Chapter One
Why Study Money,
Banking, and Financial
Markets ?
We study money because :
• 1. Its growth rate may be a driving force
behind inflation .
• 2. Money plays an important role in generating
the business cycle i.e. upward and downward
movement of aggregate output in the economy
3. Money plays an important role in the
fluctuation of interest rate . Therefore :
To see how money create inflation , we need
to study the monetary policy .
• Also, we will study the link between the money
and the business cycle when we study the
monetary policy .
• Also, we will analyze the relationship between
money and interest rate when we examine the
behavior of interest rate .
• In a later chapter, we will study how central
bank can affect the quantity of money in the
economy .
Why do we study Banking ?
• Banks are important to our study of money in the
economy because :
• 1. They provide a channel for linking those who
•
wants to save with those who wants to invest.
• 2. They play an important role in determining
•
the quantity of money in the economy. For this
reason we will study how banks decide to make
loans and how money supply is determined .
Why do we study financial
markets ?
• Financial Markets are markets in which
funds are transferred from people who have
excess of available funds to people who have a
shortage of funds . Examples Bond market or
stock market.
• These markets are important in channeling funds
from people who do not have a productive use
for them to those who do . This process results in
greater efficiency .
Bond Market and interest rates
• The Bond Market is important to economic
activities because it enables corporations or
governments to borrow to finance their activities
• The interest rate is the cost of borrowing
money or the price paid for the rental funds .
• Interest rates have an impact on the overall
health of the economy because they affect
consumers willingness to spend or save and
business investment decisions . Note : We will discuss
the fluctuations in interest rate in chapters 4 through 6 .
The Stock Market
• The Stock Market : Is the financial market where
the shares of different corporations are traded .
• Issuing stock and selling it to the public is a way for
corporations to raise funds to finance their activities
• Higher price for a firm’s shares means that it can
raise a larger amount of funds which can be used to
buy production facilities and equipment .
• Note : in chapter 2 , we will examine the role of the
stock market in the financial system .
The Foreign Exchange Market
For funds to be transferred from one country to
another, they have to be converted from the currency
in the country of origin ( say dollar ) into the
currency of the country they are going to ( say euros )
.
The Foreign Exchange Market is where this
conversion takes place . It is important because it
moves funds between countries and it is the place
where the foreign exchange rate is determined . In
chapter 17 we will study how exchange rates are
determined in the foreign exchange market .
Why Study Financial Markets ?
• 1. Channels funds from savers to
investors,thereby promoting
economic efficiency.
• 2. Affect personal wealth and
behavior of business firms .
Why Study Financial Institutions
and Banks ?
• 1. Financial Intermediation helps get
funds from savers to investors .
• 2. Banks play an important role in
the creation of Money .
• 3. Financial Innovation .
Chapter 2
An Overview
of the Financial System
Function of Financial Markets
• Perform the essential function of channeling funds
from economic players that have
saved surplus funds to those that have a shortage of
funds
• Promotes economic efficiency by producing
an efficient allocation of capital, which increases
production
• Directly improve the well-being of consumers by
allowing them to time purchases better
Structure of Financial Markets
• Debt and Equity Markets
• Primary and Secondary Markets
– Investment Banks underwrite securities in primary markets
– Brokers and dealers work in secondary markets
• Exchanges and Over-the-Counter (OTC) Markets
• Money and Capital Markets
– Money markets deal in short-term debt instruments
– Capital markets deal in longer-term debt and
equity instruments
Internationalization
of Financial Markets
• Foreign Bonds—sold in a foreign country and
denominated in that country’s currency
• Eurobond—bond denominated in a currency other
than that of the country in which it is sold
• Eurocurrencies—foreign currencies deposited in
banks outside the home country
– Eurodollars—U.S. dollars deposited in foreign banks
outside the U.S. or in foreign branches of U.S. banks
• World Stock Markets
Function of Financial
Intermediaries: Indirect Finance
• Lower transaction costs
– Economies of scale
– Liquidity services
• Reduce Risk
– Risk Sharing (Asset Transformation)
– Diversification
• Asymmetric Information
– Adverse Selection (before the transaction)—more likely to select
risky borrower
– Moral Hazard (after the transaction)—less likely borrower will
repay loan
Function of Financial Markets
• The basic function of financial market is to
move the funds from those who have surplus
funds ( Savers – Lenders) to those who have
shortages of funds ( borrowers or spenders ) .
• The fund can be transferred either through :
1. Direct Finance ( Financial Market )
2. Indirect Finance (Financial Intermediaries)
Direct Finance
• Borrowers borrow money
directly from the lenders in
the financial market by selling
securities (Bonds).
Indirect Finance
• Funds can move from lenders to
borrowers by a second route
through the financial intermediaries
who borrow funds from the lenderssavers and then make loans to
borrowers or spenders .
Structure of Financial Market
• There are two ways a firm or an individual
can obtain funds in the financial market .
• 1. By issuing Debt Instruments
( Bonds )
• 2. By issuing Equity Instruments
( Common Stock )
Bonds
•
•
•
•
•
Pay fixed interest rate and has a maturity date .
Bonds, can be classified as :
1. Short-Term Bonds: maturity less than one year
2. Intermediate-Term Bond (maturity 1-10 years )
3. Long-Term Bond : maturity more than 10 years
Money Market
• Financial Market in which only ShortTerm Debt Instruments are traded . Such
as :
• U.S. Treasury bills
• Negotiable bank certificates of deposit
• Commercial Paper
• Banker’s acceptance , etc.
Capital Market
• Financial market in which Intermediate
as well as Long-Term instruments are
traded .
• Example :
• Corporate Stocks
• Corporate Bonds
• Government Bonds
• Bank commercial loans . etc.
Primary Market
• Is a financial market in which
new issues of securities such as
Bonds or Stocks are sold to
initial buyers by corporation or
government agency borrowing
the funds .
Secondary Market
• Is a financial market in which the
securities that have been previously
issued can be sold .
• The secondary market can be divided
into two types :
1. Organized Exchange Market
2. Over-the-counter (OTC) Market
Organized Exchange Market
• Is a financial market where buyers
and sellers of securities meet at one
central location to conduct trade.
Example :
• New York Exchange Market .
• Tokyo Exchange Market … etc.
Over-the-counter Market
• Is a financial market where
dealers at different locations buy
and sell securities over the
counter .
Example :
• The current financial market in
Saudi Arabia .
Function of Financial
Intermediaries
• The Basic function of financial
intermediaries is to move funds from
lenders to borrowers through the
indirect finance .
Types of Financial Intermediaries
• 1. Depository Institutions such as Banks .
• 2. Contractual Saving Institution such as Life
Insurance Company .
• 3. Investment Intermediaries such as Mutual
Funds or Money Market Mutual Funds .
I. Depository Institutions
•
•
•
•
•
Example :
A. Commercial Banks .
B. Saving & Loan Associations .
C. Mutual Saving Banks .
D. Credit Union .
Commercial Banks
• Raise Funds by issuing Deposits accounts
Such as -Demand deposits
- Saving Deposits
- Time Deposits
• And then use these funds to :
- Make consumer loans
- Make Business loans
- and buy securities .
Saving & Loan Associations
• Before 1980 they Raise Funds by making
Saving deposits only
• And use the funds to make Mortgage
loans only .
• Since 1980 they open all kinds of deposits
• And make consumers & business loans
and buy securities .
Mutual Saving Banks
• Since 1980 they raise funds by opening all
kinds of deposits and make consumers and
business loans and buy securities .
• The difference between Mutual Saving banks
and Saving & Loans Association is that
Mutual Saving banks function as mutual
which means cooperation where depositors
own the bank .
Credit Union
• Raise Funds as deposits from the union’s
members or employees of particular firm
• And use the Fund to make consumer
loans only to its members .
II. Contractual Savings
Institutions
•
•
•
•
•
Example:
1. Life Insurance Company .
2. Pension Funds .
3. Fire & Casualty Insurance companies .
They raise funds on a contractual basis and
use these funds by investing them in Longterm securities such as corporate bonds and
stocks .
III. Investment Intermediaries
•
•
•
•
Such as :
1. Mutual Funds
2. Money-Market Mutual Funds
3. Finance Companies
Mutual Funds
• Raise Funds by issuing shares to
many individuals .
• And use the Funds to buy stocks
and bonds of long-term securities
Money-Market Mutual Funds
• Raise Funds by issuing shares to many
individuals .
• And use the Fund to buy money market
instruments such as commercial papers,
Treasury bills ,etc. that are both safe and
very liquid .
Finance Companies
• Raise Funds by selling commercial
papers , stock, and bonds .
• And use the Funds to make consumers
and business loans .
CHAPTER 3
What is Money?
Definition of Money
• Economists define money as :
• “ Anything that is generally
accepted in payment for goods or
services or in the repayment of
debts .
Barter Economy
• Is an economy where
one good is being
exchanged directly
for another good .
Wealth and Money
• Wealth is much broader concept
than money. It includes money
plus all other assets owned by the
individual such as Bonds , Stock,
Land, Furniture, Cars, Houses,
etc.
Income VS. Money
• Income is a Flow of earning per
unit of time ( day, week, month,
year, etc. ) .
• Money is a Stock , i.e. certain
amount at a given point in time .
Functions of Money
• 1. Act as a medium of
exchange .
• 2. Act as a unit of Account .
• 3. Act as a store of value .
1. Money act as a medium of
Exchange
• This means that money is used to pay for
goods and services.
•Goods Money Goods
• The use of money as a medium of exchange
promotes economic efficiency by reducing the
transaction cost .
Barter Economy
• Exchanging one good for another good .
• In this economy, the Transaction cost is very
high because people have to satisfy what is
called “ Double Coincidence of Wants “ which
means that : “ They have to find someone who
has what they want, and in the same time he
wants what they have . “ But , in money
economy , you can sell what you have for
money and then use the money to buy what
you want .
II. Money Act as a Unit of Account
• Money is used to measure the
value in the economy .
• We measure the value of goods
and services in terms of money .
III. Money act as a Store of Value
• Money is a store of purchasing power over time.
• You can sell what you have for money and then
store your money until you have the time and
desire to buy .
• Money is not the only asset that has this
function. Other assets such as Bonds, Stocks,
Houses, Land, etc. have this function as well .
Why people do hold money ?
• Money is the most liquid asset
• Money is the medium of exchange .
• Money does not have to be converted to
anything else to make the purchase .
• How good money as a store of value ?
• This depends on the price level , so if
• Price level double , the value of money dropped
in half . So money losses value during inflation
when the price level rises .
Evolution of the Payments
System
•
•
•
•
•
Commodity Money
Fiat Money
Checks
Electronic Payment
E-Money
Commodity Money
• Money made up of precious metals or
another valuable commodity is called
commodity Money .
• Commodity money functioned as the
medium of exchange in all but the most
primitive societies .
• Such form of money is very heavy and hard
to transport from one place to another .
Fiat Money
• This is a paper currency decreed by government
as legal tender .
• It must be accepted as payment for debt,but not
convertible into coins or precious metal .
• Major drawbacks of paper currency that they
are easily stolen. This problem took us to
another step in the evolution of payment system,
the invention of checks .
Checks
• It is an instruction from you to your bank to
transfer money from your account to
someone else’s account when he deposits
the check.
• Checks allow transactions to take place
without the need to carry around large
amounts of currency . This improved the
efficiency of the payment system
Electronic Payment
• Banks now provide a web site in which you
just log on, make a few clicks and thereby
transmit your payment electronically.
E-Money
• Electronic payments technology can not
only substitute for checks, but can substitute
for cash as well in the form of electronic
money or e-money.
• E-money is money that exists only in
electronic form such as debit card which
look like the credit card .
• Debit card transfer funds directly from the
consumer bank account to a merchant’s
bank account.
Measuring Money
• To measure money, we need a precise
definition that tells us exactly what assets
should be included .
• There are different definitions for money
or money supply. These definitions vary
in terms of what deposits are included.
• There is Narrow definition as well as
broad definition of money .
Narrow definition of Money,M1
• M1 = currency in circulation + Any checkable Deposits
•
• M1 = C + DD + NOW deposits + ATS deposits
•
+ Traveler’s Checks + any other checkable deposits
• Where :
• NOW deposits= Negotiable Order of Withdrawal
• ATS = Automatic Transfer Service .
Broader Definition of
Money,M2 and M3
• M2 = M1 + Saving deposits +Small Time deposits
• M3 = M2 + Large denomination of Time deposits
CHAPTER 4
Understanding Interest Rate
Definition
• Interest rate is defined as :
The cost of borrowing .
Economists usually call it
“ Yield to Maturity “
Measuring Interest Rate
• In the credit market, there are four types
of credit instruments . These are :
•
•
•
•
1. Simple Loan
2. Fixed Payment Loan
3. Coupon Bond
4. Discounted Bond
Yield to Maturity
• It is the interest rate that equates the present
value of payments received from debt
instrument with its value today.
• Therefore, it is the interest rate that makes :
• PV of future cash flow = Net investment
•
( value today )
• Therefore, How the yield to maturity is
calculated for the 4 types of credit market
instruments ?
Simple Loan
•
•
•
•
Assume you are given the following :
Net investment = $ 10,000
Future value after one year = $ 11,000
Find the yield to maturity for this
investment ?
The Answer
• The yield to maturity can be calculated as :
• PV of net investment = PV of Future
•
payment
•
10,000
= 11,000 .
1
(1+i )
10,000 + 10,000 i = 11,000
10,000 i = 1,000 Therefore i = 1000 . = 10%
10,000
Conclusion
• Therefore, for a simple loan, the yield to
maturity equals the simple interest rate
because :
• The simple interest rate = amount of interest
•
amount of the loan
• The simple interest rate = 1000 . = 10 %
•
10,000
Fixed Payment Loan
• Assume you are given the following data :
•
The amount of loan at t=0 is $ 1000
•
Fixed payment = $ 126 per year
•
n = 25 years
Required : Find the Yield to maturity or i ?
The Answer
•
•
•
•
•
•
PV of net Investment = PV of future payments
1000 = 126 + 126 + 126 + ……….. + 126
1
2
3
25
(1+i ) (1+i ) (1+i ) ………… (1+i )
By trial and error, we see that i = 12 %
Or by using the table of PVIFA as follows :
The Answer continue
1000 = A ( PVIFA, i , n )
• 1000 = 126 ( PVIFA, i , 25 )
• 1000 = ( 7.9365 )
• 126
• Looking for this factor (7.9365) cross n = 25
• we see that i fall between 11% and 12%
• By interpolation we see that i = 11.84%
• i = 11 % + 8.422 – 7.9365 (0.01) = 11.84 %
•
8.422 – 7.843
Coupon Bond
• To calculate the yield to maturity for a coupon
bond, we have to equate :
• Net investment = PV of all
+ PV of
• of the Bond
coupon payment Face value
• Example : Given that Face value = $ 1000
•
Coupon rate 6% compounded semiannually,
•
market price = $900 , Maturity = 7 years .
The Answer
• PV of net = PV of all
+ PV of face value
• Investment coupon payment
of the bond
• 900
= A ( PVIFA, i , 14) + F ( PVIF, i ,14)
• since we have two different factors, the solution to i
must be by Trial and Error : Example if we try 3%
• 900 = 30 ( 11.296 ) + 1000 ( 0.661 )
• 900 = 338.88 + 661
• 900
999.8 or approximately 1000
Answer continue
• Now, if we try 4 % , then
•
•
•
•
•
900 = 30 (PVIFA, 4%, 14) + 1000 (PVIF, 4%,14)
900 = 30 ( 10.563 ) + 1000 ( 0.577 )
900 = 316.89 + 577
900
893.89 approximately 894
Therefore, the value of the interest rate or the yield
to maturity fall between 3% and 4% and by
interpolation i = 3% + 1000 – 900 (0.01 ) = 3.94%
•
1000 - 894
Note
• There are Bonds Tables that have been
created which allow you to read off the
yield to maturity for a bond given its
coupon rate and its years to maturity as
well as its market price .
Yield to Maturity on a 10% coupon rate ,Bond
maturing in 10 years with face value $1000
• Price of Bond
• $ 1200
•
1100
•
1000
•
900
•
800
• and so on .
Yield to Maturity
7.13 %
8.48 %
10.00 %
11.75 %
13.81 %
Note
• There are 3 facts shown by the Table :
• 1. When coupon bond is priced at its face value, then
•
the yield to maturity = the coupon rate
• 2. The price of a coupon bond and the yield to
maturity are negatively related .
• 3. When the the bond is priced below the face value,
then the yield to maturity > the coupon rate and
when the bond priced above the face value, then
•
the yield to maturity < the coupon rate
Perpetual Bond ( Consol )
• This is a bond with no maturity date and
no repayment of principal .
• To calculate the yield on this bond , i :
•
i = C where C = fixed payment
•
Pc
Pc = price of consol
• Also, to find the price of this bond , Pc
• Pc = C where i = the yield or the
•
i
market interest rate
Example
• Given the following data :
•
•
•
•
•
•
•
•
The fixed payment or C = $100 per year for ever
The market interest rate, i = 10%
Find the market price of this bond or
Find the present value of this bond ?
Price of the Bond = $100 = $ 1000
0.10 and if ( i ) rises to 20%
Price of bond = $ 100 = $ 500
0.20
Discount Bond
• The yield to maturity for a discount bond
is similar to that for a simple loan , so we
need to equate PV of bond with PV of the
future cash flow as follows :
• PV0 = FV
•
n
•
(1+i)
Example
• If a discounted bond ( with 1 year maturity ) pays
off face value of $1000 in one year and the
current purchase price is $ 900 , what is the yield
to maturity ?
•
PV = FV
or i = F - Pd
(1+i)
Pd
900 = 1000 or i = 1000 – 900 =11.1%
1+i
900
900 + 900 i = 1000 therefore i = 11.1%
Other Measures of Interest Rates
• 1. Current Yield
• 2. Yield on a Discount Basis
• 1. Current Yield, or ic :
• It is the yearly coupon payment divided by
• the price of the bond . Therefore,
•
ic = C Where C = coupon payment
•
Pb
Pb = price of bond
Example
• Given the following data :
• Pb = $ 930 ; C = $ 100 Find ic ?
• Since ic = C = 100 = 10.75 %
•
Pb 930
• When Pb = Par value , then
• Current yield, ic always equals to coupon rate
Example
• Given the following data below, find the current
yield ?
Price of Bond = $ 1000
•
Coupon Rate = 5 %
• Therefore, the current yield = C = 50 = 5%
•
Pb 1000
• Since yield to maturity = coupon rate when Pb = F
• Since coupon rate = current yield also when Pb = F
• Therefore, Yield to maturity = current yield when Pb = F
Current yield - continue
• Current yield is negatively related to the price of the
bond . Example : Given the following data below :
•
Price of Bond = $1000 ; Par value $1000 , and
•
the coupon bond = 10 % ; Find the current yield?
•
Current yield = C . = 100 = 10%
•
Pb
1000
• Now if price of bond rises from $ 1000 to $1200 ,
what is the current yield ?
• Current yield = 100 = 8.33 %
•
1200
Yield on Discount Basis or
(Discounted Yield )
• This yield is defined as : idb
• idb = F – Pd X
360
.
•
F
# of days to maturity
• Where idb = yield on discount basis
•
F = Face value
•
Pd = purchase price of discount bond
Example
• Given the following data below, calculate the
yield on discount basis ?
•
Face value of the bond = $1000
•
Purchase price = $ 900
•
Maturity = 1 year ( 365 days )
• idb = 1000 – 900 X 360 = 0.0986 or 9.86%
•
1000
365
The Distinction Between Interest rate and
Returns
• The rate of return for any security is :
• The payment to the owner Plus
• The change in its value expressed as a ratio to its
purchase price .
•
RET = C + ( Pt+1 – Pt ) = C + Pt+1 – Pt
•
Pt
Pt
Pt
RET = ic + g
where : Pt+1 = the price at time t+1
Pt = the price at time t ; ic = current yield
•
g = rate of capital gain
Example
• Given the following data below, calculate the
rate of return , RET ?
• Face value of the bond = $ 1000
• Coupon rate = 10%
• Purchase price at time t = $ 1000
• Held for one year and sold at t+1 for $ 1200
• RET = 100 + ( 1200 – 1000 ) = 300 = 30 %
•
1000
1000
The Distinction Between Real and Nominal
Interest Rates
• Nominal interest = Real interest + Expected rate
•
rate
rate
of inflation
• Real interest rate = Nominal interest – Expected rate
•
rate
of inflation
• For real interest rate to remain constant, the
nominal interest rate must change by the same
percentage as the expected rate of inflation .
CHAPTER 5
The Behavior of
Interest Rates
Note
•
•
•
•
•
•
•
•
In this chapter , we will discuss :
1. How the interest rate is determined ?
2. What factors influence the interest rate
behavior .
3. Why bond prices change .
4. The use of supply & demand analysis
for bond markets and money markets
to examine how interest rates change.
Note
• Since we know that there is a negative
relationship between the interest rate and the
price of the bond , we can explain why
interest rate fluctuate by explaining why
bond prices change .
• Therefore, our first approach to the analysis
of interest rate determination looks at supply
and demand in the Bond market .
Supply & Demand in the Bond Market
• Assume you are given the following demand and
supply schedule for one-year discounted bond
with face value of $ 1000 .
• Price of bond
•
•
$ 950
•
900
•
850
•
800
•
750
Quantity demanded
of Bond
100
200
300
400
500
Quantity supplied
of Bond
500
400
300
200
100
Market Equilibrium
• Occurs when the amount that people are willing to
buy (demand) equals the amount
that people are willing to sell (supply) at a given
price
• When Bd = Bs  the equilibrium (or market
clearing) price and interest rate
• When Bd > Bs  excess demand  price will rise
and interest rate will fall
• When Bd < Bs  excess supply  price will
fall and interest rate will rise
Notes
• The equilibrium point is where
• Quantity demand of Bonds = Quantity Supplied of Bonds
•
300
300
• If Actual Price of bond < Equilibrium price ,then
• Quantity demanded > Quantity supplied
•
of bonds
of bonds
• This will create Excess demand for bonds and put
pressure on prices of bonds to go up .
Notes - continue
• If the actual price > equilibrium price of bond
•
$ 900
$ 850
• This will create Excess supply of Bonds, and
this will put pressure on prices of bonds to go
down .
• Only when actual price = equilibrium price
•
$ 300
$ 300
• There is no pressure on prices to go up or
down . ( excess demand & supply = zero )
Equilibrium Interest rate
• Given the demand & supply schedule of bonds,
we can find the equilibrium interest rate :
•
•
•
•
•
•
•
•
Price of Quantity demanded Quantity supplied interest rate
$ 950
100
500
5.3 %
900
200
400
11.1%
850
300
300
17.6%
800
400
200
25 %
750
500
100
33 %
The equilibrium interest rate = 17.6%
Because at that point Quantity demanded of bonds = quantity
supplied of bonds = 300 .
i = RET = F- P
P
•
•
•
•
•
•
•
Example :
Price of Quantity Quantity
bond demanded supplied
$ 950
100
500
Since the face value of this bond = $ 1000
Therefore, i= 1000 – 950 = 0.053 = 5.3%
950
And so on .
Interest rate and Quantity
Exchanged of Bonds
• We can show the relationship between interest
rate and quantity demanded and quantity
supplied ( quantity exchanged ) of bonds as
follows :
• Interest rate Quantity demanded Quantity supplied
•
5.3 %
100
500
•
11.1%
200
400
•
17.6 %
300
300
•
25.0 %
400
200
•
33.0 %
500
100
Changes in equilibrium interest rate
• Any shift in supply or demand
curves of bonds create new
equilibrium value of interest rate .
• Therefore, what causes the shift in
demand or supply curves ?
Factors that causes shift in
Demand Curve for Bonds
•
•
•
•
•
1. Wealth
2. Expected Returns
3. Expected inflation
4. Risk
5. Liquidity
Shifts in the Demand for Bonds
• Wealth—in an expansion with growing wealth, the demand
curve for bonds shifts to the right
• Expected Returns—higher expected interest rates in the
future lower the expected return for long-term bonds,
shifting the demand curve to the left
• Expected Inflation—an increase in the expected rate of
inflations lowers the expected return for bonds, causing the
demand curve to shift to the left
• Risk—an increase in the riskiness of bonds causes the
demand curve to shift to the left
• Liquidity—increased liquidity of bonds results in the
demand curve shifting right
Factors that shift the supply curve of bonds
• 1. Expected profitability of investment .
• 2. Expected inflation .
• 3. Government deficit .
Shifts in the Supply of Bonds
• Expected profitability of investment
opportunities—in an expansion, the supply
curve shifts to the right
• Expected inflation—an increase in
expected inflation shifts the supply curve
for bonds to the right
• Government budget—increased budget
deficits shift the supply curve to the right
Change in Equilibrium Interest Rate
• Shift in the demand curve of bond to the right, holding
the supply curve constant , causes the interest rate to fall
.
• Shift in the demand curve to the left, holding the supply
curve constant, causes interest rate to rise
• Shift in the supply curve to the right, holding the
demand curve constant, causes interest rate to rise.
• Shift in supply curve of bond to the left , holding the
demand curve constant, causes the interest rate to fall .
Change in Expected Inflation
( Fisher’s Effect )
• Since real interest = Nominal – Expected Inflation
•
rate
interest rate
rate
• As expected inflation rises, real interest rate falls , so
cost of borrowing falls and supply of bond increases
which shift supply curve to the right .
• But , also, as expected inflation rises, and real interest
rate falls, expected return on bonds falls , so demand on
bond will decrease , and that shift the demand curve to
the left . So What will happen to the interest rate ?
Case # 1 : If No One Curve Dominate
• This means If supply curve
shift exactly by same size as
the shift in demand curve,
then interest rate will
increase, but the quantity
exchanged of bonds will not
change .
Case #2 If supply curve dominate the shift
• This means that :
• Shift in supply curve > shift in demand curve
• In this case both the interest rate
and the quantity of bond exchanged
will rise .
Case #3 If the demand curve dominate the shift
• This case means : as expected inflation rises
• Shift in demand curve > the shift in supply curve
•
to the left
to the right
• In this case, interest rate will increase ,
but the quantity of bond exchanged will
decrease .
Conclusion
• When expected inflation rise , we see that
interest rate rises in all three cases . This
result has been named as Fisher’s Effect.
• While the quantity of bond exchanged
could rise, fall , or remain constant
depending on which curve (supply or
demand ) will dominate the shift .
The effect of Business cycle expansion on
interest rate
•
•
•
•
During Business cycle expansion (Booms ) :
- Production of Goods & Services increase
- This increase National income , and
- encourage firms to borrow to finance new
investment . Therefore :
• During Booms activities both demand and
supply of bonds increase , so demand and
supply curves of bonds shift to the right .
What will happen to interest rate ?
• During the business cycle expansion both
demand & supply curves shift to the right
• This will increase quantity exchanged of
bonds .
• But, interest rate could rise , fall, or remain
constant depending on which curve dominate
the shift .
Conclusion
• During Booms activities or Business cycle
expansion both demand curve for bonds and
supply curve of bonds will shift to the right .
• This shift will increase quantity exchanged of
bonds, but the interest rate could rise , fall ,
or remain constant depending on which
curve will dominate the shift .
Liquidity Preference Framework or
(supply & demand in the money market)
• This model is developed by John Maynard
Keynes .
• This model determines the equilibrium
interest rate in terms of supply & demand of
money.
• Keynes made the following assumptions :
Keynes Assumptions
• There are only 2 assets (money & Bonds)
that people use to store their wealth .
•
W = M + B ……………….. ( 1 )
• The quantity of Bonds & Money supplied
must equal quantity of Bonds & Money
demanded s
s
d
d
•
B + M = B + M ….. (2 )
Keynes assumption-continue
•
•
•
•
•
•
Equation # 2 can be written as :
s d
d
s
B - B = M - M ………………….. ( 3 )
Equation # 3 tells us that :
s d
If money market is in equilibrium (M = M )
This implies that Bonds market is also in
equilibrium .
Keynes Assumptions
• Keynes assume that money has zero rate of
interest and bonds have expected rate of return
equal to the market interest rate .
• As the market interest rate rises, other things
being equal, the expected return on money falls
relative to expected return on bond . This causes
demand for money to fall . Therefore , there is
negative relationship between interest rate and
the demand for money .
Changes in equilibrium interest rate
• Any shift in the demand for money or in
the supply of money curves will change
the equilibrium interest rate.
• So, what causes the shift in the demand
or supply of money ?
Shift in Demand for Money
• Based on Keynes Liquidity
Preference analysis , there are
two factors that shift the demand
curve for money :
• 1. Income
• 2. Price level
Shift in Supply Curve of Money
• An increase in the money supply shift the
supply curve of money to the right , and
that decreases the interest rate .
• Therefore :
• Does a higher rate of growth in the
money supply lower the interest rate ?
Does a higher rate of growth in money
supply lower the interest rate ?
• The Liquidity Preference Analysis seems to
lead to this conclusion that :
• As money supply rises , interest rate falls
• But, Milton Friedman said, the above
conclusion would be true only if everything
else held constant. And he said that as money
supply rises may create other effect (such as
Income , price level , expected inflation )
which could lead to higher interest rate .
CHAPTER 6
Risk and Term Structure
of Interest Rate
In this Chapter we will study
•
•
•
•
•
•
•
•
1. Why Bonds with the same term to maturity
have different interest rate ?
2. Why Bonds with different term to maturity
have different interest rate ?
3. Sources and causes of fluctuations in interest
rate relative to one another .
4. a number of theories that explain these
fluctuations .
Risk Structure of Interest Rates
• The relationship among different
interest rates on bonds with the
same maturity is called :
• “ Risk Structure of Interest rate”
Factors that causes the interest rates to be
different among bonds with same maturity
• 1. Default Risk
• 2. Liquidity
• 3. Income tax considerations .
Default Risk
• A risk that the issuer of the bond
might not be able to make the
interest payment or pay off the face
value of the bond at the maturity
date .
• Bonds with no default risk are called
• “ Default-Free Bonds “
Risk Premium
• Risk
= Interest on - Interest on
• Premium
Bonds with
Default – Free
•
Default risk
Bonds
• 5%
= 15 %
10 %
Liquidity
• How quickly and cheaply can an asset be
converted into cash is called “Liquidity”.
• The more liquid an asset is , the more
desirable it is . Therefore :
• The less liquid a bond, other things being
equal, the higher its interest rate will be
relative to more liquid securities .
Income Tax Consideration
• Why some bonds have lower interest rate
than others ?
• Because, interest payment on some bonds
Example ( Municipal Bonds ) are
exempted from income tax which has
some effect on increasing the expected
return .
Term Structure of Interest Rates
• Bonds with identical risk, liquidity , and
• Tax considerations may have different
interest rate because of different terms to
maturity .
• Showing the yield on bonds with different
terms to maturity , but with same risk,
liquidity, and tax considerations, give us
what is called “ Yield curve “ .
The Yield Curve
•
•
•
•
The yield curve can be :
1. Upward sloping
2. Downward sloping
3. Flat curve .
Why the Yield curve differ ?
• Why do we most often see an upward
sloping yield curve ? And sometimes we
see other shapes ?
• There are 3 theories that explain the
Term Structure of Interest Rates :
• 1. Expectations hypothesis theory
• 2. Segmented market theory
• 3. Preferred habitat theory
Expectations Theory
• Based on this theory :
• The interest rate on a long-term bond will equal an
average of short-term interest rates that people
expect to occur over the life of the long-term bond.
• The key assumption behind this theory that
• 1. Both L-T & S-T Bonds are perfect substitutes , so
buyers of bonds do not prefer bonds of one
maturity over another . 2. Expected return on
these bonds must be equal .
The Yield Curve
• When the yield curve is upward sloping, then
the Expectation hypothesis suggest that :
• S-T interest rate are expected to rise in the
future , therefore :
• Long-Term interest > Current S-T interest
• Example: If the interest on one-year b ond is
expected as follows : 3% ; 7% ; 8% , 10%
what is the L-T interest on 2 , 3, and 4 years?
Downward Sloping Yield Curve
• When the short-term interests are expected
to fall in the future, then the yield curve slope
downward indicating that :
• Long-Term interest < Current S-T interest
• Example: If the interest on one-year bond is
expected as follows : 8% ; 7% ; 6% ; 3%
• What is the L-T interest for 4-year Bond ?
Flat Yield Curve
• In this case , the expectation hypothesis
suggest that short-term interests are not
expected to change in the future , therefore :
• Long-term interest = Current S-T interest
• Example: If the short-term interest on 1 year
bond is expected as follows : 8% ; 7%; 9% ;
and 8% what is Long-T interest on 4 year
bond ?
Term Structure Facts
• 1. Fact # 1 :
•
Short and Long rates move together
• 2. Fact # 2 :
• Yield curve tend to have upward slope
•
when short rates are low , and downward
• when short rates are high .
• 3. Fact # 3 : Yield curve is usually upward
• sloping .
Expectations Hypothesis
• 1. It explains Fact # 1 that short and long
• rates move together .
• 2. It explains Fact # 2 that the yield curve
• tend to slope upward when short rates
• are low and slope downward when
• short rates are high .
• 3. It Does not explain Fact # 3 that yield
• curve usually has upward slope .
Segmented Market Theory
• Market for different maturity bonds are
completely separate and segmented.
• Interest rate for each maturity bond is
determined by supply & demand for that
maturity bond.
• Bonds of different maturity are not substitute
at all .
Assumption of Segmented Market Theory
• Bonds of different
maturities are not
substitutes at all .
Implication
• Markets are completely
segmented .
• Interest rate at each
maturity determined
separately .
Segmented Markets Theory
• 1. Explains Fact # 3 that yield curve is
usually upward sloping , because people
prefer short-term bonds relative to longterm bond . This make higher demand
for short-term bonds which have higher
price and lower interest rate than the
long-term bonds . Hence the yield curve
will slope upward .
The Segmented Theory: Does not
explain Fact 1 & 2
• 2. This theory does not explain why interest rates
•
on bonds of different maturity tend to move
•
together ( Fact # 1 ) .
• 3. This theory can not explain why yield curve s
•
tend to slope upward when short-term
•
interest rates are low and to slope downward
•
when short-term interest rates are high
because it assumes long-t and short –t rates are
determined independently .
Liquidity Premium and Preferred
Habitat Theories
• This theory of term structure states :
• “ Interest rate on Long-term bonds
will equal an average of short-term
interest expected to occur over the
life of the long-term bond Plus a
liquidity premium that responds to
supply & demand conditions for that
bond .
Key Assumptions
• 1. Bonds of different maturities are substitutes ,
• but are not perfect substitutes .
• 2. Expected return on one bond does influence
•
the expected return on a bond of a different
• maturity .
• 3. Investors prefer short-term bonds , so they
must be offered a positive liquidity premium to
induce them to hold long-term bonds .
Numerical Example
• Given the following interest rate for a One-year
bond over the next five year s :
• 5 % ; 6% ; 7 % ; 8% ; and 9 %
• Also, you are give the term premium for One to
Five –year bonds :
• 0 % ; 0.25 % ; 0.5 % ; 0.75 % ; 1 %
• Find the interest rates on One to Five- year bonds
• Answer : 5% ; 5.75 % ; 6.5% ; 7.25% ; and
8% .
Preferred Habitat Theory or
( Liquidity Premium Theory )
• This theory explains all 3 facts .
• 1. It explains Fact # 3 which says that
Yield curve usually slope upward because
it assume investors prefer short-term
bonds .
• 2. It explains Fact 1 & 2 using same
expectations as expectations hypothesis .
Liquidity Premium Theory
int 
e
e
e
it  it1
 it2
 ... it(
n1)
 lnt
n
where lnt is the liquidity premium for the n-period bond at time t
lnt is always positive
Rises with the term to maturity
Preferred Habitat Theory
• Investors have a preference for bonds of one
maturity over another
• They will be willing to buy bonds of
different maturities only if they earn a
somewhat higher expected return
• Investors are likely to prefer short-term
bonds over longer-term bonds
Liquidity Premium and Preferred
Habitat Theories, Explanation of the
Facts
• Interest rates on different maturity bonds move together
over time; explained by the first term in
the equation
• Yield curves tend to slope upward when short-term rates are
low and to be inverted when short-term rates are high;
explained by the liquidity premium term in the first case and
by a low expected average in the second case
• Yield curves typically slope upward; explained
by a larger liquidity premium as the term to
maturity lengthens
CHAPTER 13
Multiple Deposit Creation and the
Money supply Process
Note
• This chapter will focus on :
• - How the banking system creates deposits?
• - The basic concepts needed to understand
how the money supply is determined ?
The Players in the Money Supply Process
•
•
•
•
1. The Central Bank
2. Banks ( Depositary Institutions )
3. Depositors
4. Borrowers
1. The Central Bank
• Is the Government Agency that regulate
the banking system .
• It is owned and operated by the
government .
• It is responsible for conducting the
monetary policy .
2. Banks
• These are financial
intermediaries that accept
deposits from individuals , firms
and government , and use these
deposits to make loans .
3. Depositors
• Individuals , firms , and
government who hold deposits in
the banks .
4. Borrowers
• Individuals , and institutions that
borrow from the depository
institutions . Or
• Institutions that issue Bonds that
are purchased by depository
institutions .
The Central Bank Balance Sheet and
The Monetary Base
• The central bank has its own balance sheet as
any other bank .
• The Balance Sheet consist of Assets and
Liabilities .
• We will focus on 4 items that are essential for
the money supply process .
Central Bank Balance Sheet
• Assets
Liabilities
• _________________________________________
• Government Bonds
Currency in circulation
• Discount Loans
Reserves
The Liabilities
• Currency in circulation Plus Reserves are
called “ Monetary Base “
• MB = C + R
• Reserves : include deposits at the central
bank plus currency held by bank ( Vault
cash ) .
The Assets
• Any change in the Assets leads to change
in reserves and in turn leads to change in
money supply . Example :
• If the central bank purchase government
bonds , it will increase its holding of
government bonds and in the same time
it will increase The Reserves , so that will
increase the money supply .
Example
• If the central bank purchase government bonds
worth of $ 100 million from commercial bank ,
then :
• Central Bank Balance Sheet
• Assets
Liabilities
.
• Government Bonds + 100 Reserves + 100
Control of Monetary Base
• MB = C + R
• The central bank can control the
MB by using two factors :
• 1. Open market Operations .
• 2. Making Discount Loans to
Banks .
1. Open Market Operations
• Is the process of Buying or Selling
government bonds in the financial
market . This process can be divided into
• A. Open market purchase Increase MB
• B. Open market sale
Decrease MB
Example
• If central bank purchase government bonds from a
bank ( say NCB ) or from Non-bank public (
individual or a firm) who deposit the proceeds in a
bank, then
• Reserves will increase and Currency in circulation
will remain constant, but MB will increase
• If the Non-bank public cashes the check, then
Currency in circulation will rise and Reserves will
remain constant, but MB will rise .
Therefore
• If the central bank would like to increase
the monetary base, it should conduct
open market purchase .
• If the central bank would like to decrease
the monetary base, it should conduct
open market sale .
II. Making Discount Loans
• Assume the central bank made a loan of
SR 100 million to NCB. What will happen
to the balance sheet of NCB ? And to the
balance sheet of the central bank ?
• Since MB = C + R
• Thus as DL rises , R rises , so
• MB will rise as well .
Balance sheet of NCB
• Assets
• Reserves + 100
Liabilities
Discount loan + 100
.
Monetary Base, MB
•
•
•
•
•
•
MB = C + R
Or
MB = MB n + DL
Where :
MB = Monetary Base
MB n = Non-borrowed Monetary Base
DL = Discount Loans
Shift From Deposits into
Currency
• A shift from Deposits into
Currency will affect the Reserves
, but it has no effect on the
Monetary Base .
•
MB = C + R
Example
• Assume an Individual withdraw SR
100,000 from his bank account and
never deposited that amount again in
any bank .
• The effect of this transaction on the
balance sheet of :
Non-bank public , Banking system , and
the central bank is as follows :
Balance Sheet of Non-bank Public
• Assets _________________Liabilities____
• Checkable - SR 100
• Deposits
• Currency
+ SR 100
Balance Sheet of Banking System
• Assets______________ Liabilities__________
• Reserves - SR 100
Checkable
•
Deposits - SR 100
Balance Sheet for Central Bank
• Assets______________Liabilities______________
Currency in Circulation +100
Reserves of Banks
- 100
Multiple Deposit Creation: A
Simple Model
• When the Central Bank provides
the commercial banks with
additional reserves, then the
Deposits of the commercial
banks will increase by multiple
times of that amount . This is
called “ Multiple Deposit
Creation . “
How the central bank provides additional
reserves to commercial banks ?
• There are two ways :
• 1. It can make Loans to Banks.
• 2. It can purchase government
Bonds ( Securities ) from the
financial market .
• Both will increase the Reserves of
commercial banks .
Deposit Creation:
The Banking System
Bank A
Assets
Reserves
Bank A
Liabilities
+$100 Checkable
deposits
Assets
+$100 Reserves
Loans
Reserves
+$10 Checkable
deposits
+$100
+$90
Bank B
Assets
Liabilities
Bank B
Liabilities
+$90 Checkable
deposits
Assets
+$90 Reserves
Loans
Liabilities
+$9 Checkable
deposits
+$81
+$90
The Formula for Multiple Deposit
Assuming Creation
banks do not hold excess reserves
Required Reserves (RR) = Total Reserves (R)
RR = Required Reserve Ratio (r ) times the total amount
of checkable deposits (D)
Substituting
r  D=R
Dividing both sides by r
1
D=  R
r
Taking the change in both sides yields
1
D =  R
r
Critiques of The Simple Model
•
•
•
•
•
•
The Critiques of the simple model says :
1. Commercial Banks usually hold excess
reserves .
2. Usually, there is cash drain in the
system.
Therefore, the multiplier will be smaller
and the effect on deposits and Loans will
be smaller than that of the simple model.
Chapter 14
Determinants of The
Money Supply
How the central bank control the level of
deposit in the banking system ?
• Since in the simple model we have :
• Change in Deposit = 1 X change in Reserves
•
r
• Therefore, the central bank can control the
deposits by :
• 1. Setting the required reserve ratio , r
• 2. Setting the level of reserve [change in R ]
The Critiques of the Simple Model
• The Money supply or the creation of
money will be affected by :
• 1. The required reserve ratio
• 2. The level of Reserves
• 3. Decisions made by depositors about
• their holding of currency .
• 4. Banks decisions about their holding of
• excess reserves ,
Therefore
• In this chapter , we will
develop a money supply
model in which depositors
and Banks assume their
important role .
Money Supply Model and the
Money Multiplier
•
•
•
•
•
•
•
•
•
Since R = RR + ER …………. ( 1 )
RR = r X D ………………. ( 2 )
ER = ER X D ……………… ( 3 )
D
Substituting equation ( 2 & 3 ) into ( 1)
R = ( r X D ) + { ER X D }
D
R = ( r + ER ) D ……………………( 4 )
D
Monetary Base , MB
•
•
•
•
•
•
•
•
•
Since MB = C + R ………….. ( 5 )
C = C . X D ………… ( 6 )
D
R = ( r + ER ) D
Therefore :
D
MB = (C X D ) + ( r + ER ) D
D
MB = ( r + ER + C ) D ………….. ( 7 )
D D
Monetary Base , MB continue
• Since MB = ( r + ER + C ) D
•
D
D
• Let e = ER and c = C
•
D
D
• Therefore, MB equation can be written as
MB
= ( r + e + c ) D …….. ( 7 )
• Dividing both sides of equation (7) by
• r + e + c , we get :
MB
. = D ……… ( 8 )
•
r+e+c
•
The Money Multiplier , m
•
•
•
•
•
•
•
•
•
Equation # 8 , can be re-written as :
1
. MB = D ………….. ( 8 )
r+e+c
Since M = C + D and C = C X D
D
Therefore M = ( C X D) + D
D
So
M = ( 1 + C ) D …….. ( 9 )
D
Money Multiplier - Continue
•
•
•
•
•
•
•
•
•
Since D =
1 . MB
r+e+c
Since M = ( 1 + C ) D
D
Thus M = ( 1 + C ) (
1 . MB )
D r+e+c
Therefore M = 1 + C
D___ MB
r+e+c
Money Multiplier – continue
• Let m = 1 + C
•
D = money multiplier
•
r+e+c
• Therefore M = m X MB
• Where M = Money Supply
•
m = Money multiplier
•
MB = Monetary Base
Example
•
•
•
•
•
•
Given the following data :
r = 10% ; C = SR 400 million
D = SR 800 million ; ER = SR 0.8 million
M = C + D = 1200 million
A. Find the money multiplier , m ?
B. If MB rises by SR 100 million, by how much
the money supply will change ?
The Answer
• A. m = 1 + 400
•
800_____
•
.10 + .8 + 400
•
800 800
=
1.5
. = 2.5
.10 +.001 + .5
• B. Change in M = 2.5 X 100 = SR 250 million
Factors that Determine the Money Supply
Multiplier
•
•
•
•
•
•
•
•
•
Since m = 1 + c___
r+e+c
So, the factors that determine m are :
1. Change in required reserve ratio , r
2. Change in currency-deposit ratio, C =c
D
3. Change in excess reserve ratio, ER = e
D
Both M and m are negatively related to r, e, c .
Determinant of Excess Reserve Ratio , e
• There are 2 factors that affect
the cost and benefit of holding
excess reserves . These factors
are :
• 1. Market interest rate , i
• 2. Expected deposit outflows
1. Market Interest rate, i
• As the market interest rate rises , then the
• Opportunity cost of holding excess reserve rises
• Banks try to decrease their holding of excess
reserves .
• Therefore, there is negative relationship
between the market interest rate and the excess
reserve to deposit ratio ( ER = e )
•
D
2. Expected Deposit Outflows
• If Banks expect deposit outflow to rise, then
• They will increase their holding of excess
reserves , so ER will rise .
•
D
• Therefore,
• There is positive relationship between the
excess reserve ratio and expected deposit
outflows .
Additional Factors that Determine
the Money Supply
•
•
•
•
•
•
•
•
Since M = m X MB
MB = MB n + DL
So
M = m X [ MB n + DL ]
Where : M = Money Supply
m = Money Multiplier
MB n = Non-borrowed monetary base
DL = Discount Loans
So Money supply is affected by MBn , DL, r ,
e, and c .
Changes in Non-borrowed monetary base,
MB n
• Since MB = MB n + DL
• Any increase in MB n , holding DL constant,
will increase the MB .
• And since M = m X MB
• Any increase in MB , holding the money
supply multiplier ( m ) constant will increase
the Money supply. Therefore :
• Open Market purchase increase MBn which
increases MB and in turn increases M .
• Open Market Sale decreases MBn, MB & M
2. Change in Discount Loans, DL
or Borrowed Money
• Holding MBn constant , a rise in DL
provides more reserves for commercial
banks which increase Loans and Deposits
and in turn the Money supply.
• Or As DL rises , MB rises , holding m
constant, the money supply ( M ) will rise.
• Therefore, Money supply is positively
related to the change in Discount Loans .
What Determine the Discount
Loans ?
•
•
•
•
There are two factors :
1. Market interest rate , i [ Benefit ]
2. Discount rate , id
[ Cost ]
The greater the difference between
benefit and cost ( i – id ) , the greater is
the borrowing by commercial banks from
the central bank . Therefore ,
• DL is positively related to i
• DL is negatively related to id
Complete Money Supply Model
• Since M = m X MB ……………….. ( 1 )
•
MB = MBn + DL ……………….. ( 2 )
•
m = 1 + C/D
……………….. ( 3 )
•
r + ER/D + C/D
• Therefore :
• M = 1 + C/D_____ X [ MBn + DL ] ……… ( 4 )
r + E/D + C/D
chapter 15
Tools of Monetary Policy
Monetary Policy
• Is the policy used by the
central bank to change the
money supply in order to
stabilize the economy .
Tools of Monetary Policy
• There are three tools available to
central bank to change the
money supply :
• 1. Open Market Operations
• 2. Discount Rate , rd
• 3. Required Reserve Ratio , r
Lender of Last Resort
• The Central Bank act as lender
of last resort , which means :
• The Central Bank must provide
reserves to the banking system
during any banking crises .
Disadvantages of DL
• 1. It is not completely controlled
by the central bank .
• 2. Can not be reversed easily .
Proposed reform of discount policy
•
•
•
•
•
•
•
Should the id be tied to a market interest rate?
This proposed suggested that :
1. The discount rate, id should be tied to the
market interest rate , i .
2. Penalty discount rate : setting id at a fixed rate
above i and then allowing commercial banks
to borrow all they want at that rate .
Should id be abolished ?
• Milton Friedman proposes that :
• The Central Bank should terminate its
Discount Loans Policy to have better
control over the money supply because
that will eliminate fluctuation in the
monetary base due to the change in DL .
Tools of Monetary Policy
• Open market operations
– Affect the quantity of reserves and the monetary base
• Changes in borrowed reserves
– Affect the monetary base
• Changes in reserve requirements
– Affect the money multiplier
• Federal funds rate—the interest rate on overnight loans of
reserves from one bank to another
– Primary indicator of the stance of monetary policy
Demand in the Market for
Reserves
• What happens to the quantity of reserves demanded, holding
everything else constant, as the federal funds rate changes?
• Two components: required reserves and
excess reserves
– Excess reserves are insurance against deposit outflows
– The cost of holding these is the interest rate that could have been
earned
• As the federal funds rate decreases, the opportunity cost of
holding excess reserves falls and the quantity of reserves
demanded rises
• Downward sloping demand curve
•
Supply in the Market for
Reserves
Two components: non-borrowed and
borrowed reserves
• Cost of borrowing from the Fed is the discount rate
• Borrowing from the Fed is a substitute for borrowing from
other banks
• If iff < id, then banks will not borrow from the Fed and
borrowed reserves are zero
• The supply curve will be vertical
• As iff rises above id, banks will borrow more and more at id,
and re-lend at iff
• The supply curve is horizontal (perfectly elastic) at id
Affecting the Federal Funds Rate
• An open market purchase causes the federal
funds rate to fall; an open market sale
causes the federal funds rate to rise
shifting the supply curve
• If the intersection of supply and demand
occurs on the vertical section of the supply
curve, a change in the discount rate will
have no effect on the federal funds rate
Affecting
the Federal Funds Rate (cont’d)
• If the intersection of supply and demand occurs on
the horizontal section of the supply curve, a
change in the discount rate shifts that portion of
the supply curve and the federal funds rate may
either rise or fall depending on the change in the
discount rate
• When the Fed raises reserve requirement, the
federal funds rate rises and when the Fed
decreases reserve requirement, the federal funds
rate falls shifting the demand curve
Open Market Operations
•
•
•
•
Dynamic open market operations
Defensive open market operations
Primary dealers
TRAPS (Trading Room Automated
Processing System)
• Repurchase agreements
• Matched sale-purchase agreements
Advantages of
Open Market Operations
• The Fed has complete control over
the volume
• Flexible and precise
• Easily reversed
• Quickly implemented
Discount Policy
•
•
•
•
•
Discount window
Primary credit—standing lending facility
Secondary credit
Seasonal credit
Lender of last resort to prevent
financial panics
– Creates moral hazard problem
Advantages and
Disadvantages of Discount Policy
• Used to perform role of lender of
last resort
• Cannot be controlled by the Fed; the
decision maker is the bank
• Discount facility is used as a backup facility
to prevent the federal funds rate from rising
too far above the target
Reserve Requirements
• Depository Institutions Deregulation and
Monetary Control Act of 1980 sets the
reserve requirement the same for all depository
institutions
• 3% of the first $48.3 million of checkable
deposits; 10% of checkable deposits over $48.3
million
• The Fed can vary the 10% requirement between
8% to 14%
Disadvantages
of Reserve Requirements
•
•
•
•
No longer binding for most banks
Can cause liquidity problems
Increases uncertainty
Recommendations to eliminate
CHAPTER 16
What Should Central Bank do ?
Monetary Policy: Goals, Strategy, and
Tactics
Note
• In this chapter we will see how
monetary policy is actually
conducted by the central bank,
but first we will look at the goals
that the central bank establishes
for monetary policy and its
strategies for attaining them .
Goals of Monetary Policy
• There are six basic goals for the central
bank when it conduct the monetary
policy. These goals are :
• 1. High employment .
• 2. Economic Growth .
• 3. Price Stability .
• 4. Interest Rate Stability .
• 5. Stability of Financial Markets .
• 6. Stability in Foreign Exchange Markets.
High Employment
• High employment is a worth goal because the
alternative situation , High unemployment
which causes human suffering and economic
waste of resources resulting in a loss of output
or lower GDP .
• Full employment does not mean zero
unemployment. The economy will be at full
employment when the only unemployment
that exist are only Frictional or Structural
unemployment .
Frictional Unemployment
• Represent the Normal turn over of
the labor force ( some people
entering and some people leaving
the labor force ) . Therefore always
there are businesses with unfilled
jobs and people seeking jobs .
Structural Unemployment
• Is the unemployment that arises when
changes in technology or international
competition change the skills needed to
perform jobs or changes the location of jobs.
• Structural unemployment arises because of
mismatch between job requirements and the
skills of local workers or mismatch between
demand and supply of labor . Therefore, the
goal for high employment should not seek
zero unemployment , but rather a level above
zero.
Natural rate of unemployment
•
the rate of unemployment when the
economy is operating at full
employment is called Natural rate
of unemployment currently this rate
is estimated at 4.5 % to 6 % .
II. Economic Growth
• The Goal of Economic Growth is closely
related to the high-employment goal because
businesses are more likely to invest in capital
equipment to increase productivity and
economic growth when unemployment is low.
• The central bank can promote economic
growth by directly encouraging firms to
invest or people to save by providing tax
incentive for businesses and for taxpayers.
III. Price Stability
• Policy makers are more concerned with
a stable price level as a goal of economic
policy .
• Price stability is desirable because a
rising price level ( inflation ) create
uncertainty in the economy ( Inflation
makes it hard to plan for the future ) .
IV. Interest Rate Stability
• Interest rate stability is desirable
because fluctuations in interest rates
can create uncertainty in the
economy and make it harder to plan
for the future .
V. Stability of Financial
Markets
• Promotion of more stable financial
system in which financial crises are
avoided is an important goal for central
bank.
• The stability of financial markets is also
promoted by interest rate stability
because fluctuation in interest rate
create great uncertainty for financial
institutions .
VI. Stability in Foreign
Exchange Market
• With the increasing importance of
international trade , the value of domestic
currency relative to other currencies has
become a major consideration for the central
bank .
• A rise in the value of domestic currency
makes the domestic goods less competitive
with those abroad , and a decline in the value
of domestic goods stimulate inflation in the
country. Therefore stability is a worthy goal.
Central Bank Strategy : Use of
Targets
•
•
•
•
There are two types of target variables :
1. Interest rates
2. Money aggregates and reserves aggregates.
Can the central bank choose to pursue both of
these targets at the same time when the demand
for money fluctuate ?
• The answer is no . The central bank
must choose one or the other .
1. Targeting on the Money Supply
• If the central bank chooses
the money supply as the
intermediate target, then it
should accept fluctuation in
the interest rate.
2. Targeting on the interest rate
• If the central bank chooses
the interest rate as the
intermediate target, then it
should accept the fluctuation
in the money supply.
Criteria for choosing the
Intermediate Targets
• 1. Measurability
• 2. Controllability
• 3.Predictable Effect on
Goals .
I. Measurability
• Data on interest rate are available more quickly
than on monetary aggregate .
• Data on the monetary aggregate are obtained
after a two-week delay, while interest rate data
are available almost immediately .
• Moreover, interest rates are also measured more
precisely and are rarely revised. While the
monetary aggregates are subject to fair amount
of revision.
Therefore
• At first glance, interest rate seem to be more
measurable than monetary aggregate , and more
useful as an intermediate target .
• However, the nominal interest rate that is quickly
and accurately measured is a poor measure of the
real cost of borrowing.
• Real cost of borrowing is more accurately
measured by the real interest rate which is
adjusted for expected inflation.
Conclusion
• Since real interest rate is extremely hard
to measure because we have no direct
way to measure expected inflation ,
Therefore, we see that both interest rate
and monetary aggregates have
measurability problem, and it is not
clear whether one should be preferred to
the other as an intermediate target .
II. Controllability
• The central bank must be able to exercise
effective control over a variable if it is to
function as a useful target .
• The central bank does have the ability to
exercise a powerful effect on the money
supply , but this control is not perfect .
• The central bank can set interest rates
directly by using open market operations
which affect directly the price of bonds .
Therefore
• It might appear that interest rates dominate
the monetary aggregate on the controllability
criteria .
• However , central bank can not set real
interest rates, because it does not have control
over the expected inflation .
• Therefore, there is no –clear –cut case that
interest rates are preferable to monetary
aggregate as intermediate target or vice
versa.
CHAPTER 17
The Foreign
Exchange Market
Foreign Exchange Market
• Is the financial
market where
exchange rates are
determined
The Exchange Rate
• Is the price of one currency in terms
of another .
• Most countries of the world have their
own currencies : Example
• Saudi Arabia
Riyal
• Kuwait
Dinar
• U.S.A.
Dollar
• European Monetary Union
Euro
• India
Rupee
What are Foreign Exchange
Rates?
• There are two kinds of exchange rate
transactions :
• 1. Spot Transaction:
•
This involve the immediate ( two-day)
•
exchange of bank deposits .
• 2. Forward Transactions:
• This involve the exchange of bank deposits at
• some specified future date .
Appreciation of Currency
• When a currency
increases in value , it
experience an
Appreciation .
Depreciation of a Currency
•When a currency
falls in value , it
experience
Depreciation
Example
•
•
•
•
Year
Exchange Rate
1999 1 Euro = $ 1.18 or
1 $ = 0.85 Euro
2000 1 Euro = $ 0.99 or
1 $ = 1.01 Euro
Therefore, in year 2000 the Euro worth fewer
U.S. dollars, so the Euro depreciated by 16 %
• ( 0.99 – 1.18) / 1.18 = 16%
• In the same time the value of U.S. dollar relative
to the Euro Appreciate in year 2000 by 19 %
• ( 1.01 – 0.85 ) / 0.85 = 19 %
Why Exchange Rate Important
• Exchange rates are
important because they
affect the relative price
of domestic and foreign
goods in the economy .
Example
• Suppose an American decided to buy a French
commodity ( say X ) which has price of 1000 Euro
in France and the exchange rate is :
•
1 Euro = $ 0.99
• Therefore , the cost of French good ( X ) to the
American = 1000 Euro * $.99 = $ 990
• Now if the American delays his purchase by two
months and during that period the Euro has
appreciated to $ 1.20 per Euro, what happen ?
Example – continue
• If the domestic price in France remain at 1000
Euro, then the cost of that good ( X ) to the
American will be :
• 1000 Euro * $ 1.20 = $ 1200
• Therefore, as the exchange rate rises from
• $ 0.99 = 1 Euro to $ 1.20 = 1 Euro , the cost of
French good to the American rises from $ 990 to
$ 1200 .
Note
• The appreciation of the French currency
( Euro ) relative to the foreign currency
(U.S. $ ) makes the price of the American
goods in France less expensive .
• The depreciation of the French currency
• (Euro ) relative to the foreign currency
(U.S. $ ) lowers the cost of French goods
in America , but increases the cost of
American goods in France .
Example
•
•
•
•
•
•
•
•
An American computer priced at $ 2000 .
Required:
1. How much this American computer will cost a
French programmer in Euro if the exchange
rate is $ 0.99 = 1 Euro ?
2. How much the American computer will cost
the French programmer in Euro if the
exchange rate increases to $ 1.2 = 1 Euro ?
The Answer
• 1. If the exchange rate is $ 0.99 = 1 Euro , then
• the American computer priced $2000 will cost
• a French programmer 2020 Euro as follows :
• ( $ 2000 / 0.99 ) = 2020 Euro .
• 2. If the exchange rate increases to $ 1.2 = 1 Euro
• then the American computer will cost only
• 1667 Euro as follows ( 2000/1.2 ) = 1667 Euro
Conclusion
• 1. When a country’s currency appreciate or rises
• in value relative to other currencies , then
• The country’s goods abroad become more
• expensive . This decrease exports of domestic
•
goods .
• The foreign goods in that country become
• cheaper (holding the domestic prices constant
• in the two countries) . This increase imports of
• foreign goods .
Appreciation of a Currency
• 1. Can make it harder for domestic manufacturers to
•
sell their goods abroad because it is relatively
•
more expensive .
• 2. Increase competition at home from foreign goods
• because they cost less .
• 3. Benefit the domestic consumers because foreign
• goods were less expensive .
Depreciation of a Currency
•
•
•
•
•
•
When a country’s currency depreciates,
Then :
1. Its goods abroad become cheaper , so
exports will rise .
2. Foreign goods in that country become
more expensive , so imports will fall .
How is Foreign Exchange Traded
• The foreign exchange market is
organized as an over-the –counter
market in which many dealers
( mostly banks ) stand ready to buy
and sell deposits denominated in
foreign currencies .
Exchange Rate in the Long-run
• Exchange rates are determined by the
interaction of supply and demand .
• Therefore :
• We will study how the exchange rates are
determined in the long-run, then we will see
how they are determined in the short-run .
• The starting point for understanding how the
exchange rate is determined is a simple idea
called “ The law of one price “
The Law of One Price
• If two countries produces an
identical good, and transportation
cost and trade barriers are very low,
then the price of the good should
be the same throughout the
world no matter which country
produces it .
Example
• Assume that the price of American steel is $ 100
per ton , and price of Japanese steel is 10,000 yen
per ton .
• If E = 50 yen / $ , then prices are as follows :
•
Prices of American Prices of Japanese
•
steel per ton
steel per ton
• In U. S. A.
$ 100
$ 200
• In Japan
5000 yen
10,000 yen
• Here, the price of Japanese good is twice as the
American good in both countries .
Example – continue
• If E = 100 yen / $ , then prices are :
•
Prices of American Prices of Japanese
•
steel per ton
steel per ton
• In U.S.A.
$ 100
$ 100
• In Japan
10,000 yen
10,000 yen
• Therefore , the Law of one price suggest that the
exchange rate between U.S.A and Japan should be
100 yen / $
The Law of One Price
• Suggests that the exchange rate between
the yen and the dollar must be 100 yen/$
or $ 0.01 per yen , in order for one ton of
American steel to sell for 10,000 yen in
Japan which is equal to the Japanese
steel price. And one ton of Japanese steel
to sell for $ 100 in U.S.A which is equal to
the price of the U.S steel .
Theory of Purchasing Power
Parity ( PPP )
• This theory states that exchange rates between
any two currencies will adjust to reflect changes
in the price level of the two countries .
• The theory of PPP suggests that :
• If one country’s price level rises relative to
another’s , then its currency should depreciate
(and other country’s currency should appreciate)
• The PPP theory is an application of the Law of
One price to national price level rather than to
individual prices .
Example
• Suppose that yen price of Japanese steel rises by 10% (
from 10,000 to 11,000 yen ) relative to the dollar price of
American steel ( unchanged at $100 ) .
• For the Law of one price to hold, the exchange rate must
rise to 110 yen / dollar , a 10% appreciation of the dollar
• Applying the law of one price to the price levels in the
two countries produces the theory of purchasing power
parity .
• PPP maintains that if the Japanese price level rises by
10% relative to the U.S. price level, then the dollar will
appreciate by 10% and the Japanese yen will depreciate
by 10% .
Why the theory of PPP can not fully explain the
exchange rates ?
• The theory of PPP states that :
• “ exchange rate between any two currencies will
adjust to reflect changes in the price level of the
two countries .
• This conclusion of PPP suggests that exchange
rates are determined solely by changes in relative
price level is based on the assumption that all
goods are identical in both countries and that the
transportation cost and trade barriers are very
low. But this is not always true .
Factors that affect Exchange rates in the Long-run
•
•
•
•
1. Relative price levels [ domestic Vs. Foreign ]
2. Tariffs and Quotas
3. Preferences for Domestic Vs. Foreign goods .
4. Productivity
Exchange Rate in Short-Run
• How the current exchange rates or the
spot exchange rates are determined in the
short-run ?
• Based on the theory of Asset demand :
• The most important factor affecting the
demand for domestic deposits ($) and the
foreign deposits (euro) is the expected
return on these assets relative to each
other .
Therefore
• If Domestic residents or foreigners expect the
return on domestic deposits ($) to be higher
relative to the return on foreign deposits
(euro), then there is high demand for
domestic deposits and low demand for
foreign deposits . To understand how the
demand for domestic and foreign deposits
change, we need to compare the expected
returns on domestic & foreign deposits .
Example
•
•
•
•
•
Assume that :
D
Expected return on domestic deposit ($) = i ,
F
Expected return on foreign deposit (euro) = i,
To compare the expected return on $ deposits
and foreign deposits, investors must convert
the return into the currency unit they use.
How a foreigner compares the return on
dollar deposits and foreign deposits
denominated in his currency ?
• In this case :
• The expected return on $ deposits in
terms of Euro, must be adjusted for any
expected appreciation or depreciation of
the dollar . Example:
D
• If interest on dollar deposits , i = 10 %
• Expected appreciation in $ = 7%
• Expected return on $ in terms of euro is
17% ( 10% + 7% )
Therefore for a Foreigner
•
•
•
•
•
•
•
•
D
Expected return on dollars in terms of euro= R
D
D
R in term of euro = i + Et+1 - Et
Et
F
Expected return on foreign deposits (euro) = R
Therefore : F
F
R in terms of euro = i ,
Relative expected return for foreigner
• Is the difference between expected return on
dollar and expected return on the euro , which
means :
•
D
F
• Relative return on deposit = R - R
•
D
• So Relative R in terms of euro equal :
• D
F
D F
• i + Et+1 – Et ) - i, = i, - i, +Et+1 –Et … (1)
•
Et
Et
Note
• As the Relative expected return on dollar
deposits increases, then foreigners will
want to hold more dollar deposits and
fewer foreign deposits .
• What about the decision made by the
domestic residents (Americans ) to hold
dollar deposits versus euro ?
Decision to hold $ deposits Versus Euro deposits by
Domestic residents
•
•
•
•
•
•
•
•
•
Since : F
F e
R in term of $ = i - Et+1 – Et
Et
And expected return on domestic currency ($) is
D
D
R in terms of $ = i ,
Therefore :
D D F
e
Relative R = i, - ( i , - Et+1 – Et ) …… ( 2 )
Et
Relative Expected Return on $
•
D D F e
• Relative R = i , - i , + Et+1 – Et … ( 2 )
•
Et
• Equation # 2 is the same as equation # 1
Which means that the relative expected
return on deposits is the same whether it
is calculated by domestic residents or by
foreigners .
Conclusion
• If the relative expected return on dollar
deposits increases , then both foreigners
and domestic residents responds in
exactly the same way, so both will want to
hold more dollar deposits and fewer
foreign deposits .
Interest Parity Condition
• Since Foreigners can buy dollar deposits , and
• Since domestic residents (Americans) can buy
foreign deposits (euro), and
• Since foreign deposits & dollar deposits have
similar risk and liquidity , therefore this theory
assume both deposits (foreign & domestic ) are
perfect substitutes ( equally desirable )
Therefore
• If expected return on $ > expected return on euro
• Both Foreigners & Americans will want to hold
only dollar deposits and No foreign deposits .
• If expected return on > expected return on dollar
• foreign deposits
deposits
• Both Foreigners & Americans will want to hold
only foreign deposits (euro) and No dollar deposit
• When will Foreigners & Americans will hold
both deposits ( dollar and foreign deposits ) ?
Condition for holding both deposits
• There is no difference in their expected returns .
• Relative expected return must be zero . Therefore
expected return on both deposits must be equal .
This condition can be written as :
• D F e
• i , = i , - Et+1 – Et
•
Et
This condition is called “ Interest Parity condition”
Interest Parity Condition
• D
F e
• i , = i , - Et+1 – Et This condition states that :
•
Et
•
•
•
•
•
Domestic = foreign interest – expected appreciation of
Interest rate
rate
domestic currency
Or equivalently , this condition can be written as :
Domestic = Foreign interest + expected appreciation of
interest rate
rate
foreign currency
Note
• If domestic interest rate > foreign interest rate
• There is positive expected appreciation of foreign
currency which compensates for the lower
interest rate . Example : D
• If domestic interest rate , i , = 18.6 %
• foreign interest rate =
10 %
• This means that expected appreciation of foreign
currency must be 8.6% . (depreciation in dollar)
Example
•
•
•
•
•
•
D
F e
i , = i , - Et+1 – Et
Et
18.6% = 10 % - ( 0.85 – 0.93)
0.93
18.6% = 10% - ( - 8.6% )
Conclusion
• The interest parity means
that :
• Expected returns are the
same on both domestic
deposits ( dollars ) and on
foreign deposits ( euro ) .
CHAPTER 19
The Demand For Money
This Chapter
• Discusses the theories of the demand for
money such as :
• 1. Classical theories developed by :
• - Irving Fisher ; Alfred Marshall and
•
A.C. Pigou .
• 2. Keynesian theories of demand for money .
• 3. Milton Friedman’s modern quantity theory
Quantity Theory of Money
• This theory is developed by the classical
economists in the nineteenth and early
twentieth centuries .
• This theory focus on how the nominal value
of aggregate income ( PY ) is determined .
• It also tell us how much money is held for a
given amount of aggregate income , so it is
called “ theory of demand for money .
Velocity of Money & Equation
of Exchange
• Irving Fisher examined the link between total
quantity of money ( M ) or Money Supply and
total amount of spending on final goods and
services produced in the economy ( PY )
• PY = Nominal income ( or total spending )
• P = Price Level
• Y = Aggregate Output
Velocity of Money, V
• This concept provide a link between the
money supply & the Nominal Income or
(between M and PY ) .
• Velocity is the rate of turnover of money
or it is the average # of times per year
that a dollar is spent in buying goods &
services produced in the economy .
• V = PY ……………….. ( 1 )
•
M
Example
• If the Nominal Income or GDP = $ 5 million
• And the quantity of money , M = $ 1 million
• Then , Velocity , V is :
•
•
V = PY = 5 . = 5
M
1
• It means that on average a dollar bill is spent
5 times in purchasing goods & services in the
economy .
Equation of Exchange
•
•
•
•
•
Since V = PY …………………. ( 1 )
M
Multiplying both sides of equation (1) by M
We get MV = PY ……………… ( 2 )
Equation No 2, is called Equation of Exchange
which states that quantity of money multiplied by
# of times this money is spent (velocity) in a given
year must equal the Nominal Income or PY .
Quantity Theory of Money
• Fisher assume that velocity is fairly constant in
the short-run , therefore , Fisher transformed
the equation of exchange into quantity of money.
• Since
---•
M V = PY ………………….. ( 3 )
• Where V is constant , then
• If money , M double , then PY must double
• Therefore, Nominal income is determined by the
quantity of money or M .
Example
• Given that :
• PY = $ 5 million ; M = $ 1 million
• Then V = PY = 5 = 5
•
M 1
• Now if M double from $ 1 million to 2
then MV = PY
•
2 X 5 = $ 10 million
• As M double , PY double as well .
The Implication of the
Quantity of Money
• The Classical Economists including Fisher
thought that wages and prices completely
flexible and they believe that the level of
aggregate output produced in the economy,Y
during normal time would remain at full
employment , so
• Y in the equation of exchange could be
treated as constant in the short-run.
Implication - continue
•
•
•
•
•
Since MV = PY ………………. ( 1 )
Since V and Y could be assumed constant
Therefore
__
__
M V = PY
Therefore, the quantity theory of money
implies that as M double , the price level, P
must double as well .
Example
• Given that M = $ 2 million ; P = 1 ; V = 5
•
Y = 10
• Since M X V = P X Y
•
2 X 5 = 1 X 10
•
10
= 10
• Now if M double from 2 to 4 million, holding V = 5
and Y = 10 , then since MXV = PX Y
•
4 X 5 = 2 X10
•
20 = 20
• Therefore as M rises from 2 to 4 ( by 100%)
• P also rises from 1 to 2 ( 100 % ) as well .
Conclusion
• For Classical Economists :
• Movement in the price level
result from the change in the
quantity of Money
The Theory of Demand for Money
•
•
•
•
•
•
•
•
Since the equation of exchange is :
MV = PY ……………. ( 1 )
Dividing both sides of this equation by V
We get : MV = PY
V
V
M = 1 . PY …….. ( 2 )
V
Equation # 2 is called theory of demand
for money .
Fisher’s Quantity theory of Money
•
•
•
•
•
•
Since
M = 1 . PY
V
Let k = 1 .
V
d
Therefore
M = k PY …………. ( 3 )
Equation # 3 is called Fisher’s quantity theory of
demand for money which suggest that :
• The demand for money is purely a function of
income , and interest rate has no effect on the
demand for money.
Keynes’s Liquidity Preference Theory
• John Maynard Keynes developed a demand for
money theory that emphasized the importance
of interest rate . His theory is called “ the
liquidity preference theory “ .
• Keynes started with the following question :
Why do individuals hold money ? Then he
suggested 3 motives for holding money . These
are : 1. Transactions Motive
•
2. Precautionary Motive
•
3. Speculative Motive
I. Transactions Motive
• Keynes emphasized that people hold
money because it can be used as medium
of exchange to buy goods and services .
•
d
•
M = f ( T)
•
T = f (Y) d
• Therefore
M =f (Y)
II. Precautionary Motive
• Keynes said that people hold additional money
as a cushion against unexpected need such as
accident, hospitalization, etc.
• Or because of uncertainty of timing of cash flow
• Keynes believe that the amount of money held
for this purpose is determined by the level of
transaction that people expect to make in future,
which is a function of income .
III. Speculative Motive
• Keynes agree with classical economists that
money is a store of wealth and called this motive
“ Speculative Motive for holding Money “ .
• Keynes divided the assets that can be used as a
store of value into two categories ( Money &
Bonds ) , W = M + B
• Then he asked why would individuals decide to
hold their wealth in the form of money ?
Speculative Motive-continue
• From the theory of Asset demand, we know
that people hold money if :
• Expected return on > expected return on
•
Money
Bonds
• Keynes assumed that rate of return on money
is zero , and rate of return on Bonds > 0 , so
• If i rises, PB falls, and it may cause negative
capital gain ( Loss ) .
Continue
• So if you expect i to rise substantially , the capital
loss might overweight the interest payment , and
your expected return from Bonds would be negative.
•
In this case you want to store your wealth as
Money because :
• expected return on money is 0 > negative return
•
on Bonds
• Keynes wrote the following equation for demand for
money :
Keynes’s Demand for Money
• Keynes’s Demand for money equation is
•
d
- +
• M =f ( i , Y )
• P
• Keynes conclusion that demand for
money is not related to income only , but
also to interest rate as well .
Friedman’s Modern Quantity
theory of Money
• Friedman developed a theory of demand for
money in 1956 .
• Friedman started with the following question :
• Why people choose to hold Money ?
• Friedman stated that the demand for money
must be influenced by same factors that influence
the demand for any asset. Therefore, he applied
the theory of asset demand to money .
The Theory of Asset Demand
• This theory indicate that the demand for
money should be function of :
• - Resources available to individual ( or
Wealth)
• - Expected rate of return on money relative
to expected rate of return on other assets .
• - Expected rate of inflation .
Friedman’s equation for the demand for
money
• Friedman expressed his formulation of the demand
for money as follows :
• d
• M = f ( Yp , rb- rm ; re – rm ; Exp. Inf – rm )
• P
+
• Where d
•
M = demand for real money balances
•
P
Where
• Yp = Friedman’s measure of wealth known as
•
permanent income , which is present
•
discounted value of all expected income .
•
•
•
•
rm = expected return on money .
rb = expected return on bonds .
re = expected return on equity (Common stock )
Exp. Inf = expected rate of inflation .
Note
• Friedman said that an individual can hold
wealth in several forms besides money such
as :
• Bonds ; Equity ; and Goods ) in addition
to Money .
• The incentive for holding these assets rather
than money are represented by the expected
return on each of these assets relative to
expected return on money .
Distinguishing between Friedman’s and
Keynesian theories
• 1. Friedman , includes many assets as an
alternative to money W = M + B + E + G
• While Keynes, includes only one asset as an
alternative to money W = M + B
2. Interest rate
• 2. Friedman recognize more than one interest
rate as important to the aggregate economy . He
uses rb, re , and rm .
• While Keynes uses only one interest rate rb
3. Money as substitute for goods
• Friedman viewed money and goods as
substitute.
• While Keynes did not consider goods as
substitute for money .
4. Expected Return on Money
• Friedman did not take expected return
on money to be constant .
• While Keynes did take expected return
on money to be constant and equals to
zero .
5. The effect of interest rate on the
determination of demand for money
• Friedman’s theory suggest that interest rate
should have little effect on the demand for
money and he emphasizes the permanent
income as the primary determinant of
money demand.
• While in Keynes’s theory , interest rate is
the most important determinant of the
demand for money .
CHAPTER 20
The Keynesian Framework
and the ISLM Model
The ISLM Model
• An economic model developed by Sir
John Hicks in 1937 based on Keynes’s
model .
• It explain how interest rates and total
output produced in the economy are
determined given a fixed price level .
Determination of Aggregate Output
• Keynes anaysis started with the recognition
that total quantity demanded of output for
an economy is the sum of four types of
spending . These are :
• 1. Consumer Expenditure , C
• 2. Planned Investment Spending , I
• 3. Government Spending , G
• 4. Net Exports, NX
The Aggregate Demand, Yad
• The total quantity demanded of an
output is called “ Aggregate Demand “
•
• Y ad = C + I + G + NX
• Keynes recognized that at equilibrium in
the economy, the quantity supplied of
output must equal quantity demanded ,
Therefore Y = Y ad
Equilibrium Point
• When Y = Y ad
• Where Y = Aggregate output produced
•
Y ad = Aggregate output demanded
• When this equilibrium condition is satisfied,
producers are able to sell all of their output .
• Keynes analysis assume that price level is fixed,
so output could change without causing change
in prices .
•
Simple Model of Aggregate
Output Determination
• In this model, the role of government ,
net export, and the effect of money and
interest rates are ignored. Therefore, we
need only consumer expenditure and
investment spending .
• Since G = 0 ; and NX = 0 , therefore
• Y ad = C + I
• So what determine C and I ?
Consumer Expenditure and
Consumption Function
• Keynes stated that consumer expenditure is a
function of disposable income , Y d
• (Yd= Y–T).
• Keynes called the relationship between
disposable income and consumer expenditure “
Consumption Function “
•
C = a + mpc Y d
• Where a = autonomous expenditure
•
mpc = marginal propensity to consume
Example
• Assume that mpc = .5 and a = 200
• Point Y d Change in Change in C = 200 +.5Y d
•
Yd
C
• E $0
0
0
$ 200 ( a )
• F $ 400 $ 400
$ 200
$ 400
• G $ 800 $ 400
$ 200
$ 600
• H $ 1200 $ 400
$ 200
$ 800
•
C = 200 + 0.5 Y d
Investment Spending
• There are two types of investment :
• 1. Fixed investment : spending by firms
• on equipment (such as machines , computers ) ,
• factories , offices , building , etc .
• 2. Inventory investment : spending by firms on
• additional holding of raw materials , parts and
• finished goods. The inventory is calculated as
the change in holding of these items for a given
time period .
Example
• If XYZ co. that produces personal computer has
at the end of 2003 100,000 computers sitting in
its warehouses on Dec. 31, 2003 and the price of
each computer is $ 1000 , then
• XYZ Co. has inventory investment in year 2003
• = 100,000 X $ 1000 = $ 100,000,000
• If at end of year 2004 , XYZ Co, has inventory
of $ 150,000,000 , then XYZ Co, has inventory
investment in year 2004 = $ 50,000,000
Inventory Investment
• Is the change in the level of the inventory
over the period . Therefore :
• Inventory = Inventory at - Inventory at
• Investment end of year big. of year
•
= 150,000,000 – 100,000,000
•
= $ 50,000,000
Equilibrium & Keynesian Cross
Diagram
• Since Y ad = C + I , then given that :
•
C = 200 + 0.5 Y , and I = 300 , then
• Y ad = ( 200 + .5 Y ) + 300
• Y ad = 500 + 0.5 Y
• And since Y ad = Y at the equilibrium , then
• Y = 500 + 0.5 Y
• 0. 5 Y = 500 , therefore Y = 1000 this is how
the aggregate output is determined .
The ISLM Model
The ISLM model will help you
understand how monetary policy affect
economic activity and interacts with
fiscal policy ( Change in Govt. Exp.
And Taxes) to produce a certain level
of aggregate output.
Constructing the ISLM model
• First step, we need to examine the effect
of interest rates on planned investment
spending, and hence, on aggregate
demand.
• Next step, we use a Keynesian cross
diagram to see how the interest rate
affects the equilibrium level of aggregate
output .
The IS Curve
• The resulting relationship between
equilibrium aggregate output and the
interest rate is known as IS curve .
Therefore, the IS curve shows the
combinations of interest rates and the
equilibrium aggregate output for which
aggregate output produced equals
aggregate demand .
Equilibrium in the Goods Market ( IS curve)
• In Keynesian analysis, the primary
way that interest rates affect the
level of aggregate output is
through their effect on planned
investment spending and net
export ( NX )
Interest rates and planned investment spending
• Businesses make investment in physical capital
(machines, factories, and raw materials) as long as
they expect to earn more from the physical capital
than the interest cost of a loan to finance the
investment , therefore, when interest rate is high,
only few investment in physical capital will take
place, so planned investment spending is low . And
when interest rate is low, more investment will take
place. Therefore, there is a negative
relationship between interest rate and planned
investment .
Interest rate and Net Exports , NX
• When interest rate rise (with price level fixed) the
demand for bank deposits in the domestic
currency will rise relative to deposits
denominated in foreign currency. This will cause
the domestic currency to appreciate and increase
the exchange rate. This appreciation makes the
domestic goods more expensive then foreign
goods, so export will fall and import will rise, so
net export will fall. Therefore , there is a negative
relationship between interest rate and net
exports .
Conclusion
• As interest rate rises, the planned
investment and net exports both will
fall and that will cause the aggregate
demand, Yad to fall and the aggregate
demand schedule to shift downward
which decrease the equilibrium output
or ( Y= Yad ).
The IS curve
• The IS curve describe the points at which the
Goods market is in equilibrium ( Y=Yad) .
• For each given level of the interest rate, the IS
curve tells us what aggregate output must be
for the goods market to be in equilibrium .
• To the right of the IS curve we have excess
supply of goods and to the left of the Is curve
we have excess demand for goods .
Excess Supply of Goods ( Y>Yad )
• This excess supply of goods results in
unplanned inventory accumulation
which causes output to fall toward the
IS curve. This decline stop only when
output is again at its equilibrium level
on the IS curve .
Excess Demand for Goods ( Y < Yad )
• If the economy is located in the area to the left of
the IS curve, it has an excess demand for goods,
so Yad > Y example point A on the diagram.
• This excess demand for goods results in
unplanned decrease in inventory
( Shortages ) which causes output to rise
toward the IS curve, and it will stop only
when aggregate output is again at its
equilibrium level on the IS curve .
Note
• To complete our analysis of aggregate
output determination , we need to
introduce another market that
produces an additional relationship
between output and interest rates. This
market is the money market
( LM
curve ) .
Equilibrium in the Money Market ( The LM curve)
• In Keynes’s analysis, the level of interest
rate is determined by the equilibrium in the
money market ( where Md = Ms ) .
• The Md is affected by the aggregate output
or national income ( Y ) which means as Y
rises the Md will rise and Md schedule will
shift to the right and that will cause interest
rate to rise .
The LM curve
• The LM curve describe the combinations of
interest rates and aggregate output for
which the quantity of money demanded
equals the quantity of money supplied.
• For each given level of aggregate output , Y
the LM curve tells us what interest rate
must be to have an equilibrium in the
money market .
Note
• As aggregate output rises , then the demand for
money increases and the interest rate rises so that
the money demanded equals the money supplied,
so the money market is in equilibrium.
• If the economy is located in the area to the left of
the LM curve , such as point A, then there is an
excess supply of money .
• Because of the excess supply of money, people use
this excess to buy bonds, so price of bonds goes
up and that cause the interest rate to fall until it
comes to the LM curve .
Note - Continue
• If the economy is located in the area to the right
of the LM curve, there is excess demand for
money . Example , at point B on the diagram.
• Because of this excess demand for money, people
want to hold more money than they currently do,
so they sell bonds. This put pressure on the price
of bonds to fall and as a result the interest rate
goes up to an equilibrium point on the LM curve.
ISLM approach to aggregate output and interest
rate
• To produce a model that enables us to
determine both aggregate output and the
interest rate, we need to put both the IS and
the LM curves together into the same diagram
• At the intersection point between the IS and
the LM curves, point E, we have an
equilibrium in both markets ( The Goods
market and the Money market ) .So Yad = Y
and Ms = Md .
Note
• At any other point in the diagram (other than E)
at least one of these equilibrium condition is not
satisfied, and the market forces move the
economy toward the general equilibrium, Point E
• Example at point A ( on the IS curve ) :This point
is on the IS curve, but not on the LM curve thus
the goods market is in equilibrium ( Yad = Y ),
but the money market is not on equilibrium.
• At point A, the interest rate is above the
equilibrium level , so demand for money is less
than the supply ( there is excess supply of money)
Note – continue
• Because at point A, there is excess supply of
money , people use this excess to buy bonds. This
put pressure on prices of bonds to go up and
drive interest rate to fall, which in turn , causes
investment spending and net export to rise, and
finally cause aggregate output to rise, so the
economy moves down the IS curve until the
interest rate fall to i* and aggregate output rise to
Y* too, so the economy will be at equilibrium
point E .
Another Example – Point B on LM curve
• This point is on the LM curve, but not on the IS
curve. Therefore, at this point, B, the money
market is in equilibrium where Md = Ms , but
the aggregate output is higher than the
equilibrium level ( There is excess aggregate
supply ) .
• Because of this excess supply of goods , firms are
unable to sell all their output, this put pressure
on firms to cut production and lower the output.
Point B continue
• The decline in output means that the
demand for money will fall and that
lower the interest rate , so the economy
moves down along the LM curve until
it reaches the equilibrium point E .