financial markets and the economy

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Financial Markets and the Economy

“He who controls the money supply of a nation controls the nation.”

-James A. Garfield

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In this module, we move towards an understanding of monetary policy

We’ve learned about the business cycle and that its ups and downs have

consequences.

In particular, that wobbling can lead to high unemployment or inflation/ deflation.

We now turn our attention to some policy tools that our government uses to combat that

wobbling…Monetary policy.

But before we explore monetary policy in detail, we should first understand bonds and

the money market.

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To begin…What is a bond?

At the risk of oversimplifying, a bond is a piece of paper promising to pay some amount at some point in the

future.

If for example, I wanted to build a factory costing $1 billion, I might issue

a million bonds agreeing to pay the holder $1000 in one year.

If you believed in my idea and thought my factory would be profitable, you

might buy these bonds for $900 today.

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Take note of this: Bond prices and interest rates are inversely related

If you did so, you’d be earning a return…you’d spend $900 today to get $1000 a year from now.

We can calculate the interest rate on this bond as:

[The Face Value ($1000) minus the purchase price ($900) ] divided by the purchase price

($900)

[$1000-$900] / $900 = 11.1%

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Bond prices and interest rates are inversely related

If you were not as confident in my factory’s prospects, you might only be willing to pay $750 for this bond today.

We can calculate the interest rate on this bond as:

[The Face Value ($1000) minus the purchase price ($750) ] divided by the

purchase price ($750)

[$1000-$750] / $750 = 33.3%

We now see the inverse relationship between bond prices and interest rates.

As bond prices increase, interest rates decrease and vice versa.

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What do bonds have to do with this?

To simplify, lets imagine we have only one interest rate. It is the rate that the government pays on bonds and the rate that we all earn in our savings accounts. In reality, interest rates

vary from person to person, account to account, and between governments and private businesses.

In our next slide, we’ll turn our attention to the money market: the supply and demand of actual money.

Bonds have a role in that market in this way: higher interest rates attract money. If you can earn a high rate of interest,

you are more likely to buy bonds.

At very low rates, you are probably just as happy to hold cash. The opportunity cost of doing so is low.

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Let’s turn our attention to the money market

Like nearly all things, money is supplied and demanded.

When we discuss money demand, we are referring to the amount of money that we

collectively want to have in our possession. You might have heard it called “Walking

around money”.

As you can imagine, that can depend on a lot of things including prices, your wealth, your mood, and many other factors.

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The market for money

Let’s begin by exploring demand for money.

Here we are comparing the quantity of money we all demand and the interest

rate.

At very high levels of interest, we may demand very little money.

For example, if the current interest rate was 100% interest per day, then you’d put every penny you could in bonds (or

in the bank).$10 b

100%

If we all behaved that way, perhaps we’d have little money on us…maybe a total of $10 billion if you added it all up.

Money Market

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At very low levels of interest, however, we collectively may carry around a lot

more money.

Perhaps at 1% interest, you are not too worried about the opportunity cost of

carrying cash. You simply aren’t missing out on much.

In that case, you might carry more money.

If we all behaved that way, then when all added up, we might all carry around

$100 billion on a normal day.$10 b

100%

$100 b

1%

Money Market

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These points can be connected to form a money demand curve.

This downward slope should make sense to you.

At high rates of interest we demand little money – we prefer instead to stick it in

the bank to collect interest.

$10 b

100%

$100 b

1% D

At low rates of interest we demand more money as the “cost” of carrying it

around is not bad.

Money Market

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Let’s look at the Supply of Money

The supply of money is determined by the Federal Reserve.

It is selected by Fed officials, based on their view of the health of the economy.

Imagine we lived in a smaller economy and the money supply were $50 billion.

$10 b

100%

$100 b

1%

50%

$50 b

That would be true regardless of the interest rate…

If interest rates were 100%, the money supply right now would be $50b.



Money Market

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If true, then money supply could be represented as a vertical line over the

present money supply.

$10 b

100%

$100 b

1%

S

50%

$50 b

D

And when we bring Money Supply and Money demand together we get

equilibrium.

Based on this data, it looks like the equilibrium interest rate is 50%.

Money Market

In this hypothetical economy, in this point in time, the prevailing interest

rates will be 50%.

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Let’s take a look where we are headed

This discussion so far has looked at the money market at one point in time.

Over time, things can change…obviously.

For example, we can become wealthier and demand more money…which may have an

affect on the money market.

The Fed might then respond to those changes by altering the money supply – in what is called

Monetary Policy.

Here is how that might look...

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$10 b

100%

$100 b

1%

S

50%

$50 b

D

Imagine that you won the lottery today. I think it is safe to assume you’d carry

around more cash.

If enough people felt wealthier, that would be illustrated by a rightward shift

in the money demand curve.

However, given this increase in money demand, interest rates would

rise….maybe to 80%.

80%

That should make sense to you:

Since we are wealthier, we demand more money. As a result, the price of

money (i.e. the interest rate) has increased.

Money Market

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Let’s connect this to the AD AS Model

Recall however that higher interest rates discourage investment…a part of

Aggregate demand.

Think of it this way: You neighbor is considering adding on to her factory but

she has to borrow money to do so.

Now that interest rates have gone up, she chooses not to do so.

Aggregate demand falls as she (and many others) forgo these investments.

SRAS

AD2

P2

$200b

P1

$150b

AD1

As AD falls, prices drop, Real GDP falls, and we presume unemployment begins

to climb.

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In response, and to avert what looks like a recession, the Federal Reserve might choose to increase the money supply to

keep interest rates lower.

$10 b

100%

$100 b

1%

S1

50%

$50 b

D

THAT is monetary policy.

With this increased supply of money, a new equilibrium is formed….and it

appears that it is at 50%.

That prevents you and others from eliminating your investment…and keeps

the AD curve from falling.

80%

Money Market

In doing so, the supply of money is expanded pushing the Supply curve

rightward.

S2

$80 b

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So how does the Fed increase the money supply?

The Fed’s primary policy tool is called Open Market Operations (OMO).

This involves the purchase and sale of U.S. treasury bonds.

The fed buys (or sells) millions of dollars in bonds daily to “manage” the U.S. money supply.

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Open Market Operations

If the Fed wants to increase the money supply, it instructs one or more of the 12 Regional Federal Reserve Banks to buy bonds

How do open market operations work?

These could be bought from banks……or individuals.

By buying bonds, money is injected into the economy and the money supply increases!

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Effect of open market operations

Regardless of who the Fed buys bonds from, the result is the same

Member banks who sold bonds find themselves with increased reserves, which they can then

loan out.

Increased loans cause an increase in the money supply.

People that sold bonds deposit proceeds of the bond sale in a bank. The bank finds itself with increased reserves, which it can

then loan out.

Increased loans cause an increase in the money supply.

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Open Market Operations works in reverse too

To reduce the money supply, the Fed instructs one or more of the Regional Federal Reserve Banks to Sell bonds

By selling bonds, money is removed from the economy and the money supply decreases!

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Effect of open market operations

Regardless of who the Fed sells the bonds to, the result is the same

Member banks that sell bonds find themselves with decreased

reserves, and they become less willing to lend money.

Decreased loans cause an decrease in the money supply.

People selling bonds remove savings from a bank to buy the

bonds. Member banks find themselves with decreased

reserve, which makes them less willing to lend money.

Decreased loans cause an decrease in the money supply

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In Summary

Bond prices and interest rates have an inverse relationship.

Higher interest rates lure our money – causing money demand to be low.

However, higher interest rates discourage investment and that slows

an economy.

The Federal Reserve can then manipulate the money supply to

manipulate interest rates

That is called Monetary Policy and it is a tool the Fed uses to manage our

economy.