Supply and Demand Models of Financial Markets

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Supply and Demand Models of Financial Markets
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Two Markets

• Loanable Funds Market
• Determines Interest Rate in Capital Markets
• Liquidity Market
• Determines Money Market Rate

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Loanable Funds Market

• Consider the financial market at its broadest and
  most abstract.
• an amalgamation of the bond market and the
  lending market (banks, etc.)
• Map the relationship between the interest rate
  and the quantity of funds that are lent.
• Supply curve represents the behavior of savers
  lenders
• Demand curve represents the behavior of borrowers
• Could represent the global financial market or a
  large national market.

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Supply Curve Loanable Funds

• Why does the supply curve slope up?
• When real interest rates offered by banks are
  high, savers are rewarded with more future
  consumption and are likely to be induced to save
  more.
• Caveat If some savers are setting a target for
  their level of wealth at retirement, a higher
  interest rate reduces the amount they need to
  save.
• For this reason, many economists believe saving
  curve is very inelastic.

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Demand Curve Loanable Funds

• Why does the demand curve slope down?
• Firms borrow to finance investment projects. If
  the return on investment falls below the interest
  rate, the project is not worthwhile. The higher
  the interest rate, the fewer projects fall below
  the hurdle.
• Households borrow to finance housing. The higher
  are interest rates, the smaller is the house that
  the householders can buy with a mortgage payment
  that they can afford.

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Competitive Market EquilibriumLoanable Funds
Market(Geometry)
S
r
D
r
LF
LF
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Example Investment Boom in Japan as economy
recovers
S
r
I
I
r
r
LF
LF
LF
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Savings

• We divide savings into 2 parts

SGovernment Public Saving/Government Saving (Budget Surplus)
SPrivate Private Saving (Household Business Saving)
S National Saving
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Example US Government runs a deficit to finance
military spending
S
r
S
I
r
r
LF
LF
LF
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Example US Consumers become thriftier
S
r
I
r
LF
LF
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Global Economy

• Additional Source of Savings
• Loanable Funds Supply Public Savings
• Net Capital Inflow from Abroad
• Two Effects
• Supply Curve Becomes More Elastic
• More globalized, more elastic
• Global Financial Markets also a source of shifts
  in Supply Curve

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Questions

• Compare Investment Boom in a very globalized
  economy with one in a less globalized economy.
  What happens to investment interest rates?

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Money Markets
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Liquid Assets

• Two kinds of assets
• Liquid Assets (Currency, Checking Accounts,
  Savings Accounts) that are useful for
  transactions which pay zero or below market
  interest rates.
• Money market assets (Government bills, commercial
  paper, jumbo CDs) that pay a market rate, i, but
  which cannot be used for transactions

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Liquidity Demand

• Q Why does the money demand curve slope down?
• A The greater is the market interest rate, the
  greater is the opportunity cost of holding money.

• Q What shifts the money demand curve?
• A An increase in GDP will increase the need for
  money for transactions shifting the demand curve
  out. A reduction in GDP will shift the demand
  curve in.

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Money Supply

• Supply of monetary assets governed by central
  bank.
• Prints currency
• Makes reserves available to banks
• Governs fraction of deposits that banks must keep.

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Money Market
Money Supply
Money Demand
i
i
M
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Equilibrium in the Money Market

• If interest rates are too high, excess supply of
  money
• people will want to buy interest paying assets
  like bank accounts or treasury bills.
• Bond dealers and banks can reduce the interest
  rates they are willing to offer
• If interest rates are too low, excess demand for
  money
• people will want to sell interest paying assets
  like bank accounts or treasury bills to get more
  liquidity.
• Bond dealers and banks must raise interest rates.
  

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Changes in Money Market Rates During Business
Cycles

• Money Demand Shocks What happens to interest
  rates when GDP (either prices or real GDP rises)?
• What happens when GDP falls?

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Operating Targets Target Interest Rates

• Most big country CBs target interbank interest
  rates, the rate at which banks lend reserves to
  one another (in HK, this is called what?)

Fed Federal Funds Rate
BoJ Uncollateralized Call Money Rate
ECB Main Refinancing Rate
BoK Overnight Call Rate
UK Official Bank Rate
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Target Rates Affect Money Market Rates
CEIC Database
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Money Supply

• Government can control the money supply and can
  shift the curve in or out by decreasing or
  increasing money supply.
• What does the central bank need to do to money
  supply to increase the interest rate?

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Money Market at ZIRP
Money Demand
Money Supply
i
1
i
2
3
0
i
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Learning Outcomes

• Students should be able to
• Use the Loanable Funds model to analyze the
  effects of external events on savings,
  investment, and real interest rates in capital
  markets and
• Compare capital markets in globalized economies
  with those in closed economies.
• Use the money supply and demand model of money
  markets to examine the effect of changes in the
  economy on money market rates and
• Characterize the effects of changes in monetary
  policy