2 of 36,The Demand for Money,The Fed (short for Federal Reserve Bank) is the U.S. central bank.Money, which can be used for transactions, pays no interest. There are two types of money: currency and checkable deposits.Bonds, pay a positive interest rate, i, but they cannot be used for transactions.,4-1,3 of 36,The Demand for Money,The proportions of money and bonds you wish to hold depend mainly on two variables: Your level of transactionsThe interest rate on bondsMoney market funds pool together the funds of many people and use these funds to buy bonds typically, government bonds.,4 of 36,Income is what you earn from working plus what you receive in interest and dividends. It is a flowthat is, it is expressed per unit of time.Saving is that part of after-tax income that is not spent. It is also a flow.Savings is sometimes used as a synonym for wealth (a term we will not use in this course).,Semantic Traps: Money, Income, and Wealth,5 of 36,Your financial wealth, or simply wealth, is the value of all your financial assets minus all your financial liabilities. Wealth is a stock variablemeasured at a given point in time.Investment is a term economists reserve for the purchase of new capital goods, such as machines, plants, or office buildings. The purchase of shares of stock or other financial assets is financial investment.,Semantic Traps: Money, Income, and Wealth,6 of 36,The demand for money:increases in proportion to nominal income ($Y), anddepends negatively on the interest rate (through L(i) ,note the negative sign underneath L(i) ).,7 of 36,Deriving the Demand for Money,The Demand for Money,Figure 4 - 1,For a given level of nominal income, a lower interest rate increases the demand for money. At a given interest rate, an increase in nominal income shifts the demand for money to the right.,8 of 36,The Demand for Money and the Interest Rate: The Evidence,Using this equation, you can find out how much the demand for money responds to changes in the interest rate( through L(i) ).Because L(i) is a decreasing function of the interest rate i, this equation says:When the interest rate is low, then L(i) is high, so the ratio of money demand to nominal income should be high.When the interest rate is high, then L(i) is low, so the ratio of money demand to nominal income should be low.,9 of 36,Figure 4 - 1,The Ratio of Money Demand to Nominal Income and the Interest Rate since 1960,The ratio of money to nominal income has decreased over time. Leaving aside this trend, the interest rate and the ratio of money to nominal income typically move in opposite directions.,The Demand for Money and the Interest Rate: The Evidence,10 of 36,Figure 4 -1 suggests two main conclusions:The first is that there has been a large decline in the ratio of money demand to nominal income since 1960.Economists sometimes refer to the inverse of the ratio of money demand to nominal income ($Y/Md) as the velocity of money.The second conclusion is that there is a negative relation between year-to-year movements in the ratio of money demand to nominal income and year-to-year movements in the interest rate.,The Demand for Money and the Interest Rate: The Evidence,11 of 36,Figure 4 - 2,Changes in the Interest Rate Versus Changes in the Ratio of Money Demand to Nominal Income since 1960,Increases in the interest rate have typically been associated with a decrease in the ratio of money to nominal income, decreases in the interest rate with an increase in that ratio.,A scatter diagram is a figure in which one variable is plotted against another. Each point in the figure shows the values of these two variables at a point in time.,The Demand for Money and the Interest Rate: The Evidence,12 of 36,The Determination ofthe Interest Rate. i,In this section, we assume that checkable deposits do not exist that the only money in the economy is currency. The role of banks as suppliers of money (and checkable deposits) is introduced in the next section.,4-2,13 of 36,Money Demand, Money Supply,and the Equilibrium Interest Rate,Equilibrium in financial markets requires that money supply be equal to money demand, or that Ms = Md. Then using this equation, the equilibrium condition is:Money Supply = Money demandThis equilibrium relation is called the LM relation.,14 of 36,Money Demand, Money Supply,and the Equilibrium Interest Rate,The interest rate must be such that the supply of money (which is independent of the interest rate) be equal to the demand for money (which does depend on the interest rate).,The Determination of the Interest Rate,Figure 4 - 2,15 of 36,Money Demand, Money Supply,and the Equilibrium Interest Rate,An increase in nominal income leads to an increase in the interest rate.,The Effects of an Increase inNominal Income on the Interest Rate,Figure 4 - 3,16 of 36,Money Demand, Money Supply,and the Equilibrium Interest Rate,Figure 4 - 4,An increase in the supply of money leads to a decrease in the interest rate.,The Effects of an Increase in the Money Supply on the Interest Rate,17 of 36,Open Market Operations,In modern economies ,the way central banks change the supply of money is by buying or selling bonds in the bonds market,these actions are called Open-market operations, because they take place in the “open market” for bonds, it is the standard method central banks use to change the money stock in modern economies.If the central bank buys bonds, 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, this operation is called a contractionary open market operation because the central bank decreases (contracts) the supply of money.,18 of 36,Figure4-5 is the balance sheet of the cental bank .The asset of the cental bank are bonds it hold in its portfolio(資產(chǎn)組合).Its liabilities are the stock of money in the economy . Open market operations lead to equal but contrary change in assets and liabilities.,19 of 36,Bond Prices and Bond Yields,The Balance Sheet of the Central Bank and the Effects of an Expansionary Open Market Operation,Figure 4 - 5,The assets of the central bank are the bonds it holds. The liabilities are the stock of money in the economy.An open market operation in which the central bank buys bonds and issues money increases both assets and liabilities by the same amount.,20 of 36,Bond Prices and Bond Yields,You must understand the relation between the interest rate and bond prices:Treasury bills, or T-bills are issued by the U.S. government promising payment in a year or less. In fact, what is determined in bonds markets is not interest rates,but prices; the interest rate on a bond can be infered from the price of the bond .,21 of 36,If you buy the bond today and hold it for a year, the rate of return (or interest) on holding a $100 bond for a year is ($100 - $PB)/$PB.If we are given the interest rate, we can figure out the price of the bond using the same formula.,22 of 36,Choosing Money orChoosing 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(through open market operations which purchase bonds and at same time increase the amount of money in the economy. ).,Figure 4 - 4,Typically ,the cental bank first thinks about the interest rate it want to achieve and then change the money supply in the economy so as to achieve it .,23 of 36,SUMMARIZATION:The interst rate is determined by the equality of 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 in bonds market, which are purchases or sales of bonds for money. open-market operations are the basic tools used by morden central bankes to affect rates .,24 of 36,In bonds markets what is determined is not interest rates,but prices;the interest rate on a bond can be infered from the price of the bond . 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, an increase in the interest rate.,25 of 36,The Determination ofthe Interest Rate, II,Financial intermediaries are institutions that receive funds from people and firms, and use these funds to buy bonds or stocks, or to make loans to other people and firms.The assets of these institutions consists of the stocks and bonds they own and loans they have made .Their liabilities are what they owe to the people and firms from whom they have received funds.Banks receive funds from people and firms who either deposit funds directly or have funds sent to their checking accounts. The liabilities of the banks are equal to the value of these checkable deposits. (note :this is just a simplied version ,bank have other types of liabilities in addition to checkabe deposits. ).Banks keep as reserves some of the funds they receive.They hold them partly in cash and partly in an account the banks have at the the central bank .,4-3,26 of 36,What Banks Do,Banks hold reserves for three reasons:On any given day, some depositors withdraw cash from their checking accounts, while others deposit cash into their accounts.In the same way, 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 are subject to reserve requirements. The actual reserve ratio the ratio of bank reserves to bank checkable deposits is about 10% in the United States today.,27 of 36,The Balance Sheet of Banks and the Balance Sheet of the Central Bank Revisited,28 of 36,What Banks Do,Loans represent roughly 70% of banks nonreserve assets. Bonds account for the rest (30%).The assets of the central bank are the bonds it holds. The liabilities of the central bank are the money it has issued, central bank money. The new feature is that not all central bank money is held as currency by the public. Some of its is held as reserves by banks(partly in cash and partly in their cenrtral bank accounts.),29 of 36,Rumors that a bank is not doing well and some loans will not be repaid, will lead people to close their accounts at that bank. If enough people do so, the bank will run out of reservesa bank run.To avoid bank runs, the U.S. government provides federal deposit insurance.An alternative solution is narrow banking, which would restrict banks to holding liquid, safe, government bonds, such as T-bills.,Bank Runs,30 of 36,The Supply and the Demandfor Central Bank Money,Lets think in terms of the supply and the demand for central bank money.The demand for central bank money is equal to the demand for currency by people plus the demand for reserves by banks .The supply of central bank money is under the direct control of the central bank.The equilibrium interest rate is such that the demand and the supply for central bank money are equal.,31 of 36,The Demand for Money,Demand for currency:,Demand for checkable deposits:,When people can hold both currency and checkable deposits, and demand for money by people is for both checkable deposits and currency. The demand for money involves two decisions. First, people must decide how much money to hold. Second, they must decide how much of this money to hold in currency and how much to hold in checkable deposits.,32 of 36,The Demand for Reserves,Relation between deposits (D) and reserves (R):,Demand for reserves by banks:,The larger the amount of checkable deposits, the larger the amount of reserves the banks must hold, both for precautionary and for legal reasons.,33 of 36,The Demand for Central Bank Money,Demand for central bank money:,Then:,Since,Then:,The demand for central bank money is equal to the sum of the demand for currency and the demand for reserves.,34 of 36,The Supply and the Demandfor Central Bank Money,35 of 36,SUMMARIZATION:1.demand for money by people is for both checkable deposits and currency. 2.Because banks have to hold reserves against checkable deposits ,the demand for checkable deposits leads to a demand for reserves by banks;3.Consequently, the demand for central bank money is equal to the sum of the demand for currency and the demand for reserves4.The supply of central bank money is determined by the central bank. 5.In equilibrium ,the demand and the supply of central money must be equal.,36 of 36,The Determination ofthe Interest Rate,In equilibrium, the supply of central bank money (H) is equal to the demand for central bank money (Hd):,Or restated as:,Please Consider the different means when c=0,c=1,0c1,and =0 ?,37 of 36,The Determination ofthe Interest Rate,The equilibrium interest rate is such that the supply of central bank money is equal to the demand for central bank money.,Equilibrium in the Market for Central Bank Money, and the Determination of the Interest Rate,Figure 4 - 8,38 of 36,The demand for central bank money,CUd+Rd,is drawn for a given level of nominal income .A higher interest rate implied a lower demand for central bank money for two reason:(1)The demand for currency by people goes down :(2)The demand for checkable deposits by people also goes down. This also leads to lower demand for reserves by banks. Both leads to lower demand for central bank money.The changes in nominal income and in the supply of central bank money can both lead to the shift of the demand and supply curve of central bank money.,39 of 36,Two Alternative Ways toThink about the Equilibrium*,In addition to the equilibrium in terms of the equality of demand and supply of central money, there are two other way of looking at the equilibrium .Firstly , the equilibrium that the supply and the demand for bank reserves be equal:,The federal funds market is a market for bank reserves rate,where the interest rate moves up and down to balance the supply and demand for reserves.Banks that have excess reserves at the end of the day lend them to banks that have insufficent reserves . In equilibrium, demand (Rd) must equal supply (H-CUd). The interest rate determined in the market is called the federal funds rate which is typically thougt of as the main indicator of U.S. monetary policy.,4-4,40 of 36,The Supply of Money, the Demand for Money and the Money Multiplier,The second equilibrium is that the overall supply of money is equal to the overall demand for money (including currency and checka