The Money Market

1
The Money Market
2
Money and Bonds

• Money, which can be used for transactions, pays
  no interest.
• currency
• checkable deposits

3
Money in the US (June 2005, in billions)
4
Money and Bonds

• Bonds, pay a positive interest rate, i, but they
  cannot be used for transactions.
• The proportions of money and bonds you wish to
  hold depend on
• your level of transactions
• the interest rate on bonds

5
Semantic Traps

• Income is what you earn from working plus what
  you receive in interest and dividends. It is a
  flowthat is, it is expressed per unit of time.
• Saving is that part of after-tax income that is
  not spent. It is also a flow.
• Savings is sometimes used as a synonym for wealth
  (a term we will not use in this course).

6
Semantic Traps

• Financial wealth - the value of your financial
  assets minus your financial liabilities.
• Wealth is a stock variablemeasured at a given
  point in time
• Money - financial assets that can be used
  directly to buy goods.
• Includes currency and checkable deposits.
• Investment - the purchase of new capital goods,
  such as machines, plants, or office buildings.
• The purchase of shares of stock or other
  financial assets is financial investment.

7
Deriving the Demand for Money

• The demand for money
• increases in proportion to nominal income (Y),
  and
• depends negatively on the interest rate (L(i)).

8
Deriving the 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.

9
The Determination of the Interest Rate

• We assume that only the central bank supplies
  money, in an amount equal to M, so M Ms.

• Equilibrium in financial markets requires that
  money supply be equal to money demand

10
Money Demand, Money Supply and the Equilibrium
Interest Rate

• The interest rate must be such that the supply of
  money (which is independent of the interest rate)
  be equal to the demand for money (which does
  depend on the interest rate).

11
Money Demand, Money Supply and the Equilibrium
Interest Rate

• An increase in nominal income leads to an
  increase in the interest rate.

12
Monetary Policy andOpen-Market Operations

• An increase in the supply of money leads to a
  decrease in the interest rate.

13
Monetary Policy andOpen-Market Operations

• Open-market operations, which take place in the
  open market for bonds, are the standard method
  central banks use to change the money stock in
  modern economies.

14
Monetary Policy andOpen-Market Operations

• An open market operation in which the central
  bank buys bonds and issues money increases both
  assets and liabilities by the same amount.

15
Monetary Policy and Open-Market Operations

• In an expansionary open market operation, the
  central bank buys 1 million worth of bonds,
  increasing the money supply by 1 million.

16
Monetary Policy and Open-Market Operations

• Bonds issued by the government, promising a
  payment in a year or less, are called Treasury
  bills, or T-bills
• When the central bank buys bonds, the demand for
  bonds goes up, increasing the price of bonds.

17
Bond Prices and Bond Yields

• The relation between the interest rate and bond
  prices
• If we buy a bond (T-bill) today and hold it for a
  year, the rate of return (or interest) on holding
  a 100 bond for a year is (100 - PB)/PB.
• If we are given the interest rate, we can figure
  out the price of the bond using the formula

18
The Determination of the Interest Rate

• Financial intermediaries are institutions that
  receive funds from people and firms, and use
  these funds to buy bonds or stocks, or to make
  loans to other people and firms.

19
What Banks Do

• Banks keep as reserves some of the funds they
  have received, for three reasons
• To honor depositors withdrawals
• To pay what the bank owes to other banks
• To maintain the legal reserve requirement, or
  portion of checkable deposits that must be kept
  as reserves

20
What Banks Do

• Loans represent roughly 70 of banks nonreserve
  assets. Bonds account for the other 30.
• The assets of a central bank are the bonds it
  holds. The liabilities are the money it has
  issued, central bank money, which is held as
  currency by the public, and as reserves by banks.

21
Bank Runs

• Rumors that a bank is not doing well and some
  loans will not be repaid, will lead people to
  close their accounts at that bank. If enough
  people do so, the bank will run out of reservesa
  bank run.
• To avoid bank runs, the U.S. government provides
  federal deposit insurance.
• An alternative solution is narrow banking, which
  would restrict banks to holding liquid, safe,
  government bonds, such as T-bills.