Notes on Chapter 3: Financial Institutions, Money and Interest Rates

Chapter 3: The Basic Model II: Financial Institutions, Money and Interest Rates

Outcomes

  • Understand and explain the everyday operation of financial markets.
  • Describe how interest rates are influenced by money supply and demand.
  • Explain the differences and roles of nominal and real interest rates in economic behavior.
  • Analyze the chain reactions of monetary disturbances affecting interest rates and the real economy with graphical aids.
  • Assess the role of monetary policy and the Reserve Bank in the determination of real income.

Introduction

  • Focuses on explaining interest rates, enhancing understanding of the monetary sector and its impact on economic activities.
  • Short-run fluctuations in expenditure are affected by the functioning of financial institutions.

Monetary Sector and Interest Rates

Definitions
  • Nominal Interest Rates: Rates at which banks lend money or what is earned on savings accounts.
  • Real Interest Rates: Rates adjusted for inflation, reflecting the true cost of borrowing. Formula: r ≈ i - π.
Structure of Financial Markets
  • Divided into two main categories:
  • Money Market: Short-term instruments/assets (up to 1 year).
  • Capital Market: Long-term instruments/assets (over 1 year).
  • No physical location; transactions happen via digital links between banks, investment funds, and insurers.

Practical Determination of Nominal Interest Rates

  • Financial institutions involved include:
  • Commercial banks
  • Investment banks
  • Pension funds
  • Insurers
  • The money market connects surplus fund lenders with borrowers.
Financial Instruments
  • Various money market papers exist, each with designated nominal interest rates:
  • Treasury Bills (TB’s): Government issued to finance budget deficits.
  • Negotiable Certificates of Deposit (NCD’s): Issued by banks for liquidity issues.
  • Banker’s Acceptance (BA’s): Guaranteed by banks as payment measures.
Price and Interest Rate Relationship
  • Inverse relationship:
  • If the price of financial instruments rises, the nominal interest rate decreases.
  • Changes in supply/demand affect nominal interest rates.

Money Supply and Demand

Demand for Money (MD)
  • Defined as the amount required for transactions.
  • Influenced by factors such as:
  • Income (Y): Higher income leads to increased demand for money.
  • Price Levels: Higher prices necessitate more money to conduct the same volume of transactions.
  • Nominal Interest Rates: Higher rates decrease the demand for money due to opportunity costs.
Types of Demand for Money
  1. Transactions demand: Money for active use in transactions.
  2. Precautionary demand: Money held for unforeseen transactions.
  3. Speculative demand: Cash held based on interest rate changes and asset portfolio management.
Key Equations
  • Nominal Demand for Money: MD = f(i; Y; P)
  • Real Demand for Money: MD/P = f(i; Y)

Money Supply (MS)

Definitions
  • Money Supply: The total amount of money available in the economy.
  • Various official definitions based on types of deposits:
  • M1A: Coins, banknotes, cheque deposits.
  • M1: Includes M1A plus demand deposits.
  • M2: M1 plus short-term and medium-term deposits.
  • M3: M2 plus long-term deposits.
Creation Process of Money Supply
  • Money creation occurs through:
  • Lending by commercial banks.
  • Actions by the Reserve Bank (monetary policy).
  • The credit multiplier effect amplifies initial money injections due to repeated lending cycles.
Role of the Reserve Bank
  • Influences money supply through:
  • Setting reserve requirements.
  • Adjusting the repo rate: Higher rates discourage borrowing, reducing money supply.

Equilibrium in the Monetary Market

  • Equilibrium achieved when Money Supply equals Money Demand: MS = MD.
  • Shifts in supply/demand curves lead to changes in the interest rate:
  • Increase in money demand (due to increased income) causes interest rates to rise.
  • Increase in money supply causes interest rates to decrease.
Chain Reactions in the Money Market
  • A growth in income leads to increased money demand, resulting in higher interest rates as market adjusts to excess demand by selling financial instruments.

Yield Curve

  • Positive Yield Curve: Short-term interest rates lower than long-term rates indicate expected future increases.
  • Negative Yield Curve: Short-term rates higher than long-term rates suggest future decreases in interest rates.