Supply and Demand Models of
Financial Markets
Two Markets
• Loanable Funds Market
– Determines Interest Rate in Capital Markets
• Liquidity Market
– Determines Money Market Rate
Loanable Funds Market
• Consider the financial market at its
broadest and most abstract.
– an amalgamation of the bond market and the
lending market (banks, etc.)
• Map the relationship between the interest
rate and the quantity of funds that are lent.
– Supply curve represents the behavior of
savers & lenders
– Demand curve represents the behavior of
borrowers
• Could represent the global financial
market or a large national market.
Supply Curve: Loanable Funds
• Why does the supply curve slope up?
– When real interest rates offered by banks
are high, savers are rewarded with more
future consumption and are likely to be
induced to save more.
– Caveat: If some savers are setting a target
for their level of wealth at retirement, a
higher interest rate reduces the amount
they need to save.
• For this reason, many economists believe
saving curve is very inelastic.
Demand Curve: Loanable Funds
• Why does the demand curve slope down?
– Firms borrow to finance investment projects. If
the return on investment falls below the interest
rate, the project is not worthwhile. The higher
the interest rate, the fewer projects fall below the
hurdle.
– Households borrow to finance housing. The
higher are interest rates, the smaller is the
house that the householders can buy with a
mortgage payment that they can afford.
Competitive Market Equilibrium:
Loanable Funds Market
(Geometry)
r
S
D
r*
LF*
LF
Example: Investment Boom in
Japan as economy recovers
r
S
I
I´
r**
r*
LF*
LF**
LF
Savings
• We divide savings
into 2 parts:
SGovernment
+
SPrivate
= S
Public Saving/Government Saving
(Budget Surplus)
Private Saving
(Household + Business Saving)
National Saving
Example: US Government runs a
deficit to finance military spending
r
S´
S
I
r**
r*
LF**
LF*
LF
Example: US Consumers become
thriftier
r
S
I
r*
LF*
LF
Global Economy
• Additional Source of Savings
Loanable Funds Supply = Public Savings +
Net Capital Inflow from Abroad
• Two Effects
1. Supply Curve Becomes More Elastic
More globalized, more elastic
2. Global Financial Markets also a source of
shifts in Supply Curve
Questions
• Compare Investment Boom in a very
globalized economy with one in a less
globalized economy. What happens to
investment & interest rates?
Money Markets
Liquid Assets
Two kinds of assets
1. Liquid Assets (Currency, Checking
Accounts, Savings Accounts) that are
useful for transactions which pay zero or
below market interest rates.
2. Money market assets (Government bills,
commercial paper, jumbo CD’s) that pay
a market rate, i, but which cannot be
used for transactions
Liquidity Demand
Q: Why does the money
demand curve slope
down?
A: The greater is the
market interest rate,
the greater is the
opportunity cost of
holding money.
Q: What shifts the
money demand
curve?
A: An increase in GDP
will increase the need
for money for
transactions shifting
the demand curve
out. A reduction in
GDP will shift the
demand curve in.
Money Supply
•
Supply of monetary assets governed by
central bank.
1. Prints currency
2. Makes reserves available to banks
3. Governs fraction of deposits that banks
must keep.
Money Market
Money Demand
Money Supply
i
i*
M
Equilibrium in the Money Market
• If interest rates are too high, excess supply of
money:
– people will want to buy interest paying assets like
bank accounts or treasury bills.
– Bond dealers and banks can reduce the interest
rates they are willing to offer
• If interest rates are too low, excess demand for
money:
– people will want to sell interest paying assets like
bank accounts or treasury bills to get more
liquidity.
– Bond dealers and banks must raise interest rates.
Changes in Money Market Rates
During Business Cycles
• Money Demand Shocks: What happens to
interest rates when GDP (either prices or
real GDP rises)?
• What happens when GDP falls?
Operating Targets: Target Interest
Rates
• Most big country CB’s target interbank interest
rates, the rate at which banks lend reserves to
one another (in HK, this is called what?)
Fed
BoJ
ECB
BoK
UK
Federal Funds Rate
Uncollateralized Call Money Rate
Main Refinancing Rate
Overnight Call Rate
Official Bank Rate
Target Rates Affect Money Market
Rates
Money Market Rates USA
7
6
5
4
3
2
1
C.P. Rate
CEIC Database
Fed Funds
T-Bill 3 Mo
Mar-06
Sep-05
Mar-05
Sep-04
Mar-04
Sep-03
Mar-03
Sep-02
Mar-02
Sep-01
Mar-01
Sep-00
Mar-00
Sep-99
Mar-99
Sep-98
Mar-98
Sep-97
0
Money Supply
• Government can control the money supply
and can shift the curve in or out by
decreasing or increasing money supply.
• What does the central bank need to do to
money supply to increase the interest
rate?
Money Market at ZIRP
Money Demand
Money Supply
i
i*
i**
0
1
2
3
M
Learning Outcomes
• Students should be able to:
• Use the Loanable Funds model to analyze the
effects of external events on savings, investment,
and real interest rates in capital markets and;
• Compare capital markets in globalized economies
with those in closed economies.
• Use the money supply and demand model of
money markets to examine the effect of changes
in the economy on money market rates and;
• Characterize the effects of changes in monetary
policy