Macroeconomic Analysis (ECM402) Lecture 3 - Financial Markets Engelbert Stockhammer


 Macroeconomic Analysis (ECM402)

 Lecture 3 – Financial Markets
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 Engelbert Stockhammer
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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard 1 of 32
Outlook
 What is money?
 That turns out to be a tricky question
 What are the main determinants of the demand for
money?
 How does the central bank influence the money
supply and/or interest rates?
 Which of the two does it influence?
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 What is the equilibrium curve on the money market?
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Functions of money
 Unit of account
 Medium of exchange
 Store of wealth
 Standard of deferred payment (credit)

Note

 Different financial assets will have different degrees

ts of “money-ness”
 How liquid is an asset?
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Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
Balance sheet of a commercial bank
 Commercial bank
Assets 
Liabilities
Notes & coins 
Deposits
Loans  Other liabilities
Other assets  Capital
Deposits with CB 
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Money supply measures
UK / BoE USA / FED € / ECB
M0 Cash outside BoE + Cash + Banks‘
Banks‘ deposits with deposits with FED
M1 discontinued
BoE Cash at banks Cash
+ demand + ON deposits
M2 discontinued M1 + most savings M1 + Deposits
("checking“)
accounts,
accounts + retail maturity up to 2
M3 discontinued M2
MMMF+ all+other
smallCDs,
time M2
yrs ++ Deposits
repos +
+ eurodollar deposits MMF
deposits up to 3 m’s
M4 Cash outside banks + repos) – shares/units
notice +
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+ private-sector retail discontinued Debt securities
ke deposits + Private- up to 2 years
sector wholesale
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Measuring the money supply
 M0: cash + deposits commercial banks hold with the

central bank
 M1 (“narrow money”): sight deposits + cash
 M2 (“broad money”): M1 + savings deposits
 M3: M2 +other liquid assets = large, fixed term
deposits, deposits at non-bank institutions
 UK: M4 (“broad money”) is effectively “international”
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M3
ke  Note: definition of monetary aggregates differs
across countries
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 UK only publishes M0 and M4

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 ... and they changes over time

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In the money supply??
 Maturity
 Notice period
 Small (retail) or large (wholesale) accounts
 FX deposits?
 Deposits in domestic currency abroad?
 Other financial instruments? Derivatives ...

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UK 1999
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How much control does the FED have over
the money supply?
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Balance sheet of a commercial bank
 Commercial bank
Assets 
Liabilities
Notes & coins 
Deposits
Loans  Other liabilities
Other assets  Capital
Deposits with CB 
What is money?
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 Cash and sight deposits
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 In practice?
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(=deposits)
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4-1 Modeling the Demand for Money
§ Money, which you can use for transactions, pays no

interest. There are two types of money: currency,
coins and bills, and checkable deposits, the bank
deposits on which you can write checks.
§ 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

mainly on two variables:
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§ The interest rate on bonds
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Money market fundspool together the funds of many people.

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4: The funds are then used to buy bonds—typically government
bonds.
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Semantic Traps: Money, Income, and Wealth
Incomeis 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.
Savingis 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 book).
Your financial wealth, or simply wealth, is the value of all your

ts financial assets minus all your financial liabilities. In contrast to
ke income or saving, which are flow variables, financial wealth is a stock
ar variable.
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na capital goods, from machines to plants to office buildings. When you
Fi want to talk about the purchase of shares or other financial assets,
you should refer them as a financial investment.
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4-1 The Demand for Money
Deriving the Demand for Money
Let’s go from this discussion to an equation describing the

demand for money.
M d = $Y L(i )
( −)
Read this equation in the following way: The demand for
money, M d , is equal to nominal income, $Y, times a function
ts of the interest rate, i, with the function denoted by L(i ). – if
ke everything else is constant.
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The demand for money:
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§ increases in proportion to nominal income ($Y), and
4: § depends negatively on the interest rate (L(i) and the
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4-1 The Demand for Money
Deriving the Demand for Money
M d
= $ Y ( Li )
(−)
Figure 4 - 1
The Demand for Money
For a given level of
nominal income, a lower
interest rate
increases the demand
ts for money. At a given
ke interest rate, an
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increase in nominal
M
income shifts the
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demand for money to
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the right.
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4-2 The Determination of the Interest Rate, I
Money Demand, Money Supply, and the Equilibrium
Interest Rate
Equilibrium in financial markets requires that money supply

be equal to money demand, or that Ms = Md. Then using
this equation, the equilibrium condition is:
Money Supply = Money demand
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M = $Y L(i)
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Interest Rate
Figure 4 - 2
The Determination of the
Interest Rate
The interest rate must
be such that the
supply of money (which
is independent of the
interest rate) is equal
to the demand for
money (which does
ts depend on the interest
ke rate).
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Interest Rate
Figure 4 - 3
The Effects of an
Increase in Nominal
Income on the Interest
Rate
An increase in nominal
income leads to an
increase in the
interest rate.
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What can shift the money demand?
 What happens in case of a stock market crash?

 Note: money is one of many different financial
assets
 If the price of any of these other financial assets
changes the demand for money will also
change!
 or the volatility of any of these other financial
assets changes the demand for money will also
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Interest Rate
Figure 4 - 4
The Effects 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.
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Copyright © 4444 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 4 /e • Olivier Blanchard 22 of 32
Monetary Policy and Open Market Operations
Open 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.

If the central bank buys bonds, this operation is called


an expansionary open market operation because the

ts central bank increases (expands) the supply of money.
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If the central bank sells bonds, this operation is called a

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
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central bank decreases (contracts) the supply of money.
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Copyright © 4444
Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 4/e • Olivier Blanchard 23 of 32
Open market operations
Figure 4 - 5
The Balance Sheet of
the Central Bank and the
Effects of an
Expansionary Open
Market Operation
The assets of the

central bank are the
bonds it holds. The
liabilities are the
ts
stock of money in the
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economy. An open market
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operation in which the
M
central bank buys
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bonds and issues money
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increases both assets
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and liabilities by the
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same amount.
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Copyright © 4444
Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 4/e • Olivier Blanchard 24 of 32
Bond Prices and Bond Yields
Understanding the relation between the interest rate and bond
prices will prove useful both here and later in this book:
§Treasury bills, or T-bills are issued by the U.S.

government promising payment in a year or less. If you
buy the bond today and hold it for a year, the rate of
return (or interest) on holding a $100 bond for a year is
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($100 - $PB)/$PB.
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of the bond using the same formula.
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$ 1 −0 $ P0 B $ 1 0 0
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i = ⇒ $ PB =
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Bond Prices and Bond Yields
Let’s summarize what we have learned so far in this chapter:
§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
ts of bonds for money.
ke
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increases the money supply by buying bonds lead to an
increase in the price of bonds and a decrease in the
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na interest rate.
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4: §Open market operations in which the central bank
er decreases the money supply by selling bonds lead to a
decrease in the price of bonds and an increase in the
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Choosing Money or Choosing the Interest Rate?
A decision by the central

bank to lower the interest
rate from i to i ’ is equivalent
to increasing the money
supply.
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Money, Bonds, and Other Assets
We have been looking at an economy with only two assets:

money and bonds. This is obviously a much simplified
version of actual economies, with their many financial
assets and many financial markets.
There is one dimension, however, to which our model must

be extended. We have assumed that all money in the
economy consists of currency supplied by the central bank.
ts In the real world, money includes not only currency but
also checkable deposits.
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4-3 The Determination of Interest Rate, II*
What Banks Do
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.
■ Banks receive funds from people and firms

who either deposit funds directly or have funds
sent to their checking accounts. The liabilities of
ts the banks are therefore equal to the value of these
ke checkable deposits.
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they receive.
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Competing views on the money supply and
interest rates
 Exogenous money supply: Central Banks control the
money supply (through the money multiplier).
 CB control “high powered money”
 Commercial bank have to keep reserves on
deposits
 CB controls the money supply by varying the
required reserve ratio
 Endogenous money supply: Central Banks set the
interest rate (and the money supply adjust
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 CB sets the base (short-run) interest rate
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 Commercial banks mark up this interest rate

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

What if the CB set the interest rate rather than the


money supply?

-> white board


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Key Terms
§Federal Reserve Bank (Fed) §expansionary, and contractionary,

§income open market operation
§flow §Treasury bill, (T-bill)
§saving §financial intermediaries
§savings §(bank) reserves
§financial wealth, wealth §reserve ratio
§stock §bank run
§investment §federal deposit insurance
§financial investment §narrow banking
§money §central bank money
§currency §federal funds market
§checkable deposits §federal funds rate
ts §bonds §money multiplier
ke §money market funds §high-powered money
ar §LM relation §monetary base
M §open market operation
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What Banks Do
Banks hold reserves for three reasons:
1.On any given day, some depositors withdraw cash from their
checking accounts, while others deposit cash into their
accounts.
2.
3.In the same way, on any given day, people with accounts at the
bank write checks to people with accounts at other banks,
ts and people with accounts at other banks write checks to
ke people with accounts at the bank.
4.
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ratio – the ratio of bank reserves to bank checkable deposits
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What Banks Do
■ Loans represent roughly 70% of banks’ non-reserve assets.

Bonds count for the rest, 30%.
The assets of the central bank are the bonds 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.
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What Banks Do
Figure 4 - 6
The Balance Sheet of
Banks and the Balance
Sheet of the Central
Bank, Revisited
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The Supply and the Demand for Central Bank Money
Let’s think in terms 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

ts control of the central bank.
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and the supply for central bank money are equal.
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Figure 4 - 7
Determinants of the
Demand and the Supply
of Central Bank Money
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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 reserves—a bank run.
To avoid bank runs, the U.S. government provides
federal deposit insurance.
An alternative solution is narrow banking, which would
ts restrict banks to holding liquid, safe, government bonds,
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The Demand for Money
When people can hold both currency and checkable deposits,
the demand for money involves two decisions.
First, people must decide how much money to hold. Second,

they must decide how much of this money to hold in currency
and how much to hold in checkable deposits.
ts We can assume that overall money demand is given by the

ke same equation as before: M d = $Y L(i )
(−)
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The demands for currency and checkable deposits are given
by:
na
CU = c M
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d d
4:
D d = (1 − c ) M d
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The Demand for Reserves
The larger the amount of checkable deposits, the larger

the amount of reserves the banks must hold, for both
precautionary and regulatory reasons.
The relation between reserves (R) and deposits (D):
ts R =θD
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The demand for reserves by banks is given by:

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Rd = θ ( 1 − c ) M d
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The Demand for Central Bank Money
The demand for central bank money is equal to the sum of

the demand for currency and the demand for reserves.
H d
= C Ud + R d
Replace CU d and R d with their expressions from equations

(4.4) and (4.7) to get:
H d = cM d + θ ( 1 − c ) M d = c + θ ( 1 − c )  M d
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Finally, replace the overall demand for money, M ,d

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4:
H d = c + θ ( 1 − c )  $Y L ( i )
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The Determination of the Interest Rate
In equilibrium, the supply of central bank money (H) is


equal to the demand for central bank money (Hd):
H = H d
ts Or restated as:
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H d = c + θ ( 1 − c )  $Y L ( i )
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The Determination of the Interest Rate
Figure 4 - 8
Equilibrium in the
Market for Central Bank
Money and the
Determination of the
Interest Rate
The equilibrium
interest rate is such
that the supply of
central bank money is
ts
equal to the demand
ke
for central bank money.
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4-4 Two Alternative Ways of Looking
at the Equilibrium*
The Federal Funds Market and the Federal Funds Rate
The equilibrium condition that the supply and the demand

for bank reserves be equal is given by:
H − C U= R
d d
The federal funds marketis a market for bank reserves.

In equilibrium, demand (Rd) must equal supply (H-CUd).
ts The interest rate determined in the market is called the
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federal funds rate.
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at the Equilibrium*
The Supply of Money, the Demand for Money, and the
Money Multiplier
1
H = $Y L(i )
[c + θ (1 − c)]
Supply of money = Demand for money
■ The overall supply of money is equal to central bank money

times the money multiplier:
1/ ( c + θ ( 1 − c ) )
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High-powered money is the term used to reflect the fact

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nc that the overall supply of money depends in the end on the
amount of central bank money (H), or monetary base.
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at the Equilibrium*
The Supply of Money, the Demand for Money, and the
Money Multiplier
Understanding the Money Multiplier
We can think of the ultimate increase in the money


supply as the result of successive rounds of purchases

of bonds—the first started by the Fed in its open market
operation, the following rounds by banks.
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Macroeconomic Analysis (ECM402) Lecture 3 - Financial Markets Engelbert Stockhammer

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

 Macroeconomic Analysis (ECM402)

 Different financial assets will have different degrees

Other assets  Capital

 M0: cash + deposits commercial banks hold with the

 UK only publishes M0 and M4

 ... and they changes over time

Other assets  Capital

§ Money, which you can use for transactions, pays no

The proportions of money and bonds you wish to hold depend

Money market fundspool together the funds of many people.

Savingis that part of after-tax income that is not spent. It is also a

Your financial wealth, or simply wealth, is the value of all your

Let’s go from this discussion to an equation describing the

Equilibrium in financial markets requires that money supply

Money Supply = Money demand

 What happens in case of a stock market crash?

Open-market operations, which take place in the

“open market” for bonds, are the standard method

If the central bank buys bonds, this operation is called

an expansionary open market operation because the

If the central bank sells bonds, this operation is called a

The assets of the

§Treasury bills, or T-bills are issued by the U.S.

A decision by the central

We have been looking at an economy with only two assets:

There is one dimension, however, to which our model must

Financial intermediaries are institutions that receive

■ Banks receive funds from people and firms

 Commercial banks mark up this interest rate

What if the CB set the interest rate rather than the

-> white board

§Federal Reserve Bank (Fed) §expansionary, and contractionary,

Banks hold reserves for three reasons:

■ Loans represent roughly 70% of banks’ non-reserve assets.

■ The demand for central bank money is equal to the

■ The supply of central bank money is under the direct

First, people must decide how much money to hold. Second,

ts We can assume that overall money demand is given by the

The larger the amount of checkable deposits, the larger

The relation between reserves (R) and deposits (D):

The demand for reserves by banks is given by:

The demand for central bank money is equal to the sum of

Replace CU d and R d with their expressions from equations

Finally, replace the overall demand for money, M ,d

In equilibrium, the supply of central bank money (H) is

equal to the demand for central bank money (Hd):

The equilibrium condition that the supply and the demand

The federal funds marketis a market for bank reserves.

■ The overall supply of money is equal to central bank money

High-powered money is the term used to reflect the fact

We can think of the ultimate increase in the money

supply as the result of successive rounds of purchases

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