Assignment

of

Money & capital Market

Submitted to: Mam. Syeda Fizza

Submitted by:

Syed Ali Kamran L1f09mbam1165

UNIVERSITY OF CENTRAL PUNJAB LAHORE

Monetary Policy:
The regulatory policy which is formulated to control the money supply prevailing in the market.
A monetary policy can be “Contractsionary” limit money supply or it can be “Expansionary”
increasing the money supply, depending upon the situations.

Monetary Policy Tools

Monetary base
Monetary policy can be implemented by changing the size of the monetary base.
This directly changes the total amount of money circulating in the economy. A central bank can
use open market operations to change the monetary base. The central bank would
buy/sell bonds in exchange for hard currency. When the central bank disburses/collects this hard
currency payment, it alters the amount of currency in the economy, thus altering the monetary
base.
Reserve requirements
The monetary authority exerts regulatory control over banks. Monetary policy can be
implemented by changing the proportion of total assets that banks must hold in reserve with the
central bank. Banks only maintain a small portion of their assets as cash available for immediate
withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the
proportion of total assets to be held as liquid cash, the State Bank changes the availability of
loanable funds. This acts as a change in the money supply. Central banks typically do not change
the reserve requirements often because it creates very volatile changes in the money supply due
to the lending multiplier.
Discount window lending
Many central banks or finance ministries have the authority to lend funds to financial institutions
within their country. By calling in existing loans or extending new loans, the monetary authority
can directly change the size of the money supply.
Interest rates
The contraction of the monetary supply can be achieved indirectly by increasing the nominal
interest rates. Monetary authorities in different nations have differing levels of control of
economy-wide interest rates. In the Pakistan, the State Bank can set the discount rate, as well as
achieve the desired Federal funds rate by open market operations. This rate has significant effect
on other market interest rates, but there is no perfect relationship. or both In the Pakistan open
market operations are a relatively small part of the total volume in the bond market. One cannot
set independent targets to monetary base and the interest rate because they are both modified by
a single tool — open market operations; one must choose which one to control.

By raising the interest rate(s) under its control, a monetary authority can contract the money
supply, because higher interest rates encourage savings and discourage borrowing. Both of these
effects reduce the size of the money supply.

Goals of Monetary Policy

1) Price Stability
Unanticipated inflation leads to lender losses. Nominal contracts attempt to account for
inflation. Effort successful if monetary policy able to maintain steady rate of inflation.

2) High Employment
The movement of workers between jobs is referred to as frictional unemployment. All
unemployment beyond frictional unemployment is classified as unintended
unemployment. Reduction in this area is the target of macroeconomic policy.

3) Economic Growth
Economic growth is enhanced by investment in technological advances in production.
Encouragement of savings supplies funds that can be drawn upon for investment.

4) Interest Rate Stability

Volatile interest and exchange rates generate costs to lenders and borrowers. Unexpected
changes that cause damage, making policy formulation difficult.

5) Financial Market Stability

6) Foreign Exchange Market Stability

Money market:

A security market where short term, more liquid and less riskier securities are traded is called the
money market.

Goods market Equilibrium:

We combine aggregate supply with the aggregate demand curve by drawing them both on the
same set of axis.

AD= As

Y=C+I--------------1

Y=C+S-------------2

C+I= C+S

I=S

Money Market Equilibrium:

When the money demand by consumers and firms equals the money supply with the State Bank
has allowed the banking system to make available.

Md = Ms

We consider Ms, as an exogenous factor not influenced from the external factors.

Money demand has three motives:

1) Transactionary motive. (Md t)

2) Precautionary motive. (Md p)

3) Speculative motive. (Md s)

i) Md t= f(y)

Md t= K1(y)

ii) Md p= f(y)

Md p= K2(y)
 iii) Md s = f(i)

Md s = -mi

Put Ms = M0

Md = Md t + Md p + Md s

K1y+K2y-mi---------------------- 1

K1y+K2y-mi=Mo

i= Ky-mo /m

ISLM Curve:
A diagram used to determine what values of interest rate and total income together produce
equilibrium in money market , “supply of money equals to money demanded” and equilibrium in
goods market is “planned expenditure equals to real GDP.

The IS/LM model is a macroeconomic tool that demonstrates the relationship between interest
rates and real output in the goods and services market and the money market. The intersection of
the IS and LM curves is the "General Equilibrium" where there is simultaneous equilibrium in all
the markets of the economy. IS/LM stands for Investment Saving / Liquidity preference Money
supply.
 Th
Formulation

The model is presented as a graph of two intersecting lines in the first quadrant.

The horizontal axis represents national income or real gross domestic product and is
labeled Y. The vertical axis represents the nominal interest rate, i.

The point where these schedules intersect represents a short-run equilibrium in the real and
monetary sectors (though not necessarily in other sectors, such as labor markets): both product
markets and money markets are in equilibrium. This equilibrium yields a unique combination of
interest rates and real GDP.

Asset
Money Market
IS Schedule
The IS schedule is drawn as a downward-sloping curve with interest rates as a function
of GDP (Y). The initials IS stand for "Investment and Saving equilibrium" but since 1937 have
been used to represent the locus of all equilibriums where total spending (consumer spending +
planned private investment + government purchases + net exports) equals an economy's total
output (equivalent to real income, Y, or GDP). To keep the link with the historical meaning,
the IS curve can represent the equilibriums where total private investment equals total saving,
where the latter equals consumer saving plus government saving (the budget
surplus) plus foreign saving (the trade surplus). Either way, in equilibrium, all spending is
desired or planned; there is no unplanned inventory accumulation (i.e., no general glut of goods
and services). The level of real GDP (Y) is determined along this line for each interest rate.

Thus the IS schedule is a locus of points of equilibrium in the "real" (non-financial) economy.
Given expectations about returns on fixed investment, every level of interest rate (i) will generate
a certain level of planned fixed investment and other interest-sensitive spending: lower interest
rates encourage higher fixed investment and the like. Income is at the equilibrium level for a
given interest rate when the saving that consumers choose to do, out of this income equals
investment (or, more generally, when "leakages" from the circular flow equal "injections"). A
higher level of income is needed to generate a higher level of saving (or leakages) at a given
interest rate. Alternatively, the multiplier effect of an increase in fixed investment raises real
GDP. Both ways explain the downward slope of the IS schedule. In sum, this line represents the
line of causation from falling interest rates to rising planned fixed investment (etc.) to rising
national income and output.
LM Schedule
The LM schedule (curve) shows the combinations of interest rates and levels of real income for
which the money market is in equilibrium. It is an upward-sloping curve representing the role of
finance and money. The initials LM stand for "Liquidity preference and Money supply
equilibrium". As such, the LM function is the equilibrium point between the liquidity
preference or Demand for Money function and the money supply function (as determined
by banks and central banks).

The liquidity preference function is simply the willingness to hold cash balances instead
of securities. For this function, the interest rate (on the vertical axis) is plotted against the
quantity of cash balances (or liquidity, on the horizontal). The liquidity preference function is
downward sloping. Two basic elements determine the quantity of cash balances demanded
(liquidity preference) - and therefore the position and slope of the function:
  1) Transactions demand for money: this includes both a) the willingness to hold
cash for everyday transactions as well as b) as a precautionary measure - in case of
emergencies. Transactions demand is positively related to real GDP (represented by Y,
and also referred to as income). This is simply explained - as GDP increases, so does
spending and therefore transactions. As GDP is considered exogenous to the liquidity
preference function, changes in GDP shift the curve. For example, an increase in GDP
will, ceteris paribus (all else equal), move the entire liquidity preference function
rightward in response to the GDP increase.
 2) Speculative demand for money: this is the willingness to hold cash as an asset
for speculative purposes. Speculative demand is inversely related to the interest rate. As
the interest rate rises, the opportunity cost of holding cash increases - the incentive will
be to move into securities.

The money supply function for this situation is plotted on the same graph as the liquidity
preference function. The money supply is determined by the central bank decisions and
willingness of commercial banks to loan money. Though the money supply is related indirectly
to interest rates in the very short run, the money supply in effect is perfectly inelastic with
respect to nominal interest rates (assuming the central bank chooses to control the money supply
rather than focusing directly on the interest rate). Thus the money supply function is represented
as a vertical line - it is a constant, independent of the interest rate, GDP, and other factors.
Mathematically, the LM curve is defined by the equation M / P = L(r,Y), where the supply of
money is represented as the real amount M/P (as opposed to the nominal amount M), with P
representing the price level, and L being the real demand for money, which is some function of
the interest rate and the level Y of real income. The LM curve shows the combinations of interest
rates and levels of real income for which money supply equals money demand -- that is, for
which the money market is in equilibrium.

For a given level of income, the intersection point between the liquidity preference and money
supply functions implies a single point on the LM curve: specifically, the point giving the level
of the interest rate which equilibrates the money market at the given level of income. Recalling
that for the LM curve, the interest rate is plotted against real GDP (whereas the liquidity
preference and money supply functions plot interest rates against the quantity of cash balances),
an increase in GDP shifts the liquidity preference function rightward and hence raises the interest
rate. Thus the LM function is positively sloped.
Shifts

One hypothesis is that a government's deficit spending ("fiscal policy") has an effect similar to
that of a lower saving rate or increased private fixed investment, increasing the amount
of aggregate demand for national income at each individual interest rate. An increased deficit by
the national government shifts the IS curve to the right. This raises the equilibrium interest rate
(from i1 to i2) and national income (from Y1 to Y2), as shown in the graph above.

From the point of view of quantity theory of money, fiscal actions that leave the money supply
unchanged can only shift aggregate demand if they receive support from the monetary sector. In
this case, the velocity or demand of money determines aggregate demand. If the velocity of
money remains unchanged at the initial level of output, so does aggregate demand. Essentially,
the monetary sector is the source of any shift that occurs. From the monetarist perspective,
money velocity is stable, but, from a Keynesian point of view, an increase in aggregate demand
can increase the velocity of money and lead to higher output.

The graph indicates one of the major criticisms of deficit spending as a way to stimulate the
economy: rising interest rates lead to crowding out – i.e., discouragement – of private fixed
investment, which in turn may hurt long-term growth of the supply side (potential output).
Keynesians respond that deficit spending may actually "crowd in" (encourage) private fixed
investment via the accelerator effect, which helps long-term growth. Further, if government
deficits are spent on productive public investment (e.g., infrastructure or public health) that
directly and eventually raises potential output, although not necessarily as much as the lost
private investment might have. Whether a stimulus crowds out or in depends on the shape of the
LM curve. A shift in the IS curve along a relatively flat LM curve can increase output
substantially with little change in the interest rate. On the other hand, an upward shift in the IS
curve along a vertical LM curve will lead to higher interest rates, but no change in output (This
case represents the Treasury View).

The IS/LM model also allows for the role of monetary policy. If the money supply is increased,
that shifts the LM curve to the right, lowering interest rates and raising equilibrium national
income.

Usually the model is used to study the short run when prices are fixed or sticky and
no inflation is taken into consideration. To include these and other crucial issues, several further
diagrams are needed or the equations behind the curves need to be modified.
Relationship of Money market and ISLM Curve:

Three important facts of quantity of money demanded are:

1) Money demanded has a time trend, the result of slow changes in banking sector structure
and technology.

2) Money demanded is proportional to total income, which by the circular flow principal is
the same as total spending and the same as GDP.

3) Money demanded is inversely related to the nominal interest rates go up, demand for
money goes down.

Liquidity Trap

The term liquidity trap is used in Keynesian economics to refer to a situation where the demand
for money becomes infinitely elastic, i.e. where the demand curve is horizontal, so that further
injections of money into the economy will not serve to further lower interest rates. Under the
narrow version of Keynesian theory in which this arises, it is specified that monetary
policy affects the economy only through its effect on interest rates. Therefore, if the economy
enters a liquidity trap area—and further increases in the money stock will fail to further lower
interest rates—monetary policy will be unable to stimulate the economy.

However, the concept came back to prominence in misconception in the 1990s when the
Japanese economy fell into a period of prolong destagflation despite the presence of near-zero
interest rates. While the liquidity trap as formulated by Keynes refers to the existence of an
horizontal demand curve for money at some positive level of interest rates, the liquidity trap
invoked in the 1990s referred merely to the presence of zero interest rates (ZIRP), the assertion
being that since interest rates could not fall below zero, monetary policy would prove to be
impotent in those conditions, just as it was asserted to be in a proper exposition of a liquidity
trap.
While this 1990s invocation of the term "liquidity trap" was not in conformity with that asserted
by Keynes, both treatments have in common first the assertion that monetary policy affects the
economy only via interest rates and second the subsequent conclusion that monetary policy is
impotent with respect to being able to stimulate the economy under those conditions.

Much the same furor has emerged in the Pakistan and Europe in 2008–2009, as short-term policy
rates for the various central banks have moved close to zero.

Note that the neoclassical economists' assertion was the fact that even under an occurrence of a
liquidity trap; expansive monetary policy could still stimulate the economy via the direct effects
of increased money stocks on aggregate demand. This was essentially the hope of both the Bank
of Japan in the 1990s, when it embarked upon quantitative easing and of the central banks of the
Pakistan and Europe in 2008–2009, with their foray into quantitative easing. All these policy
initiatives are attempts to stimulate the economy through methods other than the mere reduction
of short-term interest rates.