Financial Markets

Front 1

Money

Back 1

Liquid.
Pays no interest.
Split into currency and checkable deposits.
If the transaction rates go up, demand for money goes up.

Front 2

Bonds

Back 2

Non-liquid.
Pays interest.
If the interest rate goes up, the demand for bonds also goes up.

Front 3

Demand for Money (Md)

Back 3

Roughly proportional to nominal income (£Y) but times a function of the interest rate: L(i)

Md = £YL(i)

The interest rate has a negative effect on the demand for money because if the interest rate goes up, the demand for money goes down (the demand for bonds instead of money goes up).

Front 4

Demand for Money (Graph)

Back 4

Front 5

Determining Interest Rate (i)

Back 5

The interest rate must be such that the supply of money is equal to the demand for money.

Md = Ms

Supply of money is independent of the interest rate.

Front 6

LM Relation (Graph)

Back 6

Front 7

Expansionary Open Market Operations

Back 7

Government is buying bonds to expand the money supply.

Leads to a decrease in the interest rate.

Front 8

Contractionary Open Market Operations

Back 8

Government is selling bonds to contract the money supply.

Leads to an increase in the interest rate.

Front 9

Bond Prices and Bond Yields

Back 9

Bonds don't have actual interest rates, only effective rates.

i = (£Pf - £Pb)/£Pb

Front 10

The Liquidity Trap

Back 10

Central Banks cannot reduce the interest rate below zero.

They can expand the money supply only to a certain point. This point is the liquidity trap.

Front 11

Bank Liabilities

Back 11

Checkable deposits.

Front 12

Bank Assets

Back 12

Made up of required reserves, loans, and bonds.

Banks keep reserves to cover ordinary transactions on a given day.

Front 13

Central Bank Money

Back 13

In equilibrium, demand for Central Bank money is equal to people's demand for currency plus the bank demand for reserves.

Liabilities of the Central Bank is the money received.

Supply is directly controlled by the Central Bank.

Also called 'high-powered money' or the 'monetary base.'

Front 14

Determining Interest Rate (Chart)

Back 14

Front 15

Demand for Currency (CUd)

Back 15

People hold a fixed proportion of currency (c).

Demand for currency:
CUd = c(Md)

Front 16

Demand for Deposit Accounts (Dd)

Back 16

People hold (1-c) in deposit accounts.

Demand for deposit accounts:
Dd = (1-c)(Md)

Front 17

Demand for Reserves (Rd)

Back 17

Dependent on the amount in deposit accounts (D)

With a reserve ratio: θ

R = θD
so:
Rd = θ(1-c)Md


Front 18

Demand for Central Bank Money (Hd)

Back 18

Demand for currency plus the demand for reserves, so:
Hd = CUd + Rd
so:
Hd = cMd + θ(1-c)Md = [c+θ(1-c)]Md
substituting for Md:
Hd = [c+θ(1-c)]£YL(i)

Front 19

The Interbank Market and the Overnight Interest Rate

Back 19

Banks can borrow from the central bank at the discount rate (controlled by the central bank).

Or they can borrow from each other:
US: Federal Funds Rate
EU: Euro Overnight Average (EONIA)
UK: London Interbank Rate (LIBOR)

Front 20

Money Multiplier

Back 20

Overall supply is not quite equal to the Central Bank's supply, it's multiplied by a constant multiplier dependent on the proportion or currency held (c).

1/ [c+θ(1-c)]
so:
1/ [c+θ(1-c)]*H = £YL(i)