Chapter 10
Financial Markets and
the Economy
Financial Markets are markets in
which funds accumulated by one
group are made available to
another group.
The bond market is a market in
which institutions and individuals
borrow and lend money. They do
this through buying and selling
bonds.
For example, the U.S. government wishes
to borrow money. They issue a bond like
this one. It will have a date of maturity,
or when you can turn it back into the
government and get your money back
It will also have the amount of money
you get paid back, in this case $100.
So let’s say the maturity on this bond
is one year.
You buy it now and turn give it to the
government in one year to be paid
$100. You are loaning them your
money for one year. What is the
interest rate you are getting?
That depends on how much you paid
for it.
Let’s say you pay $90 for it. In one year,
you get back $100.
You have lent $90 for a year and got
back $100. That is equal to an interest
rate of
(Face Value – Bond Price)/Bond Price
($100-$90)/$90 = $10/$90 = .1111
= 11.11%
The higher the price you pay for
the $100 bond 1 year bond, the
lower the interest rate you get.
Pay $90, then i = 11.1%
Pay $95, then i = 5.3%
Pay $99, then i = 1.0%
So now we face a choice. Do we
want to think of the bond market
as one where people lend and
borrow money at a certain interest
rate, or buy and sell bonds at a
certain price?
Both of these are correct ways of
illustrating the same thing
happening. Textbook guy uses the
2nd way. I find the 1st way much
more intuitive.
Here are both ways side-by-side. We will
primarily use the diagram on the right.
You’ve seen the 2nd diagram before back in
unit 2, where I called it the supply and
demand diagram for the credit market.
Interest
rate
Supply
(savings)
iE
Demand
(borrowing)
QE
Loanable Funds
Here is one way that a change in interest
rates can effect the macroeconomy.
Much investment spending done by
businesses is financed through
borrowing. The higher the interest rate
you have to pay on a loan to get the
money to build a new factory, the less
likely you are to build the factory.
Suppose for some reason there is an
increase in the amount available for
lending. This is an increase in supply in
the credit market.
Interest
rate
S1
i1
i2
S2
D1
Q1 Q2
Interest
Rates
Fall
Loanable Funds
The extra investment spending will
increase AD (GDP=C+I+G)
P
SRAS
P2
P1
AD1
Q1 Q2 QN
AD2
Q
This could
help get us
out of a
recession
You have a demand for money.
Do you always want more?
What can you do with your
purchasing power? 3 things.
1) Buy Goods
2) Buy bonds (or other high
interest investments)
3) Hold it as money
1) Why buy goods?
That’s obvious. You want them.
2) Why buy bonds?
To earn interest.
3) Why hold money?
Purchase future goods and services
easily. Money is very liquid.
3 Reasons to be holding money
1) Holding money to make expected
purchases later is the transactions
demand for money.
2) Holding money to protect against
unexpected purchases (emergencies)
is the precautionary demand for
money.
3) The speculative demand for
money you expect to invest in
bonds or stocks but are waiting for
a better price.
If we look just at the choice to hold
money or bonds, we can think of the
interest rate as the opportunity cost
or “price” of holding money.
If the money itself earns interest,
such as an interest earning checking
out, it is the difference in the two
interest rates that matters.
The higher the interest rate goes
on the bonds you have to give up
to hold money, the less money you
want to hold.
Or the more bonds you want to
hold. The two statements are
functionally equivalent.
Demand curve for money in terms
of interest for bonds.
What else affects the demand for
money?
1) Expected inflation – the more you
expect prices to rise, the less cash you
want to hold (remember the wealth
effect?)
2) Confidence in the future – if you fear
losing your job or that the bond you buy
may not pay off, you wish to hold more
cash.
Textbook guy lists a few more, but
you do not have to memorize the
others on the list.
I fear losing my job.
What about the
supply of money.
Let’s assume the
federal reserve
board can create as
much or little money
as it wishes through
open market
operations.
Equilibrium in the money market is
when people want to hold exactly
as much money as the fed has
created. Suppose the interest rate
is very high. People won’t want to
hold much money, they will want to
hold bonds instead. If the Fed has
created a lot of money, people will
have “too much” money.
They will get rid of the excess by
saving it into the bond market.
They will do this by buying bonds.
The interest rate will fall until
people no longer feel they have
“too much” money.
Do people really think they have too
much money? Well, imagine you
have a huge cash stash in the cookie
jar and read that Ford Auto Co. is
paying 100% on Ford bonds.
Wouldn’t you say I have too much
cash sitting around doing nothing
when it could be earning 100%?
If they have “too little” money, they
will get more by saving less into the
bond market (selling bonds) and
interest rates will rise.
There will be an interest rate at which
people want to hold the exact amount
of money created by the Fed.
When we get to that interest rate, there
will be equilibrium in the money market.
The money market graph and the
credit market graphs are two sides of
the same coin.
Interest
rate
Supply
(savings)
iE
Demand
(borrowing)
QE
Loanable Funds
If the demand curve for money shifts,
the interest rate will shift. Suppose
people fear a big rise in inflation.
More
money
goes into
the bond
market
and
interest
rates fall.
If the Fed creates more money, people
put some of that money into the bond
market and interest rates fall.
Here we see what is simultaneously
happening in the credit market.
Interest
rate
S1
i1
i2
S2
D1
Q1 Q2
Interest
Rates
Fall
Loanable Funds
Why might the Fed want to do this? AS/AD
diagram showing the effect of more
investment caused by lower interest rates.
P
SRAS This could
P2
P1
AD1
Q1 Q2 QN
AD2
Q
help get us
out of a
recession
Chapter 11
Monetary Policy and the
Fed
What are the Fed’s goals?
1) Low Inflation
2) Low Unemployment
3) High Growth
The same 3 variables that we said
determine if the macroeconomy is
working well back at the beginning of
chapter 5.
But what weight does it assign to
each goal? In the 1960’s and 70’s,
it was lower unemployment. Since
then, it has been lower inflation.
This comes from the feeling among
many bankers and economists that
the fed paid to little attention to
inflation in the 60’s/70’s.
If it did, it was probably acting on the
feeling that the fed paid too little
attention to unemployment in the
1930’s.
Some economists are arguing that this
“don’t make the same mistake we
made last time” mentality is causing
the fed to pay too much attention to
inflation now.
In theory, Congress can legally set
the goals for the fed whenever it
wants. It has given the fed a dual
mandate of low unemployment
and low inflation.
In practice, this has left the fed
almost completely independent.
So what should the fed do? Suppose
we are in a recession. In our model,
Q is in the recessionary gap.
How can we get out of the
recession? We could wait until
wages adjust, but with sticky wages,
that could take years … and years.
A quicker way out would be if the fed
could get AD to move right.
P
SRAS
P2
P1
AD2
AD1
Q1 QN
Q
Can
they
do
this?
The short answer is yes.
1) Fed buys government securities.
2) Banks have more funds to loan.
3) Drop in interest rates.
4) People borrow the new money
from the banks and buy things.
Voila, recession over!
This is known as expansionary
monetary policy. The fed creates
money and drives down the
interest rate to increase buying.
AD moves to the right and
increases output and lowers
unemployment.
We’ve already seen what
simultaneously is happening in the
credit market.
Interest
rate
S1
i1
i2
S2
D1
Q1 Q2
Interest
Rates
Fall
Loanable Funds
What about in the
money market? And
buy this, I don’t
mean the financial
market sometimes
known as the money
market. I mean
people’s choice of
how much money to
hold.
Interest rates fall, people want to
hold more money and less bonds.
So as the fed increases the money
supply, people will hold more in their
cash stash. The increase in money to be
lent will not be as large as the amount
created by the fed, since people will
respond by saving less and holding more
cash. But it is unlikely this effect will be
large enough to cancel out the effect of
the fed’s action.
But what if the problem is we are
in the inflationary gap part of the
diagram. Can we get back to QN
without inflation? Not if we wait
for the natural long-run
adjustment and the shifting SRAS
curve. But what if we move AD to
the left?
Out of the inflationary gap without
inflation.
P
SRAS
P1
P2
AD1
AD2
QN Q1
Q
To do this, we use contractionary
monetary policy. The fed decreases
the money supply, this decreasing
AD. After all, what is money used
for? So less money, less buying.
1) Sell government securities.
2) raise r.
3 raise the discount rate.
So to sum up:
To fight recessions, expansionary
monetary policy to move AD right.
To fight inflation, contractionary
fiscal policy to move AD left.
Well, that sounds easy. In fact, it
sounds too easy. If
macroeconomics is that simple,
why do we have such a hard
problem with recessions and
inflation?