Term 1 Lecture 3: Financial Markets Flashcards
What are the choices of assets consumers have (1,2)
-You have a choice of 2 assets, money and bonds
-The two types of money are currency and deposits
-Bonds pay a positive interest rate i but can’t be used for transactions
What is the demand for money formula, and how is this plotted on a graph (2)
-The demand for money (M^D) is equal to nominal income ($Y) times a decreasing function of the interest rate (L(i))
-This is a downwards sloping curve where money is on the x axis, and the interest rate on the y axis
What is the LM relation (2)
-The LM (liquidity money) relation is the equilibrium relation in financial markets that money supply = demand
-This is where the money demand curve and money supply curve (perfectly inelastic, independent of IR) cross
What is an open market operation (3)
-Central banks typically change the money supply by buying/selling bonds in the bond market (open market operations)
-The assets of the central banks are the bonds it holds, the liabilities are the stock of money in the economy
-An open market operation increases both assets and liabilities by the same amount (when the CB buys bonds, people get the money)
What is the formula for the interest on a bond (2)
Suppose a bond promises to pay $x a year from now, and the price of the bond today is $Pb
-I = ($x - $Pb)/$Pb
-Bond prices and interest rates have a negative relationship, due to the fixed nature of the final price
What is the liquidity trap (2)
-As the IR becomes 0, people become indifferent between holding money and bonds
-Therefore, expansionary monetary policy becomes useless as IR can’t go below 0
What reasons do banks hold reserves for (3)
-On a given day, people will withdraw cash from banks, as others deposit
-On any given day, people will write cheques with accounts
-Reserve requirements (ratio of bank reserves to bank deposits)
What are the demands for currency and deposits ()
-When people hold both currency and deposits, they must decide how much money to hold, then how much to hold in currency vs deposits
-CU^d = cM^d
-D^d = (1-c)M^d
What is the formula for the demand for reserves (2)
-R = θD = θ(1-c)M^d
-R = reserves, D = deposits, θ = the reserve ratio
What is the demand for central bank money formula (2)
-H^d = CU^d + R^d
-H^d = [c + θ(1-c)]$YL(i)
What are 2 ways of showing equilibrium in financial markets (2, 2)
-Equilibrium can be looked at demand for bank reserves = supply of bank reserves
-H - CU^d = R^d, so H – c$YL(i) = θ (1 - c) $Y L (i)
-Equilibrium can also be looked at demand for money = supply for money
-H / [c + θ(1-c)] = $YL(i)
How do we adjust the nominal interest rate (i) to take into account expected inflation (3, 1)
-One good this year is worth (1 + rt) goods next year
-This is as 1 good is worth pt dollars this year, (1+i) pt dollar next year
-In terms of goods, 1 good this year is worth (1+i)(pt/p^et+1)
-(1+rt) = (1+i)pt/p^et+1
(p^et+1 is the expected price level next year)
What is the one year real interest rate (2)
-one year real interest rate = nominal interest rate - expected inflation from the next term - (real interest)(expected inflation)
-rt = it - π^et+1 - rtπ^et+1
What is the fisher rule (1)
-If the real interest rate and expected inflation are not too large, a close approximate to the real interest is the nominal interest - expected inflation (rt = it - π^et+1
