The demand for money Determining the interest rate, i Monetary policy and open market operations
Macroeconomics - Licence 1 Economie Gestion Chapter 5: Financial markets
Rémi Bazillier 1 1
[email protected] http://remi.bazillier.free.fr Université d’Orléans
Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
Plan
1
The demand for money
2
Determining the interest rate, i
3
Monetary policy and open market operations
Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
The interest rate
In the last chapter: no interest rate. Time to relax this assumption! What determines the interest rate and how a central bank can affect it? This chapter How the interest rate affects demand and output? Next chapter
Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
The demand for money
Suppose that your financial wealth today is e50000. You have the choice between two assets: 1
Money, which you can use for transactions, pays no interest. Two types: Currency (Coins, bills) Checkable deposits (bank deposits on which you can wirte checks)
2
Bonds pay a positive rate, i. Cannot be used for transactions.
Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
The demand for money How much of your e50000 should you hold in money and in bonds? It depends on your level of transactions: you’ll want enough money on hand to avoid having to sell bonds too often. It depends also on the interest rate on bonds: you hold bonds only because they pay interest. If bonds paid zero, you would want to hold all your wealth in the form of money (more convenient)
Remark: individuals generally do not hold bonds directly. But indirectly through money market funds
Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
Deriving the demand for money Demand for money M d : the sum of all individual demands for money by the people in the economy. It depends on the overall level of transactions and on the interest rate. Overall level of transactions is proportional to national income M d = $YL(i)
(1)
(−)
(2)
The demand for money, M d is equal to nominal income, $Y , times a function of the interest rate i, with the function denoted by L(i)
Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
The demand for money
Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
Determining the interest rate, i Two types of money: checkable deposits (supplied by banks) and currency (supplied by the central bank) Here: only the central bank which decides to supply an amount of money, equal to M: Ms = M
(3)
Equilibrium in financial markets: Ms = Md
(4)
M = $YL(i)
(5)
This equilibrium relation is called the LM relation Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
The determination of the interest rate
Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
The effects of an increase in nominal income on the interest rate
Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
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 At the initial interest rate, the demand for money exceeds the supply. An increase in the interest rate is needed to decrease the amount of money people want to hold and to reestablish equilibrium
Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
The effects of an increase in the money supply on the interest rate
Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
The effects of an increase in the money supply on the interest rate
An increase in the supply of money by the central bank leads to a decrease in the interest rate The decrease in interest rate increases the demand for money (it decreases the demand for bonds), so it equals the now larger money supply
Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
Monetary Policy and open market operations Open market operations Central banks change the supply of money by buying or selling bonds in the bond market If a central bank wants to increase the supply of money, they buy bonds and pay for them by creating money If a central bank wants to decrease the supply of money, they sell bonds and removes from the circulation the money it receives These operations take place in the “open market for bonds”
Assets Bonds Change in bond holdings: +1 million
Liabilities Money (currency) Change in money stock +1 million
Table: The balance sheet of the central bank and the effects of an expansionary open market operation Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
Bond prices and Bond Yields What is determined in bond market: bond prices. The interest rate on a bond can be inferred from its price. Suppose that the bonds in our economy are one-year bonds (called treasury bills or T-bills in the US). Bonds promise a payment of a given number of $ in one year ($100). The price today: $PB Interest rate: i=
$100 − $PB $PB
(6)
The higher the price of bonds, the lower is the interest rate Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
Bond prices and Bond Yields We can figure out the price of bonds using the previous formula: PB =
$100 1+i
(7)
When newspaper write that “bond market went up today”, they mean that the prices of bonds went up and therefore that interest rates went down When central banks buys bond, the demand for bonds goes up, increasing their price. The interest rate on bonds goes down. When central banks sells bonds, it decreases the price of bonds. Interest rate goes up. Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
Choosing money or the interest rate? Central banks typically choose the interest rate, rather than the money supply Once they have chosen the interest rate, they adapt the money supply
Rémi Bazillier
Chapter 3: Investment
The demand for money Determining the interest rate, i Monetary policy and open market operations
The role of banks
Here: only the central bank determines the money supply In reality: banks also create money It is possible to adapt the model in order to take into account the role of banks Demand for central banks money: demand by currency by people plus demand for reserves by bank Supply of central banks money: under the direct control of central banks Interest rate : demand and supply for central banks money are equal
Rémi Bazillier
Chapter 3: Investment
