FINANCIAL MARKETS

Short run
 The Demand for Money
• Suppose, as a result of having steadily saved part of your income in the past,
your financial wealth today is Rs 50,000. You may intend to keep saving in the
future and increase your wealth further, but its value today is given. Suppose
also that you only have the choice between two assets, money and bonds.
• Money, which you can use for transactions, pays no interest. In the real world,
there are two types of money: currency (coins and bills), and demand
deposits, the bank deposits on which you can write cheques. The sum of
currency and demand deposits is called M1.
• Bonds pay a positive interest rate, i, but they cannot be used for transactions.
In the real world, there are many types of bonds and other financial assets,
each associated with a specific interest rate. For the time being, we will also
ignore this aspect of reality and assume that there is just one type of bond and
that it pays, i, the rate of interest.
• Holding all your wealth in the form of money is very convenient. You
won’t ever need to call a broker or pay transaction fees for buying
bonds. But it also means you will receive no interest income. On the
other hand, if you hold all your wealth in the form of bonds, you will
earn interest on the full amount, but you will have to call your broker
frequently to get money for daily use.
• Thus you should hold both money and bonds. The proportion you hold
either will depend on your level of transactions and the interest rate.
The higher the interest rate, the more you will be willing to deal with
the hassle and costs associated with buying and selling bonds.
 Deriving the demand for money
• The amount of money people want to hold—their demand for money—can be
denoted by Md. The demand for money in the economy as a whole is just the sum of
all the individual demands for money by the people in the economy.
• Therefore, money demand depends on the overall level of transactions in the
economy and on the interest rate. The overall level of transactions in the economy is
hard to measure, but it is likely to be roughly proportional to nominal income.
Md =Y. L(i)
(-)
• The relation between the demand for money and the interest rate for a given level
of nominal income is represented by the Md curve. The curve is downward sloping:
The lower the interest rate (the lower i), the higher the amount of money people want
to hold (the higher Md). For a given interest rate, an increase in nominal income
increases the demand for money. In other words, an increase in nominal income shifts
the demand for money to the right.
Money demand
 Determination of the interest rate
• In the real world, there are two types of money: demand deposits, which are
supplied by banks, and currency, which is supplied by the central bank. For now, we
will assume that demand deposits do not exist—that the only money in the
economy is currency.
• Suppose the central bank decides to supply an amount of money equal to M, so Ms =
M. Equilibrium in financial markets requires that money supply be equal to money
demand, that Ms = Md
M= Y. L(i)
• This equation tells us that the interest rate i must be such that, given their income
people are willing to hold an amount of money equal to the existing money supply
M. This equilibrium relation is called the LM relation. L stands for liquidity:
Economists use liquidity as a measure of how easily an asset can be exchanged for
money. We can think of the demand for money as a demand for liquidity. The letter
M stands for money. The demand for liquidity must equal the supply of money.
Equillibrium
• The demand for money, Md, drawn for a given level of nominal income is
downward sloping: A higher interest rate implies a lower demand for money.
The supply of money is drawn as the vertical line denoted Ms: The money
supply equals M and is independent of the interest rate. The equilibrium
interest rate is given by i*.
• Now that we have characterized the equilibrium, we can look at how
changes in nominal income or changes in the money supply by the central
bank affect the equilibrium 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.
• An increase in the supply of money by the central bank leads to a decrease
in the interest rate. The decrease in the interest rate increases the demand
for money so it equals the now larger money supply.
Effects of increase in Nominal Income on
Interest Rate
Effects of increase in Money supply on
interest rate
 Monetary Policy and 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 amount of money in the economy, it
buys bonds and pays for them by creating money. If it wants to decrease the amount
of money in the economy, it sells bonds and removes from circulation the money it
receives in exchange for the bonds. These actions are called open market operations
because they take place in the “open market” for bonds.
• If the central bank buys, say, Rs 1 lakh worth of bonds, the amount of bonds it holds
is higher by Rs 1 lakh , and so is the amount of money in the economy. Such an
operation is called an expansionary open market operation, because the central
bank increases (expands) the supply of money.
• If the central bank sells Rs 1 lakh worth of bonds, both the amount of bonds held by
the central bank and the amount of money in the economy are lower by Rs 1
lakh. Such an operation is called a contractionary open market operation, because
the central bank decreases (contracts) the supply of money.
• Bonds issued by the government promising payment in a year or less are called
treasury bills or T-bills. The price of the bond today is equal to the final payment
divided by 1 plus the interest rate. If the interest rate is positive, the price of the
bond is less than the final payment. The higher the interest rate, the lower the
price today.
• Open market operations in which the central bank increases the money supply
by buying bonds lead to an increase in the price of bonds and a decrease in the
interest rate. Open market operations in which the central bank decreases the
money supply by selling bonds lead to a decrease in the price of bonds and an
increase in the interest rate.
• We have describe the central bank as choosing the money supply and letting the
interest rate be determined at the point where money supply equals money
demand. Instead, we could have described the central bank as choosing the
interest rate and then adjusting the money supply so as to achieve the interest
rate it has chosen. The latter is more appropriate as central banks typically
choose the interest the rate and then move the money supply so as to achieve
it.
 Money, Bonds and other Assets
• We have assumed that all money in the economy consisted of
currency, supplied by the central bank. In the real world, money
includes not only currency but also demand deposits. Demand
deposits are supplied not by the central bank but by other banks.
• Modern economies are characterized by the existence of many types
of financial intermediaries—institutions that receive funds from
people and firms and use these funds to buy financial assets or to
make loans to other people and firms. The assets of these institutions
are the financial assets they own and the loans they have made. Their
liabilities are what they owe to the people and firms from whom they
have received funds.
 What Banks do
• What makes banks special—and the reason we focus on banks here rather than
on financial intermediaries in general—is that their liabilities are money: People
can pay for transactions by writing cheques up to the amount of their account
balance.
• Banks receive funds from people and firms who either deposit funds directly or
have funds sent to their demand accounts (via direct deposit of their
paycheques, for example.) At any point in time, people and firms can write
cheques or withdraw up to the full amount of their account balances. The
liabilities of the banks are therefore equal to the value of these demand
deposits.
• Banks keep as reserves some of the funds they receive. They are held partly in
cash and partly in an account the banks have at the central bank, which they can
draw on when they need to.
• Banks hold reserves for three reasons.
On any given day, some depositors withdraw cash from their savings
accounts while others deposit cash into their accounts. There is no reason
for the inflows and outflows of cash to be equal, so the bank must keep
some cash on hand.
In the same way, on any given day, people with accounts at the bank
write cheques to people with accounts at other banks, and people with
accounts at other banks write cheques to people with accounts at the
bank. What the bank, as a result of these transactions, owes the other
banks can be larger or smaller than what the other banks owe to it. For
this reason also, the bank needs to keep reserves.
In addition, banks are subject to reserve requirements, which require
them to hold reserves in some proportion of their demand deposits. In
India, reserve requirements are set by the RBI (CRR).
• The distinction between bonds and loans is unimportant at present—
which is to understand how the money supply is determined.
• For this reason, to keep the discussion simple, we will assume that
banks do not make loans, that they hold only reserves and bonds as
assets.
 Supply and Demand for Central
Bank Money
• 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.
• The easiest way to think about how the interest rate in this economy is determined is
by thinking in terms of the supply and the demand for central bank money.
• The demand for money by people is for both demand deposits and currency.
Because banks have to hold reserves against demand deposits, demand deposits
leads to a demand for reserves by banks. Consequently, the demand for central bank
money is equal to the demand for reserves by banks plus the demand for currency.
• The supply of central bank money is determined by the central bank. The interest
rate must be such that the demand and the supply of central bank money are equal.
Balance sheet of central bank and
banks
 The Demand for Money
• When people can hold both currency and demand 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 demand deposits.
• It is reasonable to assume that the overall demand for money
(currency plus demand deposits) is given by the same factors as
before. People will hold more money the higher the level of
transactions and the lower the interest rate on bonds.
Md =Y. L(i)
(-)
• How do people decide how much to hold in currency, and how much in
demand deposits? Currency is more convenient for small transactions (it
is also more convenient for illegal transactions.) Cheques are more
convenient for large transactions. Holding money in your saving account
is safer than holding cash.
• Let’s assume people hold a fixed proportion of their money in currency c
and, by implication, hold a fixed proportion (1 – c) in demand deposits.
We can then write
CUd (demand for currency)= c.Md
Dd (demand for demand deposits)= (1 – c) Md
 Demand for Reserves
• The demand for demand deposits leads to a demand by banks for reserves, the second
component of the demand for central bank money. To see how, let’s turn to the
behaviour of banks.
• The larger the amount of demand deposits, the larger the amount of reserves the
banks must hold, both for precautionary and for regulatory reasons. Let θ (the Greek
lowercase letter theta) be the reserve ratio, the amount of reserves banks hold per
rupee of demand deposits.
• Let R denote the reserves of banks. Let Dd denote the rupee amount of demand
deposits. Then, by the definition of θ, the following relation holds between R and D:
R = θ Dd
• If people want to hold Dd in deposits, then, banks must hold θDd in reserves. Now R, the
demand for reserves, can be written as
Rd = θ (1-c) Md
 Demand for Central Bank Money
• The demand for central bank money (Hd) is equal to the sum of the
demand for currency and the demand for reserves.
Hd = CUd + Rd
Hd = c.Md + θ (1-c) Md
= [c + θ (1 – c)] Md
• We know that Md =Y. L(i). Therefore the above expression can be
written as
Hd =[c + θ (1 – c)]Y. L(i)
 Determination of the interest rate
• We are now ready to characterize the equilibrium. Let H be the supply of central bank
money; H is directly controlled by the central bank. the central bank can change the
amount of H through open market operations. The equilibrium condition is that the
supply of central bank money be equal to the demand for central bank money.
H =[c + θ (1 – c)]Y. L(i)
• Suppose that people held only currency, so c = 1. Then, the term in brackets would be
equal to 1. In this case, people would hold only currency, and banks would play no
role in the supply of money.
• Assume instead that people did not hold currency at all, but held only demand
deposits, so c = 0. Then, the term in brackets would be equal to θ. Suppose, for
example, that θ = 0.1, so that the term in brackets was equal to 0.1. Then the demand
for central bank money would be equal to one-tenth of the overall demand for
money. People would hold only demand deposits. For every rupee they wanted to
hold, banks would need to have 10 paisa in reserves. In other words, the demand for
reserves would be one-tenth of the overall demand for money.
• Leaving aside these two extreme cases, note that, as long as people hold
some demand deposits (so that c <1), the term in brackets is less than 1:
This means the demand for central bank money is less than the overall
demand for money. This is due to the fact that the demand for reserves
by banks is only a fraction of the demand for demand deposits.
• In the following figure, central bank money (rather than money) is shown
on the horizontal axis. The interest rate is measured on the vertical axis.
The demand for central bank money, CUd + Rd, is drawn for a given level of
nominal income.
• A higher interest rate implies a lower demand for central bank money for
two reasons: (1) The demand for currency by people goes down; (2) the
demand for demand deposits by people also goes down. This leads to
lower demand for reserves by banks. The supply of money is fixed and is
represented by a vertical line at H. Equilibrium is at point A, with interest
rate i.
Equillibrium in the market for Central
bank money
 The Money Multiplier
• We have seen how we can think of the equilibrium in terms of the equality
of the supply and demand of central bank money.
• To derive an equilibrium condition in terms of the overall supply and the
overall demand for money, start with the equilibrium condition (which
states that the supply of central bank money must equal the demand for
central bank money) and divide both sides by [c + θ (1 – c)] , we get
1* H = Y. L(i)
[c + θ (1 – c)]
• The above equation just says that overall supply of money (currency plus
demand deposits) is equal to overall demand for money (currency plus
demand deposits)
• In the equation characterizing the equilibrium in an economy without banks, you will
see that the only difference is that the overall supply of money is not equal just to
central bank money but to central bank money times a constant term 1/ [c + θ (1 – c)]
• Notice also that, because [c + θ (1 – c)] is less than one, its inverse—the constant
term on the left of the equation—is greater than one. For this reason, this constant
term is called the money multiplier. The overall supply of money is therefore equal to
central bank money times the money multiplier. If the money multiplier is 4, for
example, then the overall supply of money is equal to 4 times the supply of central
bank money.
• To reflect the fact that the overall supply of money depends in the end on the
amount of central bank money, central bank money is sometimes called high
powered money (this is where the letter H we used to denote central bank money
comes from), or the monetary base. The term high-powered reflects the fact that
increases in H lead to more than one-for-one increases in the overall money supply
and are therefore “high-powered.” In the same way, the term monetary base reflects
the fact that the overall money supply depends ultimately on a “base”—the amount
of central bank money in the economy.
Understanding the money multiplier
• The presence of a multiplier implies that a given change in central bank
money has a larger effect on the money supply—and in turn a larger
effect on the interest rate—in an economy with banks than in an
economy without banks. To understand why, it is useful to return to the
description of open market operations, this time in an economy with
banks.
• To make the arithmetic easier, let’s consider a special case where
people hold only demand deposits, so c = 0. In this case, the multiplier
is 1/ θ. In other words, an increase of a rupee of high powered money
leads to an increase of 1/θ rupees in the money supply. Assume further
that θ = 0.1, so that the multiplier equals 1/θ = 10.
• Suppose the central bank buys Rs 100 worth of bonds in an open market
operation. It pays the Seller 1 Rs 100. To pay the seller, the central bank creates
Rs 100 in central bank money. The increase in central bank money is Rs 100.
When we looked earlier at the effects of an open market operation in an
economy in which there were no banks, the money supply ends here. However,
here its just the beginning.
• Seller 1 (who, we have assumed, does not want to hold any currency) deposits
the Rs 100 in a deposit account at his bank—bank A. This leads to an increase in
demand deposits of Rs 100.
• Bank A keeps Rs 100 times 0.1 = Rs 10 in reserves and buys bonds with the rest,
Rs 100 times 0.9 = Rs 90. It pays Rs 90 to the seller of those bonds—seller 2.
• Seller 2 deposits Rs 90 in a deposit account in her bank—call it bank B. This leads
to an increase in demand deposits of Rs 90.
• Bank B keeps Rs 90 times 0.1 = Rs 9 in reserves and buys bonds with the rest, Rs
90 times 0.9 = Rs 81. It pays Rs 81 to the seller of those bonds- seller 3.
• The eventual increase in money supply is equal to 1/(.1) = 10. The
money supply increases by Rs 1,000—10 times the initial increase in
central bank money.
• 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 central bank in its open market operation, the following rounds
by banks. Each successive round leads to an increase in the money
supply, and eventually the increase in the money supply is equal to 10
times the initial increase in the central bank money.