Ch. 4

Financial markets

ECON 202: Intermediate macro Olivier Giovannoni

Chapter objectives
1. Think of money demand and money supply. How are they represented on the money market graph? When do we have a shift of the curves, and when do we have a shift along the curves? 2. See the connection between money demand, money supply and the interest rate. 3. How is monetary policy conducted, and by whom precisely? What is an expansionary policy and what is a contractionary policy? How do they do them? 4. What is the interest rate targeted by monetary policy? It is the rate charged by whom to whom? Why is this interest rate important? What is the other major interest rate, and what purpose does it serve? 5. What is a liability and an asset for the banking system? Represent simplified balance sheets for the central bank and for banks.

Chapter objectives
6. What is a reserve requirement? What does FDIC stand for and what purpose does it serve? What’s the shadow banking system? 7. What letter is used to denote overall money supply in an economy? What letter is used for the central-bank supplied money? What’s the difference and who is responsible for it? 8. Provide an equation for the overall money supply as related to the monetary base. What do the letters stand for? 9. What is the money multiplier? What happens to the money multiplier if the citizens decide to bypass the banking system by keeping all they money in cash, and deposit nothing at their bank? 10. Why do we call ������ high-powered money?

Outline
The previous chapter was devoted to devising the 45-degree line diagram. To a large extent the model is primitive in the sense that it does not account for many variables, such as prices, expectations, the foreign sector, interest rates, etc. The current chapter develops a theory of the interest rate. For now we will only assume one asset, bonds, and therefore only interest rate. But the general principles exposed here will be generalized later. 4.1. Money supply and money demand in a simple framework 4.2. Monetary policy: balance sheets and open market operations 4.3. Interest rate setting with a banking system. 4.4. Money multiplier

4.1. Money supply and demand
The representative model for the demand for money is the following. • There are two assets:
– Money (currency and deposits, mostly) which can be used for day-today purchases but pays no interest – Bonds, which pay a certain interest rate, but cannot be used to pay for transactions Individuals will demand money (as opposed to demand bonds) based on the interest rate on bonds and on the level of transactions they wish to undertake. The more transactions are needed, the more “invested in cash” individuals want to be; on the other hand the higher the interest rate, the greater the incentive to be “invested in bonds”, not in money. The interest rate ������ is the opportunity cost of holding money.

• The demand for money is

where money demand is proportional to $������, the nominal GDP (used as a measure of the value of transactions). We assume that money demand is a function of the interest rate: ������(������) is a (negative) function of the interest rate ������: the higher ������, the lower ������������ .

� � ������������ = $������ . ������(������)
(+) (−)

4.1. Money supply and demand
The money demand relation can be represented as a negative relationship between the quantity of money demanded and the interest rate, for a given level of income: An increase in income Is represented as a shift of the money demand to the right. An increase in the interest rate is represented as a shift along upwards the money demand.

4.1. Money supply and demand
Now let’s introduce the money supply. For now we will assume that there is no banking system so that all the money supply comes from the central bank. Later we will see that actually most of the money supply comes from the banking system, endogenously. • Let‘s assume that money is exogenously