Set 3 Finance Markets and the Demand for Money

Financial Markets

• Financial markets are essential components of the economy, primarily influenced by the central bank's policies.
• Focus area: Role of the central bank in determining interest rates on bonds.

The Demand for Money

• Two asset choices: money (which pays no interest) and bonds (which do).
  • Money Types:
  • Currency
  • Checkable Deposits
• The demand for money and bonds depends on:
  • Level of transactions
  • Interest rates on bonds
• Money market funds allow indirect holding of bonds.
• Example: In the early 1980s, money market funds offered 14% interest, prompting wealth transfers from checking accounts.

Semantic Traps: Money, Income, and Wealth

• Definitions:
  • Money: Utilized for transactions (stock).
  • Income: Earnings (flow).
  • Saving: Part of after-tax income not spent (flow).
  • Savings: Accumulated value (stock).
  • Wealth: Financial assets value minus liabilities (stock).
  • Investment: Purchase of new capital goods (flow).
  • Financial Investment: Purchase of financial assets (flow).

Demand for Money Equation

• $M_d = Y imes L(i)$:
  • Where
  • $M_d$: Demand for money
  • $Y$: Nominal income
  • $L(i)$: Decreasing function of interest rate $i$
• As interest rates increase, demand for money decreases due to wealth allocation into bonds.
• The $M_d$ curve represents the inverse relationship between demand for money and interest rates for a given income level.

Currency Circulation

• In 2006, total currency in circulation was $750 billion:
  • U.S. households: $170 billion
  • U.S. firms: $80 billion
  • Foreign holdings: $500 billion (66% of total) for transactions, especially in high inflation areas.

Determining the Interest Rate

• Central bank supply $M<em>s$ must equal money demand $M</em>d$ to establish equilibrium.
• $M<em>s = M</em>d = M$
• Equilibrium necessitates that money supply is set independently of interest rate; however, money demand relies on it.

Effects of Changes

• Increases in nominal income lead to increased interest rates if money supply remains constant.
• Increases in money supply generally decrease interest rates.
• Open Market Operations:
  • Expansionary: Central bank buys bonds to increase money supply.
  • Contractionary: Central bank sells bonds to decrease money supply.

Bond Pricing and Interest Rate Relation

• Formula: i = rac{100}{P_B} - 1
  • Higher bond prices lead to lower interest rates.
• Central banks prioritize interest rate selection often over direct money supply manipulation.

Banks as Financial Intermediaries

• Banks facilitate flow of funds, holding checkable deposits as liabilities.
• Banks manage reserves based on fluctuation in deposits and withdrawal patterns.

Demand for Reserves

• $H<em>d = heta M</em>d$
• Where $heta$ is reserve ratio. Equilibrium condition: $H = H_d$
  • Increasing $$H$leads to lower interest rates, while decreasing$$H$ has the opposite effect.

The Federal Funds Market

• The federal funds rate is determined by the market for reserves, influencing the monetary policy of the Fed.

Liquidity Trap

• Zero Lower Bound: Interest rates cannot fall below zero, creating a situation where monetary policy is rendered ineffective.
• At zero interest rates, demand for money becomes inelastic, as individuals are indifferent between holding money or bonds.

The Liquidity Trap in the US

• From 2008 to 2015, increased central bank money supply was absorbed due to household uncertainty leading to higher deposit demand.