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MIT 14 02 - Lecture 4: Financial Markets

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Lecture 4: Financial MarketsFinancial AssetsMoney DemandMoney Demand DiagramEquilibrium Interest rateEquilibriumMonetary PolicyOpen Market OperationSlide 9Lecture 4: Financial Markets•Goal: Determine equilibrium interest rate•Short run•Main cyclical instrument (Central Bank)•Monetary policy (as opposed to fiscal policy) -- both are (primarily) aggregate demand policiesFinancial Assets•Money, bonds, stocks, mutual funds, derivatives…•Reduce to two:–Money: transaction (liquidity) role.–Bond: investment -- pays an interest rate: i•Key question: How much of each?–Tradeoff: transaction services vs return.Money DemandFix (nominal) wealth at: PWealthM + B = PWealthdd=> determine only one of themM = P Y L(i)dMoney Demand DiagramMdMd‘iMPY’ > PYHigh U.S. nominal interest rates during late 70s -early 80s => sharp decline in M/PYEquilibrium Interest rate•Simple model:–Money supply is constant (i.e. it doesn’t depend on interest rate or P or Y)•Equilibrium:– M = P Y L(i) •Our interest is to determine the interest rate, so we fix P and Y.EquilibriumiMoneyMMsMdMd’Monetary PolicyiMoneyMMsMdMs’Open Market Operation•Central Bank buys bonds in the open market•As a result, price of bonds rises=> interest rate fallsi = $100 - PBPBEquilibrium in M rather than Central Bank MMs = H c + (1-c)Ms = Md => H 1 = P Y L(i) c + (1-c)Examples: a) Y2k ; b) Prudence; c) OMO with


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MIT 14 02 - Lecture 4: Financial Markets

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