Lecture 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 Demand Fix (nominal) wealth at: PWealth M + B =d d PWealth => determine only one of them M = P Y L(i)dMoney Demand Diagram i PY’ > PY Md‘ Md M High 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.Equilibrium i Ms Md Md’ M MoneyMonetary Policy i Ms Md M s’ M MoneyOpen Market Operation • Central Bank buys bonds in the open market • As a result, price of bonds rises => interest rate falls i = B P B $100 - PEquilibrium in M rather than Central Bank M Ms= H c + θ(1-c) Ms= Md => H 1 = P Y L(i) c + θ(1-c) Examples: a) Y2k ; b) Prudence; c) OMO with
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