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Chapter 4:Financial
Market
4-1:The Demand for Money
4-2:The Determination of the Interest
Rate:Ⅰ
4-3,The Determination of the Interest
Rate:Ⅱ
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4-1:The Demand for Money
Assume that you the choice between only two
financial assets:
● Money,which can be used for transactions,but pays
zero interest,In reality,there are two types of money,
currency,the coins and bills issued by the central bank,
and checkable deposits,the bank deposits on which you
can write checks.
● Bonds,which cannot be used for transactions,but pay
a positive interest rate,i,In reality there are many other
assets than money,and in particular many types of bonds,
each associated with a specific interest rate,
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The relation between the demand for money,
nominal income,and the interest rate
Md =$YL(i) (4.1)
(-)
Md /$Y=L(i) (4.2)
? The demand for money increases in proportion to
nominal income.
? The demand for money depends on the interest
rate,This is captured by the function L(i) and the
negative sign underneath,An increase in the
interest rate decreases the demand for money.
The Demand for Money
i
M
d1
( f or $Y '>$Y )
M
d
( f or nom i nal i ncom e $Y )
M M '
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4-2:The Determination of
the Interest Rate:Ⅰ
Money Demand,Money Supply,and the
Equilibrium Interest Rate
Monetary Policy and Open Market
Operations
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The LM Relation
Equilibrium in financial market requires that money
supply be equal to money demand,that Ms= Md.Using
equation (4.1) for money demand,the equilibrium
condition is
Money supply = Money demand
M = $YL(I)
? This equation tells us that the interest rate must be
such that people are willing to hold an amount of
money equal to the existing money supply,This
equilibrium relation is called the LM relation.
The determination of the
Interest Rate
M on ey su pp ly =M on ey de m an d
M = $ Y L ( i )
i M
s
i A
M
d
M
The Effects Nominal Income
on the Interest Rate
i M
s
i ' A '
M
d '
($Y ' >$ Y )
i A
M
d
M
The Effects of an Increase in the
Money Supply on the Interest Rate
M
s
M
s '
i A
i ' A '
M
d
M M '
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Monetary Policy and Open Market
Operations
The interest rate is determined by the equality of the supply of
money and the demand for money.
By changing the supply of money,the central bank can affect
the interest rate.
The central bank change the supply of money though open
market operations,which are purchases or sales of bonds for
money
Open market operations in which the central bank increases the
money supply by buying bonds lead to an increase in the price
of bonds— equivalently,a decrease in the interest rate.
Open market operations in which the central bank decreases
the money supply by selling bonds lead to an decrease in the
price of bonds— equivalently,a increase in the interest rate.
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4-3,The Determination of the
Interest Rate:Ⅱ
What Banks Do
The supply and Demand for central Bank Money
? The Demand for Money
? The Demand for Reserves
The Determination of the Interest Rate
Two Alternative ways of Looking at the Equilibrium
? The Supply and Demand for Reserves
? The Supply and Demand for Money
Open Market Operations Revisited
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The balance Sheet of banks (a) and the
Balance sheet of the Central Bank
Revisited (b)
(a) Banks
Assets Liabilities
Reserves
Loans
Bonds
Checkable deposits
(b) Central Bank
Assets Liabilities
Bonds Central Bank Money
=Reserves+Currency
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The Supply and Demand
for Central Bank Money
Demand
For money
Demand for
Checkable
Deposits
Demand for
currency
Demand for
Reserves
(by banks) DemandFor
Central
Bank
money
Supply
Of
Central
Bank
Money
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The Demand for Money
Md =$YL(i) (4.4)
(-)
CUd =cMd (4.5)
Dd =(1-c)Md (4.6)
? Equation (4.5) gives the first component of the
demand for currency by the public,Equation (4.6)
gives the demand for checkable deposits,This
demand for checkable deposits leads to a
demand by banks for reserves,the second
component of the demand for central bank
money.
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The Demand for reserves
R=θD (4.7)
? If people want to hold Dd in deposits,then,from
equation (4.7) banks must hold θDd in reserves,
Combining equations (4.6) and (4.7),the second
component of the demand for central bank
money— the demand for reserves by banks— is
given by:
Rd = θ(1-c) Md (4.8)
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The Determination of the
Interest Rate
The equilibrium condition is that the supply of central
bank money be equal to the demand for central bank
money
H = CUd + Rd (4.9)
Replace CUd and Rd by their expressions from
equations (4.50 and (4.8) to get
H = c Md + θ(1-c) Md = [c+ θ(1-c) ] Md
Replace the overall demand for money,Md,by its
expressions from equation (4.4) to get:
H = [c+ θ(1-c) ]$YL(i) (4.10)
The Determination of the Interest Rate
when Money Includes Both Currency
and Checkable Deposits
S u p p l y
i A D e m a n d
C U
d
+R
d
H
C e n t r a l B a n k M o n e y,H
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Two Alternative ways of Looking
at the Equilibrium (1)
The Supply and Demand for Reserves
? Take the equilibrium condition (4.9) and move the
demand for currency to the left side,to get:
H- CUd = Rd
The left side gives the supply of reverses as the
amount of central bank money minus what people
hold as currency,The right side gives the demand
for reverses,The equilibrium condition now reads,
The supply of reserves must be equal to the
demand for reserves.
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Two Alternative wags of Looking
at the Equilibrium (2)
The Supply and Demand for Money
? Take equation (4.10) and divide both sides by [c+
θ(1-c) ] to get,
H/ [c+ θ(1-c) ] = $YL(i) (4.11)
Supply of money = Demand for money
? The right side of the equation gives the overall
demand for money (currency plus checkable
deposits),The left side gives the overall supply of
money (currency plus checkable deposits).The
equilibrium condition is that demand and supply be
equal,