money market

Question 1

what are the two financial assets that the average person has ?

Answer 1

money - safe asset - currency and checkable deposits

bonds - risky assets - interest bearing

the amount you chose to hold depends on IR and Levels of transaction

Question 2

what are the motives for holding money ?

Answer 2

transitionary - function of Y - + relation

precautionary - function of Y - + relation

speculative - function of Y - - relation

Question 3

what is the equation for money demand ? and what affects it ?

Answer 3

Md = £Y . L ( i )

income level x function of IR

Md rises as Y rises

Md falls as IR rises

Question 4

how much money does the central bank supply ?

Answer 4

the exact amount where Ms = Md

this is equilibrium in the money market

Question 5

how do you draw the money market on a graph ?

Answer 5

the money supply line is a vertical straight line whilst the moony demand curve is a convex line. the x axis is Q and the Y axis is IR . the pink where they meet is labeled as i and q

also known as IR equilibrium

Question 6

what does an increase in £Y ( income level ) do to the money market diagram ?

Answer 6

it will lead to an outward shift of the Md curve and increase in i.

Question 7

what changes the money supply ?

Answer 7

• QMd changes

- monetary policy adjustments

Question 8

on the graph; an increase in the Ms would lead to a decrease in the IR but in reality ……. ???

Answer 8

it is the other way around.

Question 9

describe the money market when its in excess demand ?

Answer 9

Md has increased but IR has not risen accordingly as Ms hasnt been changed yet to adjust to the new Md

so IR are too low ( too risky )

consumers sell bonds to hold safer assets

Qbonds rises - Pbonds falls - inverse relationship IR rises

until Md and and Ms is back at equilibrium

Question 10

describe the money market when its in excess supply ?

Answer 10

Ms has shifted out but i hasn’t fallen yet

IR is too high ( worth increases )

Dbonds increases - Pbonds increases - IR falls

back to equilibrium

Question 11

what relationship to bonds and interest rates have ?

Answer 11

an inverse realtionship

Question 12

what is a bond and how does it work ?

Answer 12

a certificate from a financial instiution that you have loaned money too

face value - upfront cost
IR / Coupon Rate - how much more you get payed back at the end of its life span = Cp / Pb
Coupon payment per year - amount you get payed every year

Question 13

what happens if the price of the bond…

a. increases
b. decreases

Answer 13

a. Pb rises i = 10/110 = 0.09 = 9% IR has fallen
b. Pb falls i = 10/90 = 0.11 = 11% IR has risen - more desirable as you get more back at the end

they have an inverse relationship

best

Question 14

what is scenario 2 of the supply of money ?

Answer 14

the supply of money when it includes

. currency, supplied by the central bank
. deposit accounts, supplied by banks ( non interest )

Question 15

what assets and liabilities do central banks and commercial banks hold ?

Answer 15

central banks
assets - bonds
liabilities - currency, reserves

commercial banks
assets - loans, reserves
liabilities - deposits

Question 16

why do banks keep reserves ?

Answer 16

• need by depositors to withdraw cash
• banks may owe each other at the day end
• legal requirement ( reserve requirement as a % of deposits ) in us - 0 - 10%

they make banks safer, especially if there should be another crisis.

Question 17

what is the demand for money in scenario 2 ?

Answer 17

supply and demand for overall money ( including central bank money )

made up of D for deposit accounts and

CU for currency

Question 18

what does Md = in scenario 2 ?

Answer 18

Md = Dd + CUd

CUd as a fixed percentage = C . Md

c - % of currency we keep

and (1 - c) .Md what ever is left goes in the deposit account

and we must introduce CB money - demand by banks for reserves

Rd = theta.Dd

= theta(1-C).Md

there for D for CB money ( currency and reserves )

Hd = Cud + Rd
= C.Md + theta.(1-C).Md
= Md . ( C + theta.(1-C))

Question 19

what does Hd look like when its considered as a proportion of overall demand for money ?

Answer 19

Hd = [ C + theta . (1-C) ] . £Y . L( i )

and Hs is =

Question 20

what is the money multiplier ?

Answer 20

Ms = Md = (1 / [ C + theta . (1-C) ] ) x Hd

in equilibrium H = Hd therefore

Ms = ( 1 / [ C + theta . (1-C) ] ) x H

H - supply of CB money ( monetary base )

if there is a change in the monetary base , because the CB has maybe performed monetary policy, the multiplies tells us how this effects the supply of money in the economy, as it effects commercial reserves.

Question 21

whats the liquidity trap ?

Answer 21

an extreme scenario

where there is extremely low IR environment

• CB cannot affect IR through normal monetary policy
• people hold money transactions as usual
• indifference between bonds and deposits
• bond prices are maxed ( can only fall ) so people panic sell
• monetary policy becomes powerless
• need to use QE ?

when the increase in the money supply or liquidity doesn’t effect IR

Question 22

what is the euro central bank ?

Answer 22

• controls euro monetary policy
• they decide the refi rate ( re finance rate ) the rate at which country borrow from the ECB when they are short of funds.
• increases or decreases in the refi rate can influence the IR that banks set for a number of things

Question 23

what is securitisation ?

Answer 23

important financial development if 1990s - 200s
traditionally banks or any intermediaries who loaned out mortgages or loans kept them on their own balance sheet.
local banks who only loaned out local loans and mortgages are much more exposed to local economic shocks.
having more diverse loans helps them avoid bankruptcy - called securitisation

it is the creation of securities based on bundles of assets ( e.g. a bundle of loans and morgages)

Question 24

what is an MBS ?

Answer 24

mortgage based security

Question 25

what are the advantages of securitisation ?

Answer 25

advantages that many investors ( who don’t want to hold individual mortgages ) will be willing to buy these and as the supply of funds from investors increases, the cost of borrowing goes down.

Question 26

what is wholesale funding ?

Answer 26

the process of : borrowing from other banks to finance the purchase of more assets

SIVs ( structural investment vehicles ) where set up by banks and where mostly funded through this

would again look attractive due to asset spreading but it had a cost.

they were not protected by debt insurance so if investors got scared they would have to pay.

Question 27

what are international spill overs ?

Answer 27

some european banks were directly exposed to the us housing markets, having bought ( MBSs & CDOs )
trade flows contracted due to losses in consumer demand and confidence
the increase in the USs IRs lead to and increase in europeans making it difficult for us banks to borrow from anywhere.

Question 28

what is the usa’s financial policy ?

Answer 28

to prevent a bank run, federal deposit insurance increased from 100k to 250k per account

the fed provided widespread liquidity and put in liquidity facilities ( making borrowing from them easier )

gov introduced TARP (troubled asset relief program) cleaning up banks wanted to remove complex assets from banks balance sheets this removes uncertainty but it was very hard to deal with the assets ( exchange ? price ? ) initial goal was abandoned and tried to increase capital of banks ( the EU tried the same TARP process )