5.1 The discount market

Given the expression for nding the rate of discount (5.1), we can easily nd the

price by rearranging as follows:

PRd(R · n)

(5.3)

Exercise 5.1

Rates of discount and rates of interest The current rate of discount on treasury bills is quoted at 11 per cent. (a)Calculate the price of a newly issued, ninety-one-day treasury bill for £100,000.

(b)	Assuming that interest rates remain unchanged, what will its price be when there are36 days left to redemption?

(c)	The interest rate currently quoted on three-month local authority deposits is 11.5 per cent. Is this better or worse than the return on treasury bills?

(d)	What would be the price of a newly issued, ninety-one-day treasury bill if interest rates generally rose by 1 per cent?

Answers at end of chapter

We now know that bills are short-term instruments, issued to raise funds for

periods of up to one year, and that they are issued at a discount where the discount

provides the return to the holder of the bill. If interest rates change, this must be

reected in the money markets as in all others. A rise in interest rates causes bill

prices to fall, while falling interest rates will boost bill prices.

However, when we talk of a ‘market’, we normally think of prices changing

because of changes in supply and demand. It might be useful, therefore, to see how

we can analyse the operation of the discount market, using a supply and demand

framework but maintaining a focus upon short-term interest rates. (This will be a

useful investment for the future, since much of the analysis can be applied to other

nancial markets in which we are interested.) We begin with the supply side of the

market and then turn to demand.

Compared with markets for goods and services, nancial markets display a few

curious features. The rst of these is that what we refer to as the ‘supply’ of bills is

in fact a stock rather than a ow. There is, more or less continuously, a ow of newly

issued bills and a ow of bills maturing (i.e. ceasing to exist) and the relative sizes of

these ows will cause the stock to expand or contract. But we cannot in this case take

the ow of newly issued bills, or even the net ow (new issues minus redemptions)

as the supply and learn anything useful from it about the operation of the market.

We have to take the supply of bills to be the existing stock because, as we said above,

bills are securities which can be traded. People can buy and sell existing bills. What

is more, the stock of existing bills is much larger than current ows and therefore

most transactions will involve existing bills.

In Figure 5.1 we have the price of bills on the vertical axis and the stock of bills

on the horizontal axis. Because we are treating it as a stock, the supply of bills is

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Chapter 5 • The money markets

Figure 5.1

drawn vertically, at S. However, as we said earlier, this stock may expand or contract

0

depending upon the net ow of newly issued bills. As the stock expands, the supply

curve will shift to the right, to S, and as it contracts it will shift to the left to S.

12

What causes the supply curve to shift? We know that bills are a form of short-term

nance and that they are issued by rms (usually large corporations) and central

government. In other countries, local authorities and/or public utilities are major

users of bill nance but this is not the case in the UK. For small rms, and especially

for households, the issuing costs and the minimum bill denominations are too large.

The obvious answer to our question, therefore, is that the supply curve shifts to the

right as a result of netnew issues (i.e. newly issued bills exceeding bills maturing)

and to the left as a result of net redemptions. We can, perhaps, separate long-term

inuences on supply from short-term inuences. In the long run, we expect the

economy to grow in real terms. Output increases and rms expand. As they expand,

they require more nance and some of that will be short-term nance. Over time,

therefore, other things being equal, one would expect rms to make net issues of bills.

The picture is not quite so clear cut with central government, however, since the

expansion of central government is neither so smooth nor so guaranteed. Different

governments, for example, have different views about the size of the state. However,

we can say that ifcentral government activity remains a constant fraction of the

total economy, the government’s need for short-term nance will also expand over

time. Notice also that the price level will affect the quantity of bills which both

governments and rms need to issue. It is nominalspending, the amount in money

terms, not real terms, that needs to be nanced. So ination will also have an effect

on the rate at which the supply curve shifts.

More interesting are the short-term inuences on supply. Bills are just one form

of nance (they are only one source even of short-term nance). This means that

the decision to borrow by issuing bills will depend, especially for competitive rms,

to some extent on the cost of alternative sources of borrowing. This in turn means

looking at relative interest rates as well as at any changes which may occur to costs

of issuing bills. A rise in the cost of alternative sources of funds will cause an increase

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