The Money Market

Money and Bonds

Money, which can be used for transactions, pays no interest.

currencycheckable deposits

Money in the US (June 2005, in billions)

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 transactionsthe interest rate on bonds

Semantic Traps:

Income is what you earn from working plus what you receive in interest and dividends. It is a flow—that 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).

Semantic Traps:Financial wealth - the value of your financial assets minus your financial liabilities.

Wealth is a stock variable—measured 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.

Deriving the Demand for Money

The demand for money:increases in proportion to nominal income ($Y), anddepends negatively on the interest rate (L(i)).

M YL id $ ( )

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.

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 Equilibrium in financial markets requires that money supply be equal requires that money supply be equal to money demand:to money demand:M YL i $ ( )

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).

Money Demand, Money Supply; and the Equilibrium Interest

Rate

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

Monetary Policy andOpen-Market Operations

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

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.

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.

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.

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.

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:

iP

PB

B

$100 $

$ $

$100P

iB 1

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.

What Banks DoBanks keep as reserves some of the funds they have received, for three reasons:

To honor depositors’ withdrawalsTo pay what the bank owes to other banksTo maintain the legal reserve requirement, or portion of checkable deposits that must be kept as reserves

What Banks DoLoans 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.

Bank RunsRumors 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 reserves—a 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.