Lecture 22

Financial Markets

Bernardina Algieri
e-mail: b.algieri@unical.it
In this lecture, look for the answers to these questions:

• Which are the main Central Bank interest rates?

• What is the demand for money and why people demand
money?
• When the market for money is in equilibrium?
• What is the velocity of money circulation and the
quantity theory of money?

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CENTRAL BANK INTEREST RATES
Interest Rates

• Central Banks determine the stance of monetary policy

by controlling the supply and the price of money.

• Central Banks do so by issuing banknotes and providing

liquidity (lending money) to banks, and by setting the
“key” interest rates.

• These rates and conditions are then passed on to the wider

economy where they affect the volumes of, and interest
rates on, loans to companies and households and,
ultimately, the price level.

• This process is known as the transmission mechanism

of monetary policy.
Interest Rates

• Central Banks implement their monetary policy decisions

by using a set of policy instruments.

• Traditionally the most important instruments are the

official interest rates, also known as the policy rates.
Interest Rates

In the Eurosystem, the three key ECB interest rates are:

• (1) the interest rate on the main refinancing
operations, which is the rate banks pay when they
borrow money from the ECB for one week => provide
liquidity to the banking system;

• (2) the deposit rate, which is the rate banks receive for
depositing money overnight with the Eurosystem; and

• (3) the rate on the marginal lending facility, which

determines the interest rate on overnight credit provided
by the Eurosystem to banks.
 ECB Key Interest Rates
The official ECB interest rates for the euro area are decided every six weeks by the
Governing Council.

https://data.ecb.europa.eu/main-figures/ecb-interest-rates-and-exchange-
rates/key-ecb-interest-rates

14/April/2024
Discount Rate

In the US, the main interest rates are:

❖ The Federal Funds rate is the rate banks charge other
banks to borrow money overnight. These loans are
typically for 24 hours (i.e. overnight).

The law requires banks to keep a certain percentage of

their customer's money on reserve, where the banks earn
no interest on it. Consequently, banks try to stay as close to
the reserve limit as possible without going under it, lending
money back and forth to maintain the proper level.

In other words, banks with excess reserves lend to other

banks (i.e. interbank loan) who need reserves to meet
their reserve requirement.
 Discount Rate

❖ The discount rate is the interest rate that the Fed

charges when it makes loans to banks for short-term
loans

• Banks borrow from the Fed when they have to cover any
cash shortfalls, prevent any liquidity problems, or in the
worst-case scenario, avoid the bank’s failure.

• The lower the discount rate, the cheaper is borrowed

money, and the more banks borrow at the Fed’s discount
window. Hence, a reduction in the discount rate raises
the monetary base and the money supply
Discount Rate vs. Federal Funds Rate

The Fed Funds Rate and the Discount Rate are both important
monetary policy tools that the Fed can adjust to have an effect
on the money supply.

Adjusting rates helps the Fed achieve conditions that satisfy its
dual mandate: Keep prices stable and maximize employment.
 Discount Rate vs. Federal Funds Rate

The difference is that:

➢ the discount rate is the interest rate that a bank must pay when it borrows
money from the Fed,

➢ while the Fed Funds Rate is the rate that banks must pay when they borrow from
one another on an overnight basis.

The Fed directly decides what the Discount Rate is based on the current state of the
economy.

The Fed Funds Rate, on the other hand, is determined by the demand and supply of
loanable funds on the open market. The Fed sets a target for the Fed Funds Rate
and then will buy or sell Treasury bills in order to indirectly affect the rate until that
target rate is reached.
• The Federal Open Market Committee (FOMC) meets
eight times a year to determine the Federal Funds
Target Rate

• This rate influences the Effective Federal Funds Rate

through open market operations or by buying and selling
of government bonds (government debt)
Federal Funds Rate: Target and Effective
 Discount Rate vs. Federal Funds Rate

The discount rate is higher than the fed funds effective rate, which encourages banks to
borrow and lend to each other and only turn to the central bank when necessary
The discount rate is higher than the fed funds effective and target rate. This is because the
Federal Reserve, or other central bank, typically acts as the lender of last resort to banks
that no longer have other available means of borrowing
Financial Market

• Financial markets display a wide range of interest rates,

representing borrowers with different risk premiums and
loans that are to be repaid over different periods of time.

• In general, when the federal funds rate drops

substantially, other interest rates drop, too, and when the
federal funds rate rises, other interest rates rise.
 The prime rate

• The prime rate is the interest rate banks charge their “very
best” corporate customers, borrowers with the strongest credit
ratings.

• If Google were to borrow money from Bank of America for a

short period of time, Google would be charged Bank of
America’s Prime Rate.

• Customers with less strong credit ratings would be charged

more than the prime rate (typically thought of as Prime rate
plus a premium). The prime rate is thus the floor on which a
bank’s short-term rates of different types are based.
• The prime interest rate is the benchmark banks and
other lenders use when setting their interest rates for
every category of loan from credit cards to car loans and
mortgages.

• When the prime rate changes, variable interest rates will

change also. Since each bank can charge its own prime
rate, the published prime rate is the consensus or average
rate banks charge.

• Both the Federal Funds Rate and the Prime Rate are
market determined interest rates. In other words, they are
determined through the interaction between supply and
demand in their respective credit markets.
 The prime rate vs. Fed funds rate and discount rate

Banks generally use a formula of federal funds rate + 3 to determine the prime rate they
charge to their best customers
ECB vs. Fed
Web question

Go to
www.federalreserve.gov/releases/h6/Current/

a. What has been the growth rate in M1 and M2

(SA) between October 2022 and February 2024?

b. Does this seem expansionary or restrictive?

MARKET FOR MONEY: DEMAND AND EQUILIBRIUM
Demand for Money

The demand for money is the desired holding of

financial assets in the form of money, that is:

▪ currency or cash (paper and coins)

▪ checkable deposits (the bank deposits on which you
can write checks)

It is sometimes referred to as liquidity preference.

Bonds => No Money

pay a positive interest rate, but cannot be used for
transactions
Money

Why would you hold any of

your wealth as money -- as
cash or checking deposits?

Those assets earn little or no

interest!

Would not it be more sensible

to hold all your wealth in the
form of assets that yield
income?
Money

Three motives for demanding money (Keynesian view):

➢ the transactions,
➢ the precautionary,
➢ the speculative motives.
Transactions motive

The transactions motive for demanding money arises from the fact
that most transactions involve an exchange of money.
Because it is necessary to have money available for transactions,
money will be demanded.

The total number of

transactions made in an
economy tends to
increase over time as
income rises.
As income or GDP rises,
the transactions demand
for money rises.
Precautionary motive
People often demand money as a precaution against an
uncertain future.
Unexpected expenses, such as car repair bills, often require
immediate payment.
The need to have money available in such situations is
referred to as the precautionary motive for demanding money.
When income rises, the precautionary demand for money also
increases.
Liquidity

Given that both types of demand are function of income we

can indicate them with
L1 =Liquidity =>
Ltransaction+ Lprecautionary= L1

L1 =f(Y) ΔL1/ΔY >0

Y=income
Transaction and Precautionary Demand

Y
D
Y2

C
Y1

L1A L1B L1
Speculative motive

Money, like other stores of value, is an asset. The demand for

an asset depends on both its rate of return and its
opportunity cost.
Typically, money holdings provide no rate of return and often
depreciate in value due to inflation.
Speculative motive

The opportunity cost of holding money is the interest rate

that can be earned by lending or investing one's money
holdings.
The speculative motive for demanding money arises in
situations where holding money is perceived to be less risky
than the alternative of lending the money or investing it in
some other asset.
• For example, if a stock market crash seems imminent,
the speculative motive for demanding money would
come into play; those expecting the market to crash
would sell their stocks and hold the proceeds as money.

• The presence of a speculative motive for demanding

money is also affected by expectations of future interest
rates and inflation.
• If interest rates are expected to rise, the opportunity cost of
holding money will become greater, which in turn diminishes
the speculative motive for demanding money.

• Similarly, expectations of higher inflation presage a greater

depreciation in the purchasing power of money and
therefore lessen the speculative motive for demanding
money.
Speculative demand

Indicating with L2 the speculative demand

Lspeculative = L2
=>
L2 =f(i) ΔL2/Δi < 0
Speculative Demand

i
i1 C’

D’
i2

L2A L2B L2
A Model of Aggregate Money Demand

The aggregate demand for money consists of two

components:

➢ a transactional-precautionary component (L1) that is

direct function of income
➢ a speculative component (L2) that is an inverse function
of the interest rate

Md = L1(Y) + L2 (i)

Md = f (Y ;i )

Md = aggregate demand for money in nominal terms

 A Model of Aggregate Money Demand

The aggregate demand for money Md in real terms:

𝑴𝒅
= 𝒇 𝒀; 𝒊
𝑷

P = price level; Y = national income i = nominal interest rates

The explicit aggregate demand for money in real terms

Transactional and
precautionary demand
Speculative demand for
𝑴𝒅 for money
=𝒌∙𝒀−𝒉∙𝒊
money 𝑷

k and h respectively express the sensitivity of the demand for money to the
level of income and to the "opportunity cost" inherent in holding money
Real Money Demand

i
B

For a given 𝑴𝒅
level of income, =𝒌∙𝒀−𝒉∙𝒊
𝑷
real money
demand
decreases as the A
nominal interest
rate increases….

Quantity of Money
Real Money Demand

i
When income
increases, real
money
demand
increases at
every interest
rate.….

𝑴′𝒅
𝑴𝒅
𝑷′
𝑷
Quantity of Money
A Model of Aggregate Money Demand

The real aggregate demand for money can be expressed also in

terms of real interest rate:
𝑴𝒅
=𝒌∙𝒀−𝒉∙𝒓
𝑷

where:
➢ r is a measure of real interest rates

➢ 𝑟 =𝑖−𝜋
➢ 𝜋 = 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
Money Supply

• Money Supply in nominal terms (M) is controlled by

Central Banks. The CB alters the money supply primarily
by changing the quantity of reserves in the banking
system and through the purchase and sale of government
bonds in open-market operations
MARKET FOR MONEY EQUILIBRIUM
The Market For Money

The market for money uses the (aggregate) money demand

and (aggregate) money supply.

• The condition for equilibrium in the money market is:

M s = Md
Alternatively, we can define equilibrium using the supply of
real money and the demand for real money (by dividing both
sides by the price level):
𝑴𝒔 𝑴𝒅
=
𝑷 𝑷
This equilibrium condition will yield an equilibrium nominal
interest rate (i*).
Equilibrium in the Market for Money
𝑴𝒐𝒏𝒆𝒚 𝑺𝒖𝒑𝒑𝒍𝒚

E
i*

𝑴𝒐𝒏𝒆𝒚 𝒅𝒆𝒎𝒂𝒏𝒅

𝑴𝒔 𝑴𝒅
= Real Quantity of Money
𝑷 𝑷
 Factors affecting Money Demand and Supply

There are several factors that influence the movements of the

demand and supply of money.

o Nominal money supply (Ms)

o Price level (P)

o Fiscal contraction
SHIFTERS OF THE SUPPLY OF MONEY
 Factor affecting supply of money
↑ in 𝑴𝑺 𝑴𝑺’ Movements
Nominal money The supply shifts to the
supply (Ms) right
i

For an
expansive
E
i*
monetary policy,
money supply
increases and
the interest rate E’
drops…. i*’

𝑴𝒅

𝑴𝒔 𝑴𝒅 𝑴′𝒔 𝑴′𝒅 𝑴
= =
𝑷 𝑷 𝑷 𝑷 𝑷
Reasons
When Ms increases, the real money supply
rises and reduces the equilibrium real interest
rate
 Factor affecting supply of money
𝑴𝑺’ 𝑴𝑺 Movements
↑ in i The supply shifts to
Price level (P)
i*’ E’ the left

For prices raise,

money supply
E
i*
decreases and
the interest rate
surges….

𝑴𝒅

𝑴𝒔 𝑴
Reasons 𝑷
𝑷
It reduces the real money supply and
increases the equilibrium real interest
rate
SHIFTERS OF THE DEMAND OF MONEY
 Factors affecting Money Demand and Supply

What does it happen with a Fiscal contraction?

Fiscal contraction refers to a reduction in a government's

budget deficit by declines in public expenditure or increases in
taxation.
 Movements
Factor affecting demand of money
𝑴𝑺 The demand shifts
↑ in downward to the left
Fiscal
contraction i Knowing:

Y
Following a
fiscal
E
i* M d = k Y − h  i
contraction,
money demand P
decreases and
the interest rate
drops…. i*’ E’

𝑴𝒅
𝑴𝒅’
𝑴𝒔 𝑴𝒅 𝑴
Reasons =
𝑷 𝑷 𝑷
Fiscal contraction reduces income and
the real demand for money and lowers
the equilibrium interest rate
SUMMARY

• Discount rate is the interest rate the Fed charges member

banks to borrow for short-term
• Both the federal funds rate and the prime rate are market
determined interest rates, the discount rate, by contrast, is not
market determined, but set by the Fed
• The prime rate is derived from the federal funds rate, usually
using fed funds + 3.
• The equilibrium in the market for money occurs when demand
and supply equalise

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