Closed Economy: The Financial Market (topic 3)

Question 1

Who determines the interest rate?

Answer 1

The central bank determines the interest rate.

Question 2

What is wealth?

Answer 2

Wealth is e.g., income that has been saved (it has a given value today, but the value can continue to grow if income is saved in the future).

Question 3

What does wealth consist of?

Answer 3

Money and bonds.

Question 4

What is money?

Answer 4

Money is:

• currency (coins and bills)
• deposit accounts (i.e. the bank deposit connected to your debit card)

Question 5

What are the pros/cons of money vs bonds?

Answer 5

Bonds:
pay interest, but can’t be used for transactions (would have to sell them to be able to buy a cup of coffee).

Money:
doesn’t pay interest, but can be used here and now.

Question 6

What does the composition of a person’s wealth depend on?

Answer 6

Level of transactions (need to have enough money on hand to be able to buy a cup of coffee without having to sell bonds.

The interest rate on bonds (at a higher interest rate, people will be more willing to deal with buying and selling bonds, due to the increased value).

Question 7

What does the determinant Md show?

Answer 7

The demand for money.

Question 8

What does the demand for money depend on?

Answer 8

the overall level of transactions in the economy (which can be hard to measure and are likely to be proportional to nominal income)

The interest rate
as Md = €YL(i) read as;
€Y (nominal income) * a decreasing function of i (denoted by L(i) and a minus sign underneath to show the negative relation)

Question 9

What does Md look like graphically?

Answer 9

A downward sloping curve

interest rate on the vertical axis and money on the horizontal axis

Question 10

What are the types of money in the real world?

Answer 10

Deposit accounts (supplied by banks) and currency (supplied by the central bank)

Question 11

What makes it attractive for banks to hold reserves rather than bonds or make loans?

Answer 11

a high interest rate makes it more attractive to keep more reserves (than what the central bank requires)

Question 12

What does the determinant Ms or M show?

Answer 12

Money supply.

Question 13

What is the equilibrium condition for the financial market in closed economy?

Answer 13

Ms = Md

or

M = €YL(i)

Question 14

What does the equilibrium in the financial market look like graphically?

Answer 14

Vertical axis: interest rate, i

Horizontal axis: money, M

Ms: straight vertical line.

Md: downward sloping curve

Equilibrium, A: where Md intercepts Ms.

Question 15

What is the effect on the interest rate when there is an increase in the money supply? (explain graphically)

Answer 15

An increase in the supply of money leads to an decrease in the interest rate.

The Ms line shifts to the right and the equilibrium point, A moves to the right along the Md curve, to the new equilibrium, A’

Question 16

What is the effect on the interest rate when nominal income increases? (also graphically)

Answer 16

An increase in nominal income will lead to an increase in interest rate.

Graphically will the Md curve shift to the right. The equilibrium A, will move upwards along the Ms line due to the increase in interest rate, and create the new equilibrium A’.

Question 17

What is expansionary open market operation/monetary policy? And what are the effects of it?

Answer 17

In expansionary monetary policy the central bank increases the money supply (by buying bonds and paying for them buy creating money)

When the central bank buys bonds, it increases the demand for bonds and the price for them.

The interest rate on bonds goes down.

Question 18

What is contractionary open market operation/monetary policy? And what are the effects of it?

Answer 18

In contractionary monetary policy, the central bank decreases the money supply by selling bonds and taking the money that is received in exchanged, and taking them out of circulation.

The price for bonds decreases.

The interest rate for bonds goes up.

Question 19

What does the determinant €PB show?

Answer 19

The price on a bond today.

Question 20

How is the interest rate on a bond determined?

Answer 20

i = (promised payment - €PB) / €PB

Example:
one-year bond that promise a payment of €100):
i= (100 - €PB) / (€PB )

€PB = €99

i = (100 - 99) / 99 = 1 / 99 = 0.010 = 1%

Question 21

What are the reactions between prices for bonds and the interest rate?

Answer 21

Prices for bonds go up = the interest rate goes down.

Prices for bonds go down = the interest rate goes up.

Question 22

What is ‘central bank money’?

Answer 22

The money that the central bank has issued (its liabilities)

Question 23

How is the demand for central bank money determined?

Answer 23

Currency demand from people (M = €YL(i)) + demand for reserves from banks (Hd = Theta Md = Theta €YL(i) - Read as: the demand for central bank money = the demand for reserves by banks = Theta * the demand for money by people)

Question 24

What does theta show (the greek 0 with a line through)?

Answer 24

Theta shows the required reserve ratio, so the amount of reserves that banks hold per Euro of deposit accounts.

Question 25

What does the determinant Hd show?

Answer 25

The demand for central bank money.

Hd = theta €YL (i)

Question 26

When is the interest rate in equilibrium in the financial market?

Answer 26

When supply = demand.

H = Hd

Question 27

What does the equilibrium interest rate look like graphically?

Answer 27

Vertical axis: interest rate.

Horizontal axis: central bank money

Supply of central bank money, H: straight vertical line.

Demand for central bank money, Hd: downward sloping curve.

Equilibrium interest rate: where H and Hd intercepts.

Question 28

Explain the ‘zero lower bound’.

Answer 28

The interest rate cannot go below 0 because monetary policies no longer will work as they should.

Question 29

Explain the ‘liquidity trap’.

Answer 29

the liquidity trap is when the interest rate goes below 0 and monetary policy instruments no longer work.

Once people have enough money for transaction purposes, they become indifferent between holding money and holding bonds, this leads to a horizontal demand for money.

When the interest rate is 0, it will not be affected by increases in the money supply.

Question 30

What does the LM relation show?

Answer 30

Liquidity = money.

or supply = demand