Term 1 Lecture 3: Financial Markets

Question 1

What are the choices of assets consumers have (1,2)

Answer 1

-You have a choice of 2 assets, money and bonds

-The two types of money are currency and deposits
-Bonds pay a positive interest rate i but can’t be used for transactions

Question 2

What is the demand for money formula, and how is this plotted on a graph (2)

Answer 2

-The demand for money (M^D) is equal to nominal income ($Y) times a decreasing function of the interest rate (L(i))
-This is a downwards sloping curve where money is on the x axis, and the interest rate on the y axis

Question 3

What is the LM relation (2)

Answer 3

-The LM (liquidity money) relation is the equilibrium relation in financial markets that money supply = demand
-This is where the money demand curve and money supply curve (perfectly inelastic, independent of IR) cross

Question 4

What is an open market operation (2)

Answer 4

-Central banks typically change the money supply by buying/selling bonds in the bond market (open market operations)
-An open market operation increases both assets and liabilities by the same amount (when the CB buys bonds, people get the money)

Question 5

What are the assets and liabilities of the central bank (2)

Answer 5

-The assets of the central banks are the bonds it holds
-The liabilities are the stock of money in the economy

Question 6

What is the formula for the interest on a bond (2)

Answer 6

Suppose a bond promises to pay $x a year from now, and the price of the bond today is $Pb

-I = ($x - $Pb)/$Pb
-Bond prices and interest rates have a negative relationship, due to the fixed nature of the final price

Question 7

What is the liquidity trap (2)

Answer 7

-As the IR becomes 0, people become indifferent between holding money and bonds
-Therefore, expansionary monetary policy becomes useless as IR can’t go below 0

Question 8

What reasons do banks hold reserves for (3)

Answer 8

-On a given day, people will withdraw cash from banks, as others deposit
-On any given day, people will write cheques with accounts
-Reserve requirements (ratio of bank reserves to bank deposits)

Question 9

What are the demands for currency and deposits (1,2)

Answer 9

-When people hold both currency and deposits, they must decide how much money to hold, then how much to hold in currency vs deposits

-CU^d = cM^d
-D^d = (1-c)M^d

Question 10

What is the formula for the demand for reserves (2)

Answer 10

-R = θD = θ(1-c)M^d
-R = reserves, D = deposits, θ = the reserve ratio

Question 11

What is the demand for central bank money formula (2)

Answer 11

-H^d = CU^d + R^d
-H^d = [c + θ(1-c)]$YL(i)

Question 12

What are 2 ways of showing equilibrium in financial markets (2, 2)

Answer 12

-Equilibrium can be looked at demand for bank reserves = supply of bank reserves
-H - CU^d = R^d, so H – c$YL(i) = θ (1 - c) $Y L (i)

-Equilibrium can also be looked at demand for money = supply for money
-H / [c + θ(1-c)] = $YL(i)

Question 13

How do we adjust the nominal interest rate (i) to take into account expected inflation with the changing value of goods (3, 1)

Answer 13

-One good this year is worth (1 + r_t) goods next year
-This is as 1 good is worth p_t dollars this year, (1+i) p_t dollar next year
-In terms of goods, 1 good this year is worth (1+i)(p_t/p^e_t+1)

-(1+r_t) = (1+i)p_t/p^e_t+1

(p^e_t+1 is the expected price level next year)

Question 14

What is the one year real interest rate (2)

Answer 14

-one year real interest rate = nominal interest rate - expected inflation from the next term - (real interest)(expected inflation)

-r_t = i_t - π^e_t+1 - r_tπ^e_t+1

Question 15

What is the fisher rule (2)

Answer 15

-Assume the real interest rate and expected inflation are not too large
-A close approximate to the real interest is the nominal interest - expected inflation -r_t = i_t - π^e_t+1