Financial Markets

∗
Vipul Mathur

1 Financial Markets

In our previous exposition, where we introduced money in the real economy,

the demand for money demand was motivated as a demand for transactions,

and that finally resulted into the quantity equation, M d V = P Y. We had also

brushed aside the issues of money market, and said that since the markets were

perfectly competitive, demand for money would also equate with the supply of

money, M s .

Now, we will introduce the money market with more nuances. However, we will

still retain the punchline from the transaction demand analysis: that money

demand is proportional to nominal value of transactions: M d ∝ P Y .

Instead of introducing money as “helicopter drops” we will not add a more

nuanced change: the exchange of money and bonds. It is to be noted that the

money we are referring to here, is simply the cash, or currency notes (there is

no banking sector yet).

1.1 Bonds

Bonds are IOUs, characterized by par-value, coupon rate, duration, price and

yield. In that sense, bond is an asset which pays some return on investment.
∗ Prepared for Macroeconomics course. E-mail: vipul@iimcal.ac.in

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Money pays no return and is only used for transactions. Bonds cannot be

used for transactions. So this creates a choice between investing in an asset

and holding cash. Such a choice is contingent upon the return one will get in

investing into a bond. This return is captured through the “yield” on the bond.

In our discussion of bonds, we identified the following

1. Price of a bond is inversely related to the yield of the bond

2. When interest rates go up, the prices of bonds fall, and the bond market

loses its valuation

3. When bond markets are said to be in a rally, the prices of the bonds are

rising, or equivalently, the yields are falling.

In our description, we will just have one bond, with only one interest rate to

track. We will use yields synonymously as interest-rate.

Suppose you only have a choice between two commodities: money (cash) and

bonds. If you can earn a very high interest on bonds, you may want to park

a greater part of your cash in bonds. If the bonds pay you very low interest,

you will be rather indifferent between investing in bonds and keeping cash in

wallet. Therefore, the amount of money (or cash) you will be willing to hold

(or demand) is inversely related to the interest rates that is being offered on the

bonds. Therefore,

M d ∝ (−i)

So as interest rates rise, you will want to hold more bonds and less money (cash).

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1.2 Money demand

From our earlier discussion on quantity equation, we also know that

Md ∝ PY

Combining the two we get that

M d ∝ P Y and ∝ (−i)

As always, we will want to represent this relationship in a supply-demand dia-

gram. The choice for x-axis is straightforward: it will be the quantity of money.

For the y-axis we need to choose some “price” for this quantity. Now, techni-

cally, the “price” of money is in terms of goods. If a unit of good costs P in

monetary terms, then the price of 1 unit of money is 1/P units of the good. We

will instead use interest rates on the y-axis. The exchange of money is a two

way exchange: between money and bond. Interest rates on bonds capture the

opportunity cost of holding money in time. So in a i − M diagram, the money

demand will be a downward sloping curve, drawn for one level of P Y . This is

given below:

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At this point we are withholding from putting any functional form (like rect-

angular hyperbola) for the demand function. It suffices to know that it will be

a downward sloping curve as argued before. It is to be noted that this curve

is drawn for one value of nominal value of transactions, P Y . If this changes,

the curve will shift. For instance, everything else remaining the same, the curve

will shift to the right if P Y increases. Having determined the money demand

function, we now move on to money supply.

1.3 Money Supply

As before, the money supply is completely inelastic with respect to prices, or in

this case, the interest rates. The central bank can simply print as much money

as it desires and supply it to the real economy. (This is not to be confused with

the effect of printing more money on the equilibrium value of interest rates as

discussed in the next section). The money supply curve will therefore look like

a vertical line as in the following:

If the central bank decides to increase the money supply, this line will shift to

the right and vice-versa.

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1.4 Equilibrium in Financial Markets

Now that we have the demand and supply in place, we can proceed to deter-

mine their interaction. Put together, the supply-demand graph would like the

following:

The equilibrium value of interest rate, i∗ and money, M ∗ is determined at the

intersection of the money supply and demand curves.

2 Central Bank’s operations

The Central Bank is the sole authority which can introduce money. Unlike the

“helicopter drops”, in this setup, when the central bank changes the quantity of

money in the real economy, it will have implications for the interest rate.

2.1 What happens when the Central Bank changes the

money supply?

Referring to our supply-deand diagram, when the central bank changes the

money supply, the vertical line will shift. Suppose the central bank increases

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the money supply - then, the vertical line will shift to the right as indicated in

the figure below:

What happens to the money demand curve? Recall that the money demand

curve is drawn for a particular level of P Y . It will shift if either or both, of

P , Y changes. In the immediate short-term the prices are rather sluggish.

The output, Y is anyway more persistent. Therefore, it stands to reason that

P Y may be fixed in the immediate short run, and therefore the money demand

curve would stay where it is. Using this argument, one can see clearly that the

new equilibrium interest rates would have dropped upon increasing the money

supply. Thus increasing money supply, results in drop in interest rates in the

immediate short term. What will happen in the medium run? Over time, both

P and Y will adjust and the money demand curve may shift. We will discuss

this in greater detail when we do the short-run model.

Okay so that the interest rates will drop down upon increases in money supply

is evident from the graph, but what is the mechanism? For that we need to

understand how the central bank implements this change in money supply.

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2.2 How does Central Bank change supply of money

Money and bonds constitute a two-way exchange. If the central bank wants to

push more money in the real economy, it will have to buy bonds from the real

economy and vice-versa. This change the supply of money by buying or selling

bonds in the bond market is also referred to as the open market operations.

There can be two types:

• Expansionary open market operation: the central bank expands the supply

of money by buying bonds. By doing so, the central bank “pumps in”

money in the real economy.

• Contractionary open market operation: the central bank contracts the

supply of money by selling bonds. By doing so it “sucks out” money from

the real economy.

So coming to our previous example, if the central bank is increasing money

supply, then it must be buying bonds form the real economy. This will put an

upward pressure on the prices of the bonds, and since the yield on the bond

is inversely related to prices, the yield will drop and so will the interest rate

(which we have used synonymously with the yield in our analysis). This is

the mechanism how the new interest rate in the figure is arrived at upon the

rightward shift of the vertical line (money supply).

2.3 Money supply or Interest rate: What is the policy

instrument?

In newspapers, we learn about the central bank setting the interest rates. So

is the policy instrument money supply or the interest rate? Until the late 80s,

money supply used to be the policy instrument. But rapid development in asset

markets and banking sector in the post 80s, brought up a portfolio of varied

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interest rates. Therefore, to be congruent with these developments, Central

banks resorted to communicating the policy stance in interest rates rather than

money supply. Also, rates were more naturally suited for financial analysis

especially when the investment portfolios were spread across countries.

Notwithstanding this change, the primary channel of monetary policy is still

the money supply. The central bank can announce a target interest rate - but

that policy rate is effectuated only through changes in the money supply. The

central bank chooses the interest rate and then adjusts the money supply so as

to achieve the interest rate it had chosen. When we discuss our short-run model,

we will stick to the modern instrument: the policy rate. However, it should be

noted that in the background it is the adjustment in quantities (money supply)

which the central bank is using to arrive at this equilibrium rate.