Financial Markets

Financial Markets

Department of Economics

University X


•        In this chapter the purpose is to develop a simple model of the financial market.

•        The general function of the financial market is to match those who have an excess demand for financial assets with those who have an excess supply.

•        Our focus will be on the determination of the opportunity cost, or ‘price,’ of holding money; more commonly known as the interest rate.

•        In doing so, we will see how the interest rate operates as a key macroeconomic variable.


•        In practice, agents (individuals) can choose between a very large number of financial assets.

•        The activity of optimizing a given amount of resources across a given set of financial assets is referred to as portfolio allocation or a portfolio problem.  The idea is to allocate funds in order to optimize the return against the risk.

•        Here we will consider the simplest possible portfolio allocation over just two assets; one which is ‘safe’ and one which carries a risk.

•        Keeping things simple helps focus on the ‘bigger picture’ – the macro economy.

The Demand for Money

•        The safe asset is money; it can be used for transactions but it pays no interest.  There are two types of money:  currency and checkable deposits.

•        Bonds carry a risk (that they will not be repaid) but pay a positive interest rate, i.  Obviously, they cannot be used for transactions.

•        The proportions of money and bonds you wish to hold depend on your level of transactions and the interest rate on bonds.

Semantic Traps:
Income and Savings

•        Income is what you earn from working plus what you receive in interest and dividends.  It is a flow—that is, it is expressed per unit of time.

•        Saving is that part of after-tax income that is not spent.  It is also a flow.

•        Savings is sometimes used as a synonym for wealth.

Semantic Traps

•        The financial wealth (or wealth) of an individual is the value of all their financial assets minus all their financial liabilities.  Wealth is a stock variable—measured at a given point in time.

•        Financial assets that can be used directly to buy goods are called money.


•        Suppose , as a result of having steadily saved part of your income in the past, your financial wealth is Tk. 50,000.The only choice you can make today is how to allocate this Tk. 50000 between money and bonds.

•        Are you going to hold all the wealth in the form of money?

•        Are you going to hold all the wealth in the form of money?


•        This will depend on two variables:

¡     Your Level of Transactions

¡     The interest rate on bonds

Motives for Holding Money

•        Transactions demand – to make transactions without first having to convert other assets to money.

•        Speculative demand – to avoid risks of capital loss from holding assets the price of which goes down.

•        Precautionary demand – Tends to rise in times of uncertainty.

Deriving the Demand for Money

The demand for money for the economy as a whole is just the sum of all the individuals demands for money. Thus, money demand depends on the overall level of transactions in the economy and as a whole.

The overall level of transaction in the economy is hard to measure, but is likely to be roughly proportional to nominal income.

Deriving the Demand for Money

¡     The demand for money:

l    increases in proportion to nominal income ($Y) by the transactions motive;

l    depends negatively on the interest rate (L(i)) by the speculative motive.

l    Precautionary motive not considered here.

Deriving the Demand for Money

For a given level of nominal income, a lower interest rate increases the demand for money.  At a given interest rate, an increase in nominal income shifts the demand for money to the right.

The Determination of
the Interest Rate, i

•        For now, we assume that only the central bank supplies money, in an amount equal to M, so We will also assume that the only money is currency.  (The role of banks as suppliers of money and checkable deposits is introduced later.)

•        Equilibrium in financial markets requires that money supply be equal to money demand.  The interest rate adjusts to clear the market:

Money Demand, Money Supply; and the Equilibrium Interest Rate

The Determination

Of Interest Rate

The Equilibrium Interest Rate;
an Example

•        As a particular example of


Check that dMd/di < 0:

Solve for equilibrium i:

The Effect of an Increase in Nominal Income

¡     An increase in nominal income leads to an increase in the interest rate.

The Effects of an Increase in the Money Supply on the Interest Rate

The Effects of an Increase in the Money Supply on the Interest Rate

An increase in the supply of money leads to a decrease in the interest rate. The decrease in the interest rate increases the demand for money so it equals the larger money supply.

Monetary Policy and
Open-Market Operations

•        When the central bank expands the money supply, it buys bonds with the money that it supplies.

•        Bonds issued by the government are called Treasury bills in the US.

•        The payment is fixed: Say it is $100.

•        Let the price of the bond today be $PB.

•        To be just indifferent between $100 in one year and some amount today requires:

The Bond Price and The Interest Rate

Given the bond market equilibrium condition

then we can write the bond price as

and the interest rate as


•        Say the bond pays $100 in a year and that the interest rate is set at i = 0.1 or 10%.  Then

Equivalently, if


The Determination of
the Interest Rate, II

Financial intermediaries are institutions that receive funds from people and firms, and use these funds to buy bonds or stocks, or to make loans to other people and firms.

Examples include:


Pension funds

Hedge funds

The Balance Sheet of Banks and the Balance Sheet of the Central Bank Revisited

Before                                   Now….

What Banks Do

•        Banks keep as reserves some of the funds they have received, for three reasons:

•      To honor depositors’ withdrawals

•      To pay what the bank owes to other banks

•      To maintain the legal reserve requirement, or portion of checkable deposits that must be kept as reserves:

The reserve ratio is the ratio of bank reserves to checkable deposits (currently about 10% in the US and 18 % in Bangladesh).

What Banks Do cont.

•        Loans represent roughly 70% of banks’ nonreserve assets.  Bonds account for the other 30%.

•        The assets of a central bank are the bonds it holds.  The liabilities are the money it has issued, central bank money, which is held as currency by the public, and as reserves by banks.

The Demand for Money, Reserves, and Central Bank Money

Demand for currency:

Demand for checkable deposits:

Relation between deposits (D) & reserves (R):

Demand for reserves by banks:

Demand for central bank money:



we have

The Determination of the Interest Rate

¡     In equilibrium, the supply of central bank money (H) is equal to the demand for central bank money

The Determination of the Interest Rate

The Supply of Money, the Demand for Money and the Money Multiplier

•        The overall supply of money is equal to central bank money times the money multiplier:

The Baumol-Tobin Model

A transactions theory of money demand

¡   notation:

Y = total spending, done gradually over the year

i = interest rate on savings account

N = number of trips consumer makes to the bank
to withdraw money from savings account

F = cost of a trip to the bank
(e.g., if a trip takes 15 minutes and
consumer’s wage = $12/hour, then F = $3)

The cost of holding money

¡     In general, average money holdings = Y/2N

¡     Foregone interest = i ´(Y/2N )

¡     Cost of N trips to bank = F ´N

¡     Thus,

Money holdings over the year

Finding the cost-minimizing N

Money holdings over the year

Money holdings over the year


Characteristics of Money

Two categories of money

Categories of Broad Money

Banks’ role in the money supply

A few preliminaries

No banks

100-percent reserve banking

¡     After the deposit,
C = $0,
D = $1,000,
M = $1,000.

¡     100%-reserve banking has no impact on size of money supply.

Fractional-reserve banking

The money supply now equals $1,800:

l   Depositor has $1,000 in
demand deposits.

l   Borrower holds $800 in currency.

Fractional-reserve banking

¡     Secondbank will loan 80% of this deposit.

Fractional-reserve banking

Finding the total amount of money:

Original deposit = $1000

+      Firstbank lending       = $ 800

+      Secondbank lending   = $ 640

+      Thirdbank lending      = $ 512

+      other lending…

Three instruments of
monetary policy

1. Open-market operations

2. Reserve requirements

3. The discount rate

The Quantity Theory of Money

The quantity theory of money can be described by the following quantity equation

P × T = M ×V

¡     where P is the general level of prices, T is the level of transactions (= number of times

¡     in a given period that goods and services are exchanged for money), M is the stock of

¡     money and V is the velocity of money.

The quantity equation and the link between Money and Inflation

¡     The quantity equation gives us a simple relationship between the aggregate level of prices and the stock of money in the economy.

¡     Starts with quantity equation and assumes V is constant and exogenous:

¡     With this assumption, the quantity equation can be written as

¡     The implication of this is that with V constant, changes in the money supply must

¡     cause a proportionate change in nominal GDP (P ×Y ).