also a source of shifts in Supply Curve .Global Economy • Additional Source of Savings Loanable Funds Supply = Public Savings + Net Capital Inflow from Abroad • Two Effects 1.

Questions • Compare Investment Boom in a very globalized economy with one in a less globalized economy. What happens to investment & interest rates? .

Money Markets .

Liquid Assets (Currency. Money market assets (Government bills. 2.Liquid Assets Two kinds of assets 1. Savings Accounts) that are useful for transactions which pay zero or below market interest rates. jumbo CD’s) that pay a market rate. commercial paper. i. Checking Accounts. but which cannot be used for transactions .

A reduction in GDP will shift the demand curve in. Q: What shifts the money demand curve? A: An increase in GDP will increase the need for money for transactions shifting the demand curve out. the greater is the opportunity cost of holding money. .Liquidity Demand Q: Why does the money demand curve slope down? A: The greater is the market interest rate.

1. Prints currency 2. Governs fraction of deposits that banks must keep.Money Supply • Supply of monetary assets governed by central bank. Makes reserves available to banks 3. .

Money Market Money Demand Money Supply i i* M .

excess supply of money: – people will want to buy interest paying assets like bank accounts or treasury bills. . – Bond dealers and banks can reduce the interest rates they are willing to offer • If interest rates are too low. – Bond dealers and banks must raise interest rates.Equilibrium in the Money Market • If interest rates are too high. excess demand for money: – people will want to sell interest paying assets like bank accounts or treasury bills to get more liquidity.

Changes in Money Market Rates During Business Cycles • Money Demand Shocks: What happens to interest rates when GDP (either prices or real GDP rises)? • What happens when GDP falls? .

Operating Targets: Target Interest Rates • Most big country CB’s target interbank interest rates. this is called what?) Fed BoJ ECB BoK UK Federal Funds Rate Uncollateralized Call Money Rate Main Refinancing Rate Overnight Call Rate Official Bank Rate . the rate at which banks lend reserves to one another (in HK.

P.Target Rates Affect Money Market Rates Money Market Rates USA 7 6 5 4 3 2 1 0 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 C. Rate Fed Funds T-Bill 3 Mo CEIC Database Sep-05 Mar-06 .

• What does the central bank need to do to money supply to increase the interest rate? .Money Supply • Government can control the money supply and can shift the curve in or out by decreasing or increasing money supply.

Money Market at ZIRP Money Demand Money Supply i i* 1 i** 0 2 3 M .

• Compare capital markets in globalized economies with those in closed economies. and real interest rates in capital markets and. • Characterize the effects of changes in monetary policy .Learning Outcomes • Students should be able to: • Use the Loanable Funds model to analyze the effects of external events on savings. investment. • Use the money supply and demand model of money markets to examine the effect of changes in the economy on money market rates and.