4. Financial markets I

Question 1

The demand for money

Answer 1

•Demand for money (M^d) - the sum of all the individual demands for money by the people and the firms in the economy; M^d=$Y L(i)
↳ 1. The demand for money increases in proportion to nominal income
↳ 2. The demand for money depends negatively on the interest rate.

Question 2

Determining the Interest Rate I

Answer 2

M^s=M (amount of money supplied by the central bank)
M^s = M^d <=> Money supply = Money demand
M = $Y L(i) : the interest rate i must be such that, given their income $Y, people are willing to hold an amount of money equal to the existing money supply M

• nominal income ↑ => level of transactions↑ => demand for money↑
• money supply ↑ => interest rate↓

Question 3

Monetary policy and Open Market operations

Answer 3

Open market operations - the way central bank changes the supply of money by buying and selling bonds
↳ Increase the amount of money in the economy : buy bonds and pay for them by creating money => price of bonds↑=>interest rate ↓ (expansionary open market operations)
↳ Decrease the amount of money in the economy : sell bonds and remove from circulation the money it receives in exchange for the bonds price of bonds ↓ =>interest rate↑ ( contractionary open market operations)
• The higher the price of a bond, the lower the interest rate i = ($100-$Pb) / $Pb

Question 4

The Balance Sheet

Answer 4

Central bank Banks
↙ ↘ ↙ ↘
Assets Liabilities Assets Liabilities
-Bonds -CB Money -Reserves -checkable
(reserves+currency) -Bonds deposits
-Loans

Question 5

The demand and supply by central bank money

Answer 5

• Reserve ratio θ - the amount of reserve banks hold per dollar of checkable deposits 0< θ <1
• Demand for reserve by banks : H^d= θM^d= θ $Y L(i) (the demand for central bank money, equivalent the demand for rezerves by banks, is equal to θ times the demand for money by people).

•Equilibrium in the market for central bank money: H=H^d <=> THE SUPPLY of central bank money EQUALS THE DEMAND for central bank money

Question 6

The Liquidity trap

Answer 6

• Zero lower bound - the interest rate cannot go below zero

* Liquidity trap - the interest rate is down to zero, thus monetary policy cannot decrease it further