CHAPTER
4
Financial Markets
Prepared by:
Fernando Quijano and Yvonn Quijano
And Modified by Gabriel Martinez
How Is the Interest Rate
Determined in the Short Run?
How Is the Interest Rate Determined in the
Short Run?
 By the condition that the supply of money
equals the demand for money.
– Here, there are only two assets: bonds and money.
– Here, nominal income and prices are given, so there
is no need to consider simultaneous equilibrium of
goods and financial markets.
 Investment is a function of the interest rate, so
output is affected by the interest rate.
 Monetary policy is, in large part, directed to the
determination of the interest rate.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The
Demand
for
Money
4-1
 Money, which can be used for transactions, pays
no interest. There are two types of money:
currency and checkable deposits.
 Bonds, pay a positive interest rate, i, but they
cannot be used for transactions.
 Wealth = Money + Bonds
– How much of your saving should you hold as money?
Depends on your level of
transactions
and the interest rate on bonds.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Demand for Money
 Transactions Demand for Money
– You need money (a financial asset that is an
accepted medium of exchange) to buy goods
and services on a day to day basis.
 Buying food, paying the rent, filling up the tank.
– Higher prices increase the demand for
money.
– Higher income increases the demand for
money.
–  Md is directly proportional to nominal
income.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Demand for Money
 The interest rate on bonds
– People prefer to hold liquid assets, i.e., means
of exchange.
– To get them to hold bonds (which are not
liquid), people must be paid interest.
– Money doesn’t pay interest.
– If the interest rate is high, the opportunity cost
of holding money is higher.
– There’s an inverse relation L(i) between the
holding of liquid assets and the interest rate.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Deriving the Demand for Money
M
d
 $YL ( i )
 The demand for
money:
– increases in proportion
to nominal income, $Y,
and
– depends negatively on
the interest rate: L(i).
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Deriving the Demand for Money
The Demand for Money
For a given level of
nominal income ( for a
given Md curve), a lower
interest rate increases
the quantity demanded
of money.
At a given interest rate,
an increase in nominal
income shifts the
demand for money to the
right.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Determination of
the Interest Rate, Part I
4-2
 In this section, we assume that people only
hold money in the form of currency.
 Then only the central bank supplies money,
in an amount equal to M, so M = Ms.
– The role of banks as suppliers of money (in the
form of checkable deposits) is introduced in the
next section.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Determination of
the Interest Rate, Part I
 Equilibrium in financial markets requires that
money supply be equal to money demand:
M  $ YL ( i )
 This is the LM relation.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Money Demand, Money Supply;
and the Equilibrium Interest Rate
The Determination of the
Interest Rate
The interest rate must
be such that the
supply of money
(which is independent
of the interest rate) be
equal to the demand
for money (which does
depend on the interest
rate).
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Money Demand, Money Supply;
and the Equilibrium Interest Rate
The Effects of an
Increase in
Nominal Income on the
Interest Rate
An increase in
nominal income $Y
leads to an increase
in the interest rate i.
Equivalently, if M/$Y
falls, and i will rise.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Demand for Money and the
Interest Rate: The Evidence
 The interest rate and the ratio of money to nominal
income typically move in opposite directions.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Demand for Money and the
Interest Rate: The Evidence
 There is a “secular trend” in M/$Y: it has
been falling for a long time, so it’s not
clear that interest rates are the cause.
– Is velocity high when the interest rate is low?
Not necessarily.
Econometric point: “Detrending” time series
that have a trend
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Demand for Money and the
Interest Rate: The Evidence
 So, instead, we look at the relation
between the change in i and the change
in M/$Y.
 Figure 2 shows that there’s an inverse
relation between the changes:
– If i rises, M/$Y falls.
– If i falls, M/$Y rises.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Demand for Money and the
Interest Rate: The Evidence
Changes in i versus changes in M/Y
0.05
0.04
Change in interest rate
0.03
0.02
0.01
-0.30
-0.20
-0.10
0.00
0.00
-0.01
0.10
0.20
0.30
D i= - 0.0016 - 0.0403 D M/Y
-0.02
-0.03
-0.04
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Change in M1/GDP
Macroeconomics, 3/e
Olivier Blanchard
M1 vs GDP, in changes
6%
4%
M1 = 0.0083 + 0.2408GDP
M1
2%
-2%
0%
-1%
0%
-2%
1%
2%
3%
4%
5%
6%
7%
-4%
GDP
This graph would seem to support the thesis that higher GDP growth
leads to higher money demand, which the Central Bank (or the banks
accommodate.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
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
leads to a decrease
in the interest rate.
This is the basis for
monetary policy
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy and
Open-Market Operations
Open-market
operations, which take
place in the “open
market” for bonds, are
the standard method
central banks use to
change the money
stock in modern
economies.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy and
Open-Market Operations
The Balance Sheet of the
Central Bank and the Effects of
an Expansionary Open Market
Operation
The assets of the central bank are
the bonds it holds. The main
liability is the stock of currency in
the economy. An open market
operation in which the central bank
buys bonds and issues currency
increases both assets and liabilities
by the same amount.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy and
Open-Market Operations
 In an expansionary open
market operation, the
central bank buys $1
million worth of bonds,
increasing the money
supply by $1 million.
 In a contractionary
open market operation,
the central bank sells $1
million worth of bonds,
decreasing the money
supply by $1 million.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy and
Open-Market Operations
 When the central bank buys bonds (and
issues currency), the demand for bonds
goes up: the price of bonds rises.
 There is an inverse relation between the
price of bonds and the interest rate.
– See next slide, or take ECO 342.
 Therefore, an expansionary open market
operation raises the demand for bonds and
their price and lowers interest rates.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy and
Open-Market Operations
 The inverse relation between prices of
bonds and the interest rate:
– Suppose you buy a US government bond (i.e., a
debt of the US government) at $PB and hold it
until the government pays you back the full
amount (say, $100).
– Then your return is:
i 
$100  $ PB
© 2003 Prentice Hall Business Publishing
$ PB

$ PB 
$100
1 i
Macroeconomics, 3/e
Olivier Blanchard
What did I learn in this chapter?
 Tools and Concepts
– Stock versus flow variables; wealth (a stock) versus
income (a flow).
– Monetary policy and open market operations.
– The use of balance sheets for the central bank and
private banks.
– Various terms and concepts associated with the
banking system: currency, checkable deposits,
reserves, central bank money (high powered money,
the monetary base), the federal funds market and
the federal funds rate, and the money multiplier.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard