Chapter 4

Financial markets
 What is money?

• Definition: stock of assets that is generally accepted in payment for

goods or services or in the repayment of debts

• Objects that qualify as money under this definition:

Currency (bills and coins)

Checking account deposits (on which you can write a check)

Perhaps even saving deposits

• Money can take different forms

1. Fiat money: money that has no intrinsic value, only decreed by

governments as legal tender

2. Commodity money: for example, gold, silver, or cigarettes in prisons

The island of stone money: Raay
 Semantic traps: money, wealth and income

“Joe has a lot of money”

“Mary is making a lot of money”

• Money is distinct from wealth and income

• Wealth: stock of all resources owned by an individual, including all

assets (currency and bank deposits, but also bonds, stocks, houses,
land, cars,…)

• Income: flow of earnings per unit of time

 Measuring money

• ECB publishes 3 monetary aggregates

– M1: currency + checking account deposits (also called overnight deposits)

– M2: M1 + other short/medium term deposits
– M3: M2 + marketable instruments (repurchase agreements and money market
funds shares) + debt securities up to 2 years

• Fed publishes 2 monetary aggregates

– M1: currency + checking account deposits (also called demand deposits)

– M2: M1 + other short/medium term deposits + retail money market funds shares
(Fed stopped publishing M3 in 2006 as it appeared not to convey any additional
information about economic activity that is not already embodied in M2)
Euro area monetary aggregates, 2010
Fed monetary aggregates
Euro area monetary aggregates, 1980-2014
• We will only consider the stricter definition of money

M1 = currency + deposit accounts

• In the first part of the class, only currency

• In the second part of the class, add deposit accounts and banks
 Money and bonds

Consider an economy in which wealth can be hold in only 2 assets

• Money can be used for transactions but pays no interest

• Bonds cannot be used for transactions but pay a positive interest rate i

Wealth = Money + Bonds

For given wealth, a larger demand for money corresponds

to a lower demand for bonds, and vice-versa
• By holding money

• give up interest income, but

• save on transaction costs (time costs or transaction fees) associated

with selling the bonds whenever you need money

• By holding bonds

• gain interest income, but

• will incur in high transaction costs whenever you need money

 Demand for money

• The demand for money will depend on

• the level of transactions, €Y (proxied with nominal income)

• the interest rate on bonds, i

• Money demand
Md = €Y L(i)
(-)

• raises proportionally with nominal income

• decreases with the interest rate on bonds according to the function L

 Md = €Y L(i)
(-)

• For a given level of nominal income, a lower interest rate increases the demand for
money (movement along the curve)
• At a given interest rate, an increase in nominal income increases the demand for
money (shifts of the curve to the right)
 Equilibrium interest rate
Part I: only currency

• Equilibrium in financial markets requires

Money supply = Money demand

Ms=Md

• This equilibrium relation is called the LM relation

 Supply of money

• Money is only currency

• The central bank decides to supply a quantity of money equal to M

Ms = M
 Ms = Md
M = €Y L(i)

Equilibrium interest rate must be such that the supply of money (independent of the
interest rate) is equal to the demand for money (dependent on the interest rate)
 What happens if nominal GDP increases?

• Result: Given the money supply, an increase in nominal income leads to an increase in
the interest rate

• Economic intuition: at the initial interest rate, the demand for money exceeds money
supply; an increase in the interest rate is needed to decrease the amount of money
people want to hold and restore equilibrium
 What happens if money supply increases?

• Result: An increase in money supply leads to an decrease in the interest rate

• Economic intuition: the decrease in the interest rate increases the demand for money
so it equals the now larger money supply
 Monetary policy and open market operations

• Open-market operations, which take place in the “open market” for

bonds, are the standard method central banks use to change the money
stock in modern economies

• If the central bank buys bonds and pays for them by creating money, this
operation is called an expansionary open market operation because the
central bank increases (expands) the supply of money

• If the central bank sells bonds and removes from circulation the money it
receives in exchange, this operation is called a contractionary open
market operation because the central bank decreases (contracts) the
supply of money
CB balance sheet and open market operations
 Bond prices and bond yields

• Treasury bills or T-bills are issued by the US governments promising

payment in a year or less

• If you buy the bond today and hold it for a year, the yield on holding a
$100 T-bill is

i = ($100-$Pb) / $Pb

• Alternatively, if you know the yield you can obtain the price

$Pb = $100 / (1+i)

• There is a negative relation between the price and the yield

 What have we learned so far?

• 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 changes the supply of money through 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 and a decrease in the
interest rate

• Open market operations in which the central bank decreases the money supply by
selling bonds lead to a decrease in the price of bonds and an increase in the
interest rate
 Choosing money or choosing the interest rate?

• A decision by the central bank to lower the interest rate from i to i ’ is equivalent to
increasing the money supply from M to M’
• Rather than the money supply, the central bank could have chosen the interest rate
and then adjusted the money supply so as to achieve the interest rate it had chosen
• Choosing the interest rate, instead of money supply, is what modern central banks,
including the Fed and the ECB, typically do
Now we introduce

• checking account deposits, so that money = currency + deposit accounts

• banks supplying deposits accounts

 Banks

Banks receive funds from people and firms in the form of deposit accounts,
and use these funds to buy bonds or to make loans to other people and firms

• Banks receive funds from people and firms: the liabilities of the banks are
therefore equal to the value of these checkable deposits

• Banks keep as reserves some of the funds they receive (either in the form
of cash or in an account that banks have a central banks)

• The assets of banks are the bonds and the loans plus the reserves
 Balance sheet of banks

Assets Liabilities
Bonds Deposits accounts
Loans
Reserves
Banks hold reserves for three reasons:

1. On any given day, some depositors withdraw cash from their checking
accounts, while others deposit cash into their accounts with no reason for
these flows to balance → banks need to keep reserves

2. On any given day, people with accounts at the bank write checks to people
with accounts at other banks, and people with accounts at other banks
write checks to people with accounts at the bank → banks need to keep
reserves

3. Banks are subject to reserve requirements, which require them to hold

reserves in some proportion of their deposits
Balance sheets of central bank and banks
 Equilibrium interest rate
Part II: adding deposits accounts and banks

• Equilibrium in financial markets requires

Supply of CB money = Demand of CB money

Hs=Hd

• Supply of central bank money Hs: under the direct control of the CB

• Demand of central bank money Hd?

• Demand for currency by people, CUd
• Demand for reserves by banks, Rd
 Demand for money, currency and deposits
People can now hold both currency and checkable deposits

Therefore, two decisions:

• First, people must decide how much money to hold. As before

Md = €Y L(i)

• Second, they must decide how much of this money to hold in

currency and how much to hold in checkable deposits

CUd = c Md

Dd = (1-c) Md

that is, people hold a fixed proportion c of their money in currency

and a fixed proportion 1-c in deposits
 Demand for reserves

• Banks holds a fraction of deposits as reserves

• We know Dd from the demand for deposit accounts

• Demand for reserves is

Rd = θDd = θ(1-c)Md

where θ is the fraction of reserves to deposits

 Demand for central bank money

Hd = currency by people + reserves by banks

Hd = CUd + Rd
= cMd + θ(1-c)Md
= [c + θ(1-c)]Md
= [c + θ(1-c)]€YL(i)
 Supply of CB money

• CB money is currency + reserves

• The central bank decides to supply a quantity of CB money equal to H

Hs = H
Supply of CB money = Demand of CB money

Hs=Hd

H = [c + θ(1-c)]€YL(i)
Determinants of demand and supply of central bank money
 With a graph…

• The supply of CB money is under control

of the CB and independent of the
interest rate

• The demand of CB money depends

negatively on the interest rate for 2
reasons

• First, an increase in the interest rate

decreases the demand for money and
thus the demand for currency

• Second, as the demand for money

decreases also the demand for deposits
goes down and this decreases the
demand for reserves from banks

• The effects of an increase in nominal

income or in the supply of CB money are
qualitatively the same as before

Same as before!
 2 alternative ways to look at the equilibrium

• We have seen: Supply of CB of money = Demand of CB money

• But we can represent the equilibrium also as

• Money supply = money demand

• Supply of reserves = demand of reserves

 Money supply = money demand

• Start from the condition that Hs = Hd

H = [c + θ (1− c)]$YL(i)

• Divide both sides by [c + θ(1-c)] to get

1
H = $YL(i)
Money [c + q (1 - c)] Money
supply demand

• The overall supply of money is equal to central bank money H times

1/[c + θ (1-c)]
 Supply of reserves = demand for reserves

• Start from the condition that Hs = Hd

H = CU d + R d
• Bring CUd on the other side to get

Supply of H − CU d = R d Demand for

reserves reserves

• Federal funds market is an actual market for bank reserves in the US

• Federal funds rate is the interest rate determined on that market

• Federal funds rate is the main indicator of US monetary policy since

the Fed can choose the federal funds rate it wants by changing H
Powerless monetary policy: the liquidity trap
What happens once the interest rate falls to the zero lower bound?

For now, ignore banks and assume all

money is currency

When the interest rate reaches 0, and

once people have enough money for
transactions, they become indifferent
between holding money and holding
bonds → the demand for money becomes
horizontal

As the money supply increases,

individuals are willing to hold more
money at the same interest rate, namely
zero

This implies that, when the interest rate

equals 0, further increases in money
supply have no effect on the interest rate
• What happens if we also consider banks and checkable deposits?

• A similar argument as for the demand for money by people also applies to
the demand for reserves by banks

• If the interest rate is equal to 0, banks are indifferent between holding

reserves and buying bonds

• Thus, when the interest rate is at the zero lower bound, and the central bank
increases the money supply, we are likely to see an increase in checkable
deposits and bank reserves, with the interest rate remaining at 0
 FOCUS: The Liquidity Trap in the United Kingdom

Checkable deposits and reserves with BoE, 2007−2016

Source: Bank of England, Bankstats (Monetary & Financial Statistics).

The large increase in the supply of central bank money between 2007 and 2014 was
absorbed by households and banks