FINANCIAL MARKET

Prepared by: Dr. Francis Nyoni

The Demand for Money

 Money: which you can use for transactions, pays no interest. There
two types of money which are currency and checkable deposits.
 Bonds: pay a positive interest rate, i, but they can not be used for
transactions
The Demand for Money

 Your demand for money will solely depend on two things:

 Level of transactions
 Interest rate on bonds
 Money Market Fund: known as money market mutual funds, they
pool together the funds from many people/small investors. The
funds are used to buy bonds. Interest paid in these market is slightly
lower than rate on bonds they hold.
Vocabularies to note

 Income: what you earn from working plus what you receive in
interest and dividends. Income is a flow, i.e. expressed per unit of
time.
 Saving: part of after-tax income that is not spent. It is a flow.
 Financial Wealth/Wealth: value of all your financial assets minus
financial liabilities. It is a stock, measured at a point in time.
 Investment: for economists-it refers to purchase of new capital
goods like machines, plants and office building. The purchase of
shares and other financial assets are termed as financial
investment.
Deriving the Demand for Money

 Demand for money: amount of money people want to hold,

denoted by
 Increase in proportion to nominal income and depends negatively
on interest rate; transactions can be hard to measure but a closer
proportion could be nominal income.
Deriving the Demand for Money

 Nominal demand for money in linear form

Deriving the Demand for Money

Demand for Money

 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.
Interest Rate Determination

 Assume: No checkable deposits, only money that exist is currency

in this section:
 In the next section, we shall reintroduce checkable deposits and see
the role of banks in money supply.
Money Demand, Supply and Equilibrium interest
rate
 Money supply: is a function of central bank;
 Financial Market equilibrium:

 The above relation is called LM relation.

Money Demand, Supply and Equilibrium interest
rate
The Determination of the Interest
Rate
 The interest rate must be such

that the supply of money is equal

to the demand for money.
Money Demand, Supply and Equilibrium interest
rate
The Effect of an Increase in
Nominal Income on the Interest
Rate
 An increase in nominal income

leads to an increase in the interest

rate.
Money Demand, Supply and Equilibrium interest
rate
The Effect of an Increase in the
Money Supply on the Interest
Rate
 An increase in the supply of

money leads to a decrease in the

interest rate.
Monetary Policy and Open Market Operations

 Open Market Operations: takes place in the “open market” for

bonds. It is a standard method central banks use to change the
money stock in modern economies.
 If the central bank buys bonds, this operation is called an
expansionary open market (the CB increases/expands the supply
of money).
 If the central bank sells bonds, this operation is called a
contractionary open market (the CB decreases/contracts the
supply of money)
Balance Sheet of the Central Bank

 Assets: Bonds held by central bank

 Liabilities: stock of money in the economy
 OMO: where CB buys bonds and issues money increases both
assets and liabilities by the same amount.
Bond Prices and Bond Yield

 Suppose the bonds in our economy are one-year bonds—bonds that

promise a payment of a given number of dollars, say, $100, a year
hence.
 Think of the bonds in our economy as one-year Treasury Bills.
 Let price of bond be , bond bought today will pay as rate of return
for a year.
Class Activity

 Suppose the price of bond is $95 what will be the interest rate?
 What will be interest rate if the bond price is $90?
 What is the relationship between bond price and interest rate?
 Solve for price of bond from the interest rate formula.
Summary
 The interest rate is determined by the equality of the supply of money and the
demand for money.
 By changing the supply of money, the central bank can affect the interest rate.
 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 money supply by buying
bonds lead to an increase in the price of bonds—equivalently, 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—equivalently, an increase in
the interest rate.
DETERMINATION OF INTEREST RATE

 Financial Intermediaries: institutions that receive funds from

people and firms, and use these funds to buy bonds or stock, or to
make loans to other people and firms.
 Banks receive funds from people and firms through their deposits or money
sent to their checking accounts. Liabilities to the banks are equal to the
value of these checkable deposits.
 Banks keep as reserves some of the funds they receive.
Why do banks hold reserves?

 To meet day-to-day transactions (withdrawals and deposits)

 People with accounts in, say bank A write cheques to people with

accounts in other banks, and people with accounts at other banks

write cheques to people with accounts at bank A.
The first two reasons imply that banks would want to keep some
reserves even if they
were not required to.
 Banks are subject to reserve requirements. The actual reserve ratio-

the ratio of bank reserve to bank checkable deposits (7% in

Tanzania-lowered in 2019 from 8%)
Balance sheet of the commercial banks and CB

 The assets of the central bank are

the bonds that 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.
The Supply and the Demand for Central Bank
Money
Think 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 supply for

central bank money are equal.

Determinant of the demand and supply of Central
Bank Money
Demand for Money Demand for
reserves by banks
Demand for checkable
Demand for Supply of
deposits
Central Bank Central Bank
Money Money
Demand for currency

Demand for Money Demand for reserves

by banks Supply of
Demand for Central Bank
Demand for checkable deposits Money Central Bank
Money

Demand for currency H

Demand For Money

 When holding currency and checkable deposits, two decisions are

involved:
 How much money to hold in currency; and
 How much to hold in checkable deposits
 People hold a fixed proportion of currency; call it and a fixed
proportion of checkable deposits,
 Demand for Currency:
 Demand for checkable deposits:
Demand for Reserves

 The larger the amount of checkable deposits, the larger the amount
of reserves the bank must hold (both for precautionary and legal
reasons).
 Let be reserve ratio, and be the reserves of the banks and denote
the amount of dollar/shillings in checkable deposits;

 If people hold in reserves. Thus;

Demand for Central Bank Money

 Demand for centra bank money: which is the sum of the demand
for currency and the demand for reserves.

 Replace with their expression to get:

 Replace demand for money with its expression:

The determination of interest rate

 At equilibrium supply of central

bank money must equal demand
for central bank money;
 Let be the supply of central bank
money. Therefore;

 Thus supply of central bank

money is given as:
The Supply of Money, the Demand for Money,
and Money Multiplier
 The Overall supply of money equals to central bank money times
the money multiplier:

Then:

 High-powered money: the term used to reflect the fact that overall
supply of money depends in the end on the amount of central bank
money.