Chapter 4. Financial Markets

I. Motivating Question How Is the Interest Rate Determined in the Short Run?

The interest rate is determined by equilibrium in the money market, i.e., by the condition that money supply equals money demand. Since the text abstracts from all assets other than bonds and money, equilibrium in the money market is equivalent to equilibrium in the bond market. In this chapter, nominal income is taken as given, so there is no need to consider simultaneous equilibrium of goods and financial markets.

II. Why the Answer Matters

Investment is a function of the interest rate (as will be discussed in Chapter 5), so output is affected by the interest rate. In addition, the determination of the interest rate is intimately connected with monetary policy. This chapter takes nominal GDP, which affects money demand, as given, so the financial markets can be considered in isolation from the goods market. Chapter 5 will address the joint determination of output and the interest rate in the short run.

III. Key Tools, Concepts, and Assumptions

1. Tools and Concepts

i. The chapter defines stock and flow variables and distinguishes wealth (a stock) from income (a

flow).

ii. The chapter introduces monetary policy and describes open market operations.

iii. The chapter makes use of balance sheets for the central bank and private banks.

iv. The chapter introduces various terms and concepts associated with the banking system. These include currency, checkable deposits, reserves, the reserve ratio, central bank money (high powered money, the monetary base), the federal funds market and the federal funds rate, and the money multiplier.

2. Assumptions

i. This chapter assumes that nominal GDP is given. More precisely, the chapter maintains the fixed-price level assumption from Chapter 3 and adds the assumption that real income is given. Chapter 5 considers the joint determination of the interest rate and real income.

ii. For clarity, the chapter assumes that money and bonds are the only assets available and that money does not pay interest. Money is divided into currency and checkable deposits in the section of the chapter that describes the banking system. The assumption that money does not pay interest is maintained throughout the book. Later chapters introduce other financial assets—stocks and bonds of different maturities—and physical capital.

IV. Summary of the Material

1. The Demand for Money

Suppose the financial markets include only two assets: money, which can be used to purchase goods and services and pays no interest; and bonds, which cannot be used for transactions, but pay a positive interest rate i. Financial wealth equals the sum of money and bonds.

Financial wealth is a stock variable, i.e., a variable whose value can be measured at any point in time. An individual’s financial wealth changes over time by saving or dissaving, but at any given moment, financial wealth is fixed. Saving is a flow variable, i.e., a variable whose value is meaningful only when expressed in terms of a time period. Income is also a flow variable. One speaks of income per year or income per month.

At every moment, households must decide how to allocate their given financial wealth between money and bonds. Since financial wealth is fixed, once the demand for money is known, so is the demand for bonds, and vice-versa. Accordingly, the chapter restricts attention to the demand for money.

By assumption, money is needed for transactions. Although it is hard to measure the overall level of transactions in the economy, it seems reasonable to assume that the level of transactions is proportional to nominal income, denoted $Y. So, money demand should be proportional to $Y. On the other hand, allocating wealth to money comes at the cost of forgone interest on bonds. So, money demand should decrease with the interest rate. Putting these observations together, the chapter specifies money demand as

M^d=$YL(i) (4.1)

where the function L decreases as the interest rate increases.