Financial market:

Financial market has a specific role in economy that control the costs.
The demand for many:
There are two financial assets which is money and bonds. We will use the money in our
transaction without interest. There is two kind of money: first currency, like coins and bills.
Second checkable deposit, using the debit card.
Bonds, it is a positive interest rate but we couldn’t use on our business and we can show it by (i).
Income is what we receive after working and it should be monthly and yearly.
Saving is what we receive without taxes and we don’t spend.
Investment: the economist will reserve for the buying of new capital goods.
Therefore, demand for money is the amount that people want to hold and we will show it by Md
(M is foe money and d is for demand). It is amount of all demands by people and firms in
economy that it depends on transactions and the interest rate. It means if the income goes up the
value of dollar in business will goes up and we can use this formula among the demand for
money, nominal income and interest rate: Md=$YL(i) –
In this formula $Y is for nominal income, L(i) is the interest rate and the minus under the interest
rate shows that has a negative effect in demand for money because people will put their capital in
bonds which it means an increase in the interest rate decrease the demand for money. If the
nominal income increases the demand for money will increase too and the slop in graph will shift
to right.
Interest Rate:
If the central bank suppose that money supply is equal to money demand, then we have:
Md=M => M= $L(i)
So, it means people want to have equal money and existing money supply. In result we can say
an increase in supply of money with central bank the interest rate goes down and it leads to
increase the demand for money.
Monetary policy and open market operation:
Central bank can change the supply of money by sell or buy the bonds in bond market. So, it
wants to increase the money then will buy bonds and for decreasing will sell bonds and this
operation is open market operation.
In addition, if the central bank buys $3 million bonds it is higher and this operation is
expansionary open market operation and if sell $2 million bonds it is lower than this in amount
of money in the economy which is call contraction open market operation.
Bond prices and bond yields:
Here, the bond isn’t the interest rate is the price but both of them is same. If the price of bond
be $Pb (be for bond) and we bought and holed the bond for one year it means the interest rate
should find like this: i=($100-$Pb)/$Pb and for finding the bond price we can use this:
$Pb=100/1+i and more interest year means less price of bonds.
In result the central bank can effect and control the costs, for instance by changing the supply
money bring changes in interest rate, by buying the bonds means increasing the supply of money
and decreasing the interest rate and by selling decreasing the supply money and increasing the
interest rate.
Banks:
Some establishments received funds from people and use it in buying assets or loans to others
that call financial intermediaries in modern economy and bank is a kind of financial
intermediaries. Banks hold some of funds as reserve and keep some amount in cash and some in
an account in central bank that can draw when they need it. Also the asset for central bank are
bond and the liabilities are money that has issue by central bank.
Therefore, demand for central bank has two aspects; first demand for currency by people and
second demand for reserved by banks. Md= $YL(i)- and this shows that the demand for reserves
is relative to the demand for checkable deposits Hd= ѳMd = ѳ$YL(i) which central bank can
change the amount H by open market operation.
H=Hd
H= ѳ$YL(i)
more interest rate indicated a lower demand for central bank money by way of the demand for
checkable deposits by people, so the demand for reserves by banks, goes down.
federal funds market is a market for bank reserves, where the interest rate changes to balance the
supply and demand for reserves.
The liquidity trap:
a liquidity trap is when the interest rate is less than zero, monetary policy couldn’t decrease it
more and Monetary policy no longer work in this situation.
Therefore, when the interest rate decreases the demand for money goes up and when money
supply increase it means interest rate will decrease and when the interest rate is zero then people
and bank will hold more money or bond and increasing the money supply is equal the demand
for money and it doesn’t bring changes in interest rate.