Financial Markets Notes
Federal Reserve Bank (Fed) Overview
- The Fed is the central bank of the USA, heavily influencing interest rates and, hence, the economy.
- Current Fed Chairman Ben Bernanke is seen as one of the most powerful policymakers globally.
Introduction to Interest Rate Determination
- Previous economic models ignored interest rates, simplifying analysis.
- New models consider portfolio choices between holding money and bonds, linking interest rates to money demand and supply.
Components of the Chapter
- 4-1 Demand for Money: Factors determining demand for money.
- 4-2 Money Supply Influence: Central bank controls money supply, determining the interest rate through demand and supply equilibrium.
- 4-3 Role of Banks: Understanding banks as money suppliers, analyzing how they impact interest rates.
- 4-4 Alternative Equilibrium Explanations: Two additional perspectives on equilibrium in financial contexts.
Understanding Demand for Money (4-1)
- Definitions in Economics:
- Money: Currency and checkable deposits (M1).
- Bonds: Interest-bearing assets, cannot be used for transactions.
- Financial Wealth: The total value of financial assets minus liabilities; a stock variable.
Allocation of Wealth between Money and Bonds
- Individuals decide how much to hold in money (for transactions) vs. bonds (interest earnings).
- Key considerations for allocation:
- Average monthly transactions (spending) determining liquidity needs.
- Interest rate on bonds impacting the decision to hold bonds versus cash.
Deriving the Demand for Money
- Money demand, denoted as $Md$, is a function of nominal income ($Y$) and interest rate ($i$):
- Behavior of Money Demand:
- Positive correlation with nominal income (increase in $Y$ raises $M_d$).
- Negative correlation with interest rate (higher $i$ reduces $M_d$).
Understanding Financial Markets
- Currency Dynamics: Average household holds about $1,600 in cash, suggesting a larger amount is unaccounted mostly due to foreign holdings or underground economy.
- Foreign-held currency enhances U.S. monetary stance but influences domestic money demand.
Money Supply and Interest Rate (4-2)
- Interest rate determined by equilibrium condition:
- Equilibrium relation shows influence of central bank money supply on interest rates.
- Open Market Operations: Central banks alter the money supply by buying/selling bonds, affecting bond prices and interest rates similarly.
- Interest rate determined by equilibrium condition:
Role of Banks in Money Supply
- Banks hold reserves and issue checkable deposits (liabilities).
- Reserve requirement impacts the money multiplier effect, affecting how monetary policy works.
- Money multiplier impacts change in overall money supply from shifts in central bank money.
Interest Rates from Bond Markets
- Understanding the relationship between bond prices and interest rates:
i = rac{100 - PB}{PB} - Inverse relationship: higher bond prices lead to lower interest rates and vice versa.
- Understanding the relationship between bond prices and interest rates:
Federal Funds Market
- Market where banks lend excess reserves to each other: interest rate determined here is pivotal for monetary policy.
- Fed influences the federal funds rate through open market operations, affecting overall interest rates.
Conclusion and Summary of Key Points
- Interest rates are driven by money demand/supply equilibrium.
- Central banks use open market operations to influence interest rates.
- Understanding the broader implications of both interest rates and monetary policy vital for economic analysis.
- Equilibrium can also be evaluated through reserves or overall money supply dynamics in relation to central bank control.