TOC
The Demand for Money
Holding money and bonds will depend on:
- level of transactions
- the interest rate of bonds
Demand for money in the economy as a whole: sum of individual demands for money:
- it depend on the overall level of transactions in the economy
- the level of transactions is hard to measure, assumed as proportional to nominal income (output)
denote the demand for money as :
- : nominal income
- : a decreasing function of the interest rate
Curve
For individuals, wealth = that is demand of bonds plus demand of money.
Interest rate Determination - Central Bank
Supply of money:
- currency: bills and coins
- supplied by the central bank (CB)
- assume CB supplies
- deposit accounts
- supplied by (commercial banks)
suppose economy only has currency
Equilibrium in Money Market
money supply = money demand
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Curve
Sensitive Analysis
Liquidity Preference
- Keynes suggests: in the short run, the interest rate adjusts to balance the supply and demand of the most liquid asset
- The supply of money is taken as given in the short run, thus the focus is on the demand for money
- We focus on the equilibrium in the money market when discussing the equilibrium in financial markets. The theory of liquidity preference is behind our derivation
Monetary Policy and Open Market Operations
Methods used by CB to change money supply:
- buy or sell bonds in the bond market
- change deposit requirements (reserve requirements)
As for bonds method:
- Expansionary Operation
- CB buys bonds and pays for them by creating money
- CB increases the amount of money in the economy
- interest rate decreases
- Contractionary Operation
- CB sells bonds and removes the money it receives in exchange from circulation
- CB decreases the amount of money in the economy
- interest rate increases
Explanation๏ผ
Bond Price = Future Cash Flow /
Bond Price is neg-proportional to
- when CB buy bonds in market, demand inceases so bond price goes up thus decreases
- when CB sell bonds in market, supply increases so bond price goes down thus increases
Typically, CBs (including BoE, ECB, Fed) think about the interest rate and adjust the money supply to achieve the desired level
Interest rate Determination - Banks
The role of Banks:
- Financial intermediaries:
- institutions that receive funds from households and firms
- use these funds to buy financial assets or to make loans
- Banks:
- a type of financial intermediaries
- liabilities are money
Banksโ Balance
- Liabilities:
- equal to deposit accounts
- Assets:
- bonds, loans (having claims against borrowers)
- reserves of some of their deposits
Reserves
Reserves are held partly in cash and partly in an account the banks have at the central bank
Banks hold reserves for four reasons:
- Cash on hand to balance withdraws and deposits
- Cover transactions of depositors
- Reserve requirements
- Interest on reserves: In some countries, the CB pays interest on reserves
Balance Sheet of Banks and CBs
Equilibrium in Money Market with Banks
money market equilibrium in terms of CB money:
- Demand for CB money: currency held by the public and reserves held by banks
- Currency held by the public
- assume people only hold deposit accounts (no currency)
- demand for deposit accounts equals demand for money
- Demand for reserve banks
- , is reserve ratio
- According to the assumption, the demand is just the reserves
- Supply of CB money: under the direct control of CB
- equal to demand
Curve
The Liquidity Trap
When interest rate is down to zero, monetary policy cannot decrease it further.
Monetary policy no longer works, the economy is in a liquidity trap
Why monetary policy no longer works:
When the CB increases the money supply, itโs likely that deposit accounts and bank reserves increase. But:
- as i is 0, people are indifferent to how much money or bonds they hold, so they may be willing to hold more money (and fewer bonds) at the same interest rate
- as i is 0, banks are indifferent to holding reserves or buying bonds, they may be willing to hold more reserves at the same interest rate
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