Money Market

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• Money Market

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In these notes that follow we will refer to short
term interest rates. An important short term
rate is the FED FUNDS rate. This is the rate
banks charge each other when one bank lends to
the other for a length of 1 day! Yes banks lend
to each other and the length is 1 day. Other
short term assets are 30, 60 or 90 day government
treasury bills and the rate of interest paid is a
short term rate.
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Overview
Monetary Policy is undertaken by the FED. The
FED can use open market operations to change the
money supply. The idea is for the interest rate
to change. This will change the level of
investment and hence the AD curve. Open market
operations consist of FED purchases or sales of
bonds (like we saw before). We want to spend a
little time understanding the relationship
between bond prices and the interest rate.
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Present and future values
Lets first note that 1 today can grow into
1.10 at the end of the year if the interest rate
is 10. Thus 1.10 1(1.1), or F
P(1r). The future amount is the present amount
times (1 the interest rate). Bonds have a
fixed future amount, F. If you hold a bond as of
a certain date in the future you get paid a
certain amount of money. The amount you pay for
the bond today, P, determines the interest rate
you earn, r.
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Present and future values
If you pay 1 for a bond that pays 1.10 next
year you earn 10.
If you pay 0.90 for a bond that pays
1.10 next year you earn 22 So, bond prices and
interest rates move in opposite directions. On
the previous screen I had the formula F P(1r).
Rearranging terms we have r (F/P) 1. If F
1.10 and P 1, then r (1.10/1) 1 .1 or
10 If F 1.10 and P 0.90, then r
(1.10/.9) 1 .22 or 22. The point I want you
to remember is that bond prices and interest
rates move in opposite directions.
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Now here is what happens when there is a FED
purchase of securities from a bank like we saw
before. 1) The FED purchase means the FED goes
into the bond market reducing the supply of bonds
banks (or people for that matter) can hold. This
pushes the price of bonds up. 2) As bond prices
go up, interest rates come down. 3) Banks can
thus lend more at lower rates. 4) At the same
time the supply of bonds is reduced, the money
supply rises.
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Money market focus
On the previous screen we saw that a FED purchase
reduces the supply of bonds or, equivalently,
increases the supply of money. Here we will
focus on the money market impact. There is an
equivalent impact in the bond market. Lets turn
to the demand for money.
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Money demand
i
In a graph we will see the demand for money look
like this. This means the higher the interest
rate, i, the lower the quantity of money
demanded. On the following screens lets see
the economic rational for this graph.
Md
Qm
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Money demand - transactions
Remember money is currency and checkable
deposits. A reason we hold money is to make
transactions. Lets imagine a person gets a
paycheck once a month. Lets also say when they
get the paycheck they put all the funds into the
bond market. This way they can earn interest on
their wealth. Typically this means they can earn
more than what they would if they put their funds
into a checking account.
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Money demand - transactions
What happens when the individual wants to make a
transaction? They would have to sell some bonds
to get money because merchants want to be paid
money. This could be a hassle - time consuming
and maybe bad timing on the bonds. So, there is
a trade-off involved here. If we want to earn
interest we must put assets in the form of bonds.
But when we want to make transactions we have to
sell the bonds for money. There is a risk the
bonds wont yield much at that time and we could
lose out. We are more willing to take the risk
when the current rate of interest is high, and
thus the quantity of money we demand would be
low. When the rate of interest is low we do not
take the risk and thus demand a greater quantity
of money.
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Money demand - precautionary
People hold some money for emergencies
emergencies can be costly. But, they recognize
when holding money they can NOT earn interest on
things like bonds. Thus, the higher the interest
rate (equivalent to low bond prices) the lower
the quantity of money people demand because
although the emergency is costly, it is even more
costly to give up the interest.. Or, the lower
the interest rate, the greater the quantity of
money people will demand.
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Money demand - asset
Money is an asset. Two desirable features of
money as an asset is its liquidity and lack of
risk. Liquidity refers to an assets ability to be
used in transactions. Money is the most liquid
asset because it can be used in transactions
right now. Real estate, for example, is less
liquid than money because you have to find a
buyer, get financing and other stuff that takes
time. So real estate is not an asset that can be
readily used in transactions. It has to be sold
first. Money has no risk of losing its value as
money. A dollar is always 100 pennies. Stocks,
bonds and other stuff can lose value. The asset
demand is inversely related to the interest rate
just as is the precautionary demand.
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Interest rate determination
r Ms
Remember the money supply can be set by the FED
through open market operations. The interest rate
is determined where the MsMd in the economy. On
the following few screens lets see how the
interest rate changes by FED action.
r0
Md
Qm
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FED purchase
r Ms1 Ms2
When the FED purchases securities in the open
market banks find they have more reserves to lend
and this means an increase in the money supply.
The interest rate falls.
r1
Md
r2
Qm
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FED sale - money supply fall
The logic of a FED sale is similar, but in
reverse, of a FED purchase.
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Investment impact
r Md Ms1 Ms2
r r1 r2
I
I1 I2
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FED purchase again
On the previous screen you can see the money
market and the investment function. You need
to remember 1) The logic of the money market
change - FED purchase of securities or bonds in
the open market. 2) Why investment changes when
the interest rate changes.
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Expansionary Monetary Policy
Recall Fiscal policy shifted AD by working on G
and C (C, by changing T). Monetary Policy is
going to work on AD through I. When Fed gets
reserves in the banking system to grow the
interest rate falls, increasing I and shifting AD
to the right. The action is useful if the economy
is in recession.
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Contractionary Monetary Policy
When Fed gets reserves in the banking system to
shrink the interest rate rises, decreasing I and
shifting AD to the left. The action is useful if
the economy is in an inflationary period. Note,
when AD shifts to the left the price level may
not fall, but at least the rising price level is
stabilized.
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Problems of Monetary Policy
Similar to fiscal policy, monetary policy may not
always work as great as we see it can in theory
because of recognition and operational lags
(although it does not have administrative
lag). Again, the point is it takes time to
recognize the economy is in jeopardy and it takes
time to put into place the policy to cure the
ill.