Lecture4:FinancialMarkets

Goal:Determineequilibriuminterestrate
Shortrun
Maincyclicalinstrument(CentralBank)
Monetarypolicy(asopposedtofiscal
policy)-- bothare(primarily)aggregate
demandpolicies
FinancialAssets
Money,bonds,stocks,mutualfunds,
derivatives
Reducetotwo:
Money:transaction(liquidity)role.
Bond:investment-- paysaninterestrate:i
Keyquestion:Howmuchofeach?
Tradeoff:transactionservicesvsreturn.
MoneyDemand
Fix(nominal)wealthat:PWealth
M + B =
d
d
PWealth
=> determineonlyoneofthem
M =PYL(i)
d
MoneyDemandDiagram
i
PY > PY
M
d

M
d
M
HighU.S.nominalinterestratesduring late70s-
early80s=>sharpdeclinein M/PY
EquilibriumInterestrate
Simplemodel:
Moneysupplyisconstant(i.e.itdoesntdepend
on interestrateorPorY)
Equilibrium:
M = PYL(i)
Ourinterestistodeterminetheinterestrate,
sowefixPandY.
Equilibrium
i
M
s
M
d
M
d
M
Money
MonetaryPolicy
i
M
s
M
d
M
s
M
Money
OpenMarketOperation
CentralBankbuysbondsintheopenmarket
Asaresult,priceofbondsrises
=> interestratefalls
i =
B
P
B
$100- P
EquilibriuminMratherthan
CentralBankM
M
s
= H
c+(1-c)
M
s
=M
d
=>
H 1 = PYL(i)
c+(1-c)
Examples:a)Y2k;b)Prudence;c)OMOwithmultiplier