3/1/2022

Macroeconomics
Eighth Edition, Global Edition

Chapter 4
Financial Markets Ⅰ

• Copyright © 2021 Pearson Education Ltd.

Chapter 4 Outline
Financial Markets I
4.1 The Demand for Money
4.2 Determining the Interest Rate: Ⅰ
4.3 Determining the Interest Rate: Ⅱ
4.4 The Liquidity Trap

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Financial Markets
• Financial markets are intimidating, but they play an
essential role in the economy.
• In this chapter, we focus on the role of the central bank in
affecting these interest rates.
• We learn how the interest rate on bonds is determined,
and the role of the central bank (Federal Reserve Bank,
or the Fed, in the United States) in this determination.

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4.1 The Demand for Money (1 of 5)

• Suppose you only have a choice between two assets:
money and bonds.
• Money are used for transactions, but it pays no interest.
• Two types of money: currency and checkable deposits.
• Bonds pay a positive interest rate, i (the rate of interest),
but cannot be used for transactions.

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4.1 The Demand for Money (2 of 5)

• The holding of money and bonds depends on:
– Your level of transactions
– The interest rate on bonds
• You can hold bonds indirectly through money market
funds, or money market mutual funds.
• In the early 1980s, the interest rate on money market
funds reached 14% per year, so people earned more
interest by moving their wealth from checking accounts to
these funds.

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FOCUS: Semantic Traps: Money,

Income, and Wealth
• Money is what can be used to pay for transactions.
• Income is what you earn, and it is a flow.
• Saving is the part of after-tax income that you do not spend,
and it is also a flow.
• Savings is the value of what you have accumulated over time.
• Financial wealth, or wealth, is the value of all your financial
assets minus all your financial liabilities, and it is a stock
variable.
• Investment is what economists refer to as the purchase of new
capital goods.
• Financial investment is the purchase of shares or other
financial assets.

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4.1 The Demand for Money (3 of 5)

• Demand for money (Md) is equal to nominal income $Y (a
measure of level of transactions in the economy) times a
decreasing function of the interest rate i:

𝑀 = $𝑌 𝐿 𝑖 (4.1)
(−)

• An increase in the interest rate decreases the demand for

money, as people put more of their wealth into bonds.

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4.1 The Demand for Money (4 of 5)

• Equation (4.1) means that the demand for money:
– increases in proportion to nominal income, and
– depends negatively on the interest rate.
• The relation between the demand for money and interest
rate for a given level of income $Y is represented by the
Md curve.

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4.1 The Demand for Money (5 of 5)

Figure 4.1 The Demand for Money
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.

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FOCUS: Who Holds U.S. Currency

• The amount of currency in circulation in 2006 was $750
billion.
• U.S. households together held $170 billion in currency.
• U.S. firms held another $80 billion.
• Foreigners abroad held $500 billion, or 66% of the total, for
transactions, especially in countries suffering from high
inflation in the past.

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4.2 Determining the Interest Rate: Ⅰ (1 of 9)

• Suppose the central bank decides to supply an amount of
money equal to M:

M =M

• Equilibrium in financial markets requires that Ms=Md=M:

Money supply = Money demand

𝑀 = $𝑌 𝐿 𝑖 (4.2)

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4.2 Determining the Interest Rate: Ⅰ (2 of 9)

Figure 4.2 The Determination of the Interest Rate
The interest rate must be such that the supply of money
(which is independent of the interest rate) is equal to the
demand for money (which does depend on the interest rate).

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4.2 Determining the Interest Rate: Ⅰ (3 of 9)

Figure 4.3 The Effects of an Increase in the Money Supply
on the Interest Rate
An increase in the supply of money leads to a decrease in
the interest rate.

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4.2 Determining the Interest Rate: Ⅰ (4 of 9)

Figure 4.4 The Effects of an Increase in Nominal Income on
the Interest Rate
Given the money supply, an increase in nominal income
leads to an increase in the interest rate.

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4.2 Determining the Interest Rate: Ⅰ (5 of 9)

• For a given money supply, an increase in nominal income
leads to an increase in the interest rate.
• An increase in the supply of money by the central bank
leads to a decrease in the interest rate.

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4.2 Determining the Interest Rate: Ⅰ (6 of 9)

• Central banks typically change the supply of money by
buying or selling bonds in the bond market—open market
operations.
• Expansionary open market operation: the central bank
expands the supply of money by buying bonds.
• Contractionary open market operation: the central bank
contracts the supply of money by selling bonds.

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4.2 Determining the Interest Rate: Ⅰ (7 of 9)

Figure 4.5 The Balance Sheet of the Central Bank and the
Effects of an Expansionary Open Market Operation
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.

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4.2 Determining the Interest Rate: Ⅰ (8 of 9)

• Suppose a bond such as a Treasury bill, or T-bill,
promises to pay $100 a year from now.
• If the price of the bond today is $PB, then the interest rate
on the bond is:
$100 − $P
i=
$P

• The higher the price of the bond, the lower the interest
rate.
• The higher the interest rate, the lower the price today.

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4.2 Determining the Interest Rate: Ⅰ (9 of 9)

• 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 the money supply, is
what modern central banks, including the Fed, typically do.

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4.3 Determining the Interest Rate: Ⅱ (1 of 6)

• Financial intermediaries: Institutions that receive funds
from people and firms and use these funds to buy financial
assets or to make loans to other people and firms.
• Banks are financial intermediaries that have money, in the
form of checkable deposits, as their liabilities.
• Banks keep as reserves some of the funds they receive.
• The liabilities of the central bank are the money it has
issued, called central bank money.

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4.3 Determining the Interest Rate: Ⅱ (2 of 6)

Figure 4.6 The Balance Sheet of Banks, and the Balance
Sheet of the Central Bank Revisited

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4.3 Determining the Interest Rate: Ⅱ (3 of 6)

• Assume people hold no currency so the demand for
money by people is the demand for checkable deposits:
𝑀 = $𝑌 𝐿 𝑖 (4.3)
(−)

• The demand for reserves by banks depends on the

amount of checkable deposits:

𝐻 = 𝜃𝑀 = 𝜃$𝑌 𝐿 𝑖 (4.4)

• θ is the reserve ratio, and Hd is demand for high-power

money or the monetary base.

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4.3 Determining the Interest Rate: Ⅱ (4 of 6)

• Let H denote the supply of central bank money, then the
equilibrium condition:
𝐻 = 𝐻 (4.5)

• Or using equation (4.4):

𝐻 = 𝜃$𝑌 𝐿 𝑖 (4.6)

• An increase in H leads to a decrease in the interest rate,

and a decrease in H leads to an increase in the interest
rate.

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4.3 Determining the Interest Rate: Ⅱ (5 of 6)

Figure 4.7 Equilibrium in the Market for Central Bank Money
and the Determination of the Interest Rate
The equilibrium interest rate is such that the supply of central
bank money is equal to the demand for central bank money.

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4.3 Determining the Interest Rate: Ⅱ (6 of 6)

• The federal funds market is an actual market for bank
reserves.
• The federal funds rate is the interest rate determined in
the federal funds market.
• The federal funds rate is the main indicator of U.S.
monetary policy because the Fed can choose the federal
funds rate it wants by changing H.

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FOCUS: Will Bitcoins Replace

Dollars?
• Bitcoins are virtual assets that can be used for
transactions.
• As of December 2018 the total value of bitcoin in
circulation was $67 billion.
• Bitcoins are not likely to replace dollars for 3 reasons:
1. Most transactions are quoted in dollars, so price risk exists.
2. Verifying bitcoin transactions takes too much electricity.
3. Governments do not want bitcoin to be the accepted currency
since they want to control monetary policy.

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4.4 The Liquidity Trap (1 of 2)

• Zero lower bound: The interest rate cannot go below
zero.
• The economy is in a liquidity trap when the interest rate is
down to zero, monetary policy cannot decrease it further.

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4.4 The Liquidity Trap (2 of 2)

Figure 4.8 Money Demand, Money Supply, and the Liquidity
Trap
When the interest rate is equal to
zero, and once people have enough
money for transaction purposes,
they become indifferent between
holding money and holding bonds.
The demand for money becomes
horizontal.
This implies that, when the interest
rate is equal to zero, further
increases in the money supply have
no effect on the interest rate, which
remains equal to zero.

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FOCUS: The Liquidity Trap in Action

• The large increase in the supply of central bank money
between 2008 and 2015 was absorbed by households and
banks.

Figure 1 Checkable Deposits and Bank Reserves,

2005−2018 (billions).

Source: FRED: TCP, WRESBAL

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