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2123 ch04
2123 ch04
Fei DING
The Hong Kong University of Science and Technology
FINANCIAL MARKETS
PREVIOUSLY …
LEARNING OBJECTIVES
❖ Understand sources and determinants of demand from decomposition of GDP.
❖ Define and derive the short run equilibrium output using two approaches.
❖ Describe effects of fiscal policy on equilibrium output, and its limitations.
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Ch4: Financial Markets
LEARNING OBJECTIVES
❖Explain factors that determine the demand for money and write down the
money demand function.
❖ Define and derive equilibrium interest rate in the financial markets.
❖ Describe roles of banks and understand how the supply and demand of money
change with and without the presence of banks.
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CNBC NEWS (MAR. 2020)
Federal Reserve cuts rates to zero and launches
massive $700 billion quantitative easing program
PUBLISHED SUN, MAR 15 2020 UPDATED MON, MAR 16 2020
Steve Liesman@STEVELIESMAN
KEY POINTS
In an emergency move Sunday, the Federal Reserve announced it is dropping its benchmark
interest rate to zero and launching a new round of quantitative easing.
The QE program will entail $700 billion worth of asset purchases entailing Treasurys and
mortgage-backed securities.
Markets responded negatively, with Dow futures pointing to a drop of 900 points when the
market opens Monday morning.
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QUANTITATIVE EASING (QE)
QE1, QE2, and QE3
The expression "QE2" became a "ubiquitous nickname" in 2010, usually used to
refer to a second round of quantitative easing by central banks in the United
States. Retrospectively, the round of quantitative easing preceding QE2 may be
called "QE1". Similarly, "QE3" refers to the third round of quantitative easing
following QE2.
QE3 was announced on September 13, 2012. In an 11-to-1 vote, the Federal
Reserve decided to launch a new $40 billion a month, open-ended, bond
purchasing program; to continue until at least mid-2015. According to
NASDAQ.com, this is effectively a stimulus program which allows the Federal
Reserve to print $40 billion dollars a month for an unlimited amount of
time. Ratings firm Egan-Jones said it believes the Fed’s decision “will hurt the
U.S. economy and, by extension, credit quality.” As a result, the firm once again
slashed the U.S. bond rating bringing it down to AA-. Federal Reserve chairman
Ben Bernanke acknowledged concerns about inflation.
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SEP. 16, 2020
FEDERAL RESERVE OFFICIALS EXPECT TO
LEAVE INTEREST RATES NEAR ZERO FOR
YEARS — THROUGH AT LEAST 2023 — AND
WILL TOLERATE PERIODS OF HIGHER
INFLATION AS THEY TRY TO REVIVE THE
LABOR MARKET AND ECONOMY, BASED ON
THEIR SEPTEMBER POLICY STATEMENT AND
ECONOMIC PROJECTIONS RELEASED
WEDNESDAY.
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THINGS TO THINK ABOUT…
❖ What’s the relation between interest rate and overall
condition of the economy?
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FINANCIAL MARKETS OVERVIEW
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~Zero interests
MONEY Easy transactions
A type of wealth
Self-sufficiency
Without Money
Barter economy
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MONEY VS. OTHER FINANCIAL ASSETS
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MONEY – THE MOST LIQUID OF ALL
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THE DEMAND FOR MONEY
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THE DEMAND FOR MONEY
M d = $Y L (i )
( −)
❖ Increases proportionally with nominal income ($Y) – captures
transaction purpose of money (and taken as given for now)
➢ Suppose real income is unchanged but prices double leading to a
doubling of nominal income. We need to hold twice as much cash to
buy the same consumption baskets.
➢ Hyperinflation – super high inflation under which people must carry lots
of money, but real income is unchanged.
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THE DEMAND FOR MONEY – GRAPH
M d = $YL(i )
(− )
Figure 4 - 1
The Demand for Money
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MONEY MARKET EQUILIBRIUM
Figure 4 - 2
The Determination of
the Interest Rate
The interest rate must be
such that the supply of
M = $Y L(i)
money (which is
independent of the interest
rate) is equal to the
demand for money (which
does depend on the
interest rate).
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MONEY MARKET EQUILIBRIUM
Figure 4 - 3
The Effects of an Increase
in Nominal Income on the M = $Y L(i)
Interest Rate
An increase in nominal income
leads to an increase in the
interest rate.
$Y ↑ → transaction ↑ → Md ↑
(at any i) → money demand
curve shifts to the right.
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HOW DOES MARKET BALANCE ITSELF?
Hold money vs. hold bond
❖ Our usual way of thinking
➢ $1 → $1, interest on money is 0.
➢ $1 → $(1+i), interest on bond is i.
❖ The way that works in reality
❖ Money: $100 gets you $100 in the future.
❖ Bond: $p gets you $100 in the future.
❖ What’s the relation between p and i?
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BOND PRICE AND YIELD
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HOW DOES MARKET BALANCE ITSELF?
At the current interest rate, suppose the supply
of money is less than the demand for money.
Given this information, we know that:
1) the price of bonds will tend to increase.
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MONEY MARKET EQUILIBRIUM
Figure 4 - 4 Ms'
The Effects of an Increase
in the Money Supply on the
Interest Rate M = $Y L(i)
An increase in the
supply of money leads
to a decrease in the
interest rate.
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MONETARY POLICY
Suppose nominal
income increases and
that the central bank
wants to keep the
interest rate unchanged.
What monetary policy
should it use?
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OPEN MARKET OPERATIONS
Figure 4 - 5
The Balance Sheet of the
Central Bank and the
Effects of an Expansionary
Open Market Operation
Open market operations
lead to equal changes in
assets and liabilities.
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REFRESH
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REFRESH
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INTEREST RATE – CAVEATS
❖ We assumed one interest rate i, but in real world,
many rates.
➢ Treasury bills (T-bills) mature in 1 year or less.
➢ Treasury notes (T-notes) mature in 2-10 years.
➢ Treasury bonds (T-bonds) mature 20-30 years.
➢ Time deposits, money market savings account, etc.
❖ The central bank can, through open market
operations, change the short-term interest rate.
❖ QE vs. OMO
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THE MONEY MARKET – SUMMARY
❖ Interest rate i
➢ Price or conversion ratio of current vs. future consumptions
➢ Determined by demand and supply of money
❖ So far, only focus on currency/cash controlled by the
central bank through OMO.
❖ But M1 = currency/cash + checkable deposits.
➢ Checkable deposits are supplied by (private) banks.
➢ Can central bank still control i?
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WHAT BANKS DO
❖ Financial intermediaries: receive (borrow) funds from some and
provide (lend) to others.
➢ Deposits: liabilities of banks
➢ Loans, bonds, other assets: assets of banks
❖ Subject to regulations because of the risk involved.
➢ Credit risk: What if the loans cannot be repaid?
➢ Liquidity risk: What if the loans cannot be called back when I need the
money?
❖ Reserve ratio: % of deposits that must be kept as “reserve”
~10% in the US
➢ The rest: loans, bonds, interbank loans, etc.
➢ Would banks voluntarily hold more than the reserve requirement???
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A RUN ON A BANK OF EAST ASIA BRANCH IN HONG
KONG, CAUSED BY "MALICIOUS RUMOURS" IN 2008.
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Bank Runs
Rumors that a bank is not doing well and some loans will not
be repaid, will lead people to close their accounts at that bank.
If enough people do so, the bank will run out of reserves—a
bank run.
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WHAT BANKS DO
Figure 4 - 6
The Balance Sheet of Banks
and the Balance Sheet of
the Central Bank, Revisited
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OMO – BALANCE SHEET ANALYSIS
Central bank bought $10,000 bond from nonbank.
Central bank Nonbank (the public)
assets liabilities assets liabilities
bonds currency bonds -$10,000
+$10,000 (in circulation) currency (or cash)
+$10,000 +$10,000
Figure 4-A1 Determinants of the Demand and the Supply of Central Bank Money
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SEE YOU NEXT TIME ☺
❖ Assigned reading:
➢ Textbook Chap. 4 (4-3, 4-4, and appendix optional
but need to know the materials from lecture slides)
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