The Central Bank and the money market equilibrium The role of central banks The money market...

The Central Bank and the money market

equilibrium

The role of central banksThe money market equilibrium

The Central bank and the Money market

Last we clarified the nature and functions of money in an economyClassical functions related to exchangeKeynesian functions related to liquidity and

uncertainty As a result, there is a demand for money

from agents, and a supply of money from the banking system.

This week we examine how these balance out, including the role of the central bank


The link between asset markets and money markets

Central bank intervention on the financial markets

Equilibrium in the money market

Asset markets and money markets

The first aspect is to clarify the linkage between the money market and the market for assets. Agents spread their wealth spread over assets

and money (liquidity) Assets earn a return, but cannot be exchanged

easily Money can be exchanged freely (liquidity) but

earns no return To simplify the picture we will assume

there is only a single kind of asset: bonds


The agent therefore allocates his wealth over bonds and money

Equilibrium on both financial markets requires:

Both equilibria are simultaneous, because of the inverse price/interest relationship on the bond market.

dd MBW

dsds MMBB


Importantly: the return of a bond is a “coupon”, i.e. A fixed pre-agreed nominal amount, which is a given % of the original issue price

When you buy the same bond on the market, the rate of return of the bond (its interest rate) is

price

couponinterest


Imagine that when the bond was issued, the rate of interest rate was 5%.

A bit later, interest rates are lowered to 2.5%, so new bonds are issued with a smaller coupon.

What happens to the value of my 5% bond with respect to the value of newer bonds? My bond is more valuable, because its coupon is larger ! The price of my bond increase until the effective rate of

return of the coupon is 2.5% (the price will double)

price

couponinterest


The inverse relation between bond prices and interest rates is crucial:Money has no intrinsic “price” It only has an opportunity cost (the interest

rate) This means that intervention in one market

will have effects on the other market through the joint determination

So equilibrium in the money market means equilibrium on the bonds market


Just a quick annex on the fisher equation Gives the difference between nominal and real

rates of return in the presence of inflation Imagine you have a bond that nominally pays

15% per year : Is this a large amount? That depends on the level of inflation !

The fisher equation says that

This is an approximation, valid for low inflation

ir

Central Bank Intervention

It is important to distinguish between two different policy-issues:Objectives

What is the goal of the central bank in its intervention?

What is the central bank trying to achieve? Often these are either determined by law or

by the statutes of the institution Instruments

How does the central bank achieve its objectives?


Central bank objectives:

ECB: The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community.

FED: The Federal Reserve’s duties is to conduct the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.


How does a central bank intervene? 1: Changing the reserve ratio

Remember that the (simplified) multiplier between money base (controlled by the CB) and the money supplied by banks is

Changing the multiplier therefore changes the amount of money supplied in the economy

rdB

M s 1


How does a central bank intervene? 1: Changing the reserve ratio

This policy is not used, however. It is not subtle: even small changes in the

reserve ratio bring large changes in money supply

It would force banks to review constantly the structure of their assets (costly)

Most of these “prudential ratios” are agreed internationally, so they are difficult to change


How does a central bank intervene? 2: Changing the Repo rate

Is what happens when the bank “change the interest rates”

The “repo” rate is the interest rate at which the central bank lends to regular banks on the interbank market

The central bank makes it more or less expensive to borrow monetary base, giving more or less of an incentive to keep excess reserves in the bank.



It is important to understand that the central bank doesn’t control all the interest rates !

Typically, banks then carry the rate forwards to customers, so all interest rates will follow the repo rate

However, most of the time the rates follow the repo, but not always...


How does a central bank intervene? 3: Open market operations

The central banks intervene directly into the interbank market to by buying or selling bonds to increase or reduce the amount of base money available

Example: when the Central Banks intervened to inject liquidities after the subprime bubble burst.

This is a policy commonly used for changing interest rates other than the repo



If the CB buys bonds (against money) then there is excess money supply, and excess bond demand.

The price of bonds increases, reducing the excess bond demand

This reduces interest rates (inverse relation), which increases demand for money, correcting the excess supply of money.



If the CB sells bonds (reducing money) then there is excess bond supply, and excess money demand

The price of bonds falls, increasing demand for bonds, correcting the excess bond supply

This increases interest rates (inverse relation), which reduces the excess demand for money.


Importantly: in real life, a central bank’s control of money supply is not precise. Money is ultimately supplied by banks, which

have motivations of their own. The bank has strong influence, but it isn’t perfect

Likewise, its control of interest rates is not precise The bank only controls directly the repo rate. Other rates can be modified by open market

operations, but again, the CB does not set them.


Given all this, how do we model equilibrium in the financial markets ?Wealth is spread over several markets:

agents want to hold money, but they also want assets.

What about the other financial markets?A change in interest rates/money supply

doesn’t just affect the money market, it also changes the bond/money balance that agents hold

Asset markets are therefore affected too!


Given all this, how do we model equilibrium in the financial markets ?We use equilibrium in the money market:Money supply = money demandThe inverse relation between asset prices

and the interest rate means that adjustment in one market brings adjustments in the other

Therefore we only need to look at the money market equilibrium to describe equilibrium on the other financial markets


Money supplyWe assume that money supply Ms is set

exogenously by the central bankThis is a convenient simplification

Money demandWe use the demand for liquidity function

we derived last week

iYLP

M d

,


iDemand for Real Money Balances is a negative

function of interest rates

Liquidity trap

M

iYLP

M d

,

Below a certain interest rate, the opportunity cost of holding money is low enough that agents will not want to hold assets, and will demand only

money


iDemand for Real Money Balances is a positive

function of output

M

A higher level of output increases money demand all other things constant, as agents require more money for transaction and precaution purposes

YYiYLP

M d

22 ,,

Liquidity trap

iYLP

M d

,


iMoney supply is exogenous

Liquidity trap

M

iYLP

M d

,

The market equilibrium occurs at the level of interest of which money supply is equal to money

demand

i*

M*

P

M s


iAn increase in money supply reduces interest

rates

Liquidity trap

M

iYLP

M d

,

There is excess money supply, which agents will want to convert into asset holdings. This

increases the price of bonds, and reduces the rate of interest. The opportunity cost of holding money

falls, and money demand increases

P

M s2

i*

M*

P

M s

i*2

M*2


iAn increase in output increases interest rates

Liquidity trap

M

iYLP

M d

,

Because the increased output increases money demand, interest rates have to increase to

compensate and keep the money demand equal to the fixed money supply

i*

M*

P

M s

i*2

YYiYLP

M d

22 ,,

The Central Bank and the money market equilibrium The role of central banks The money market...

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