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MIT 14 02 - Financial Markets

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Lecture 5: Financial Markets• Current events (FT 09/22/99)• Review Lecture 4– Basic aggregate demand model– The goods market.– DynamicsDynamics$Y145c0+I+G0-c1*TY0 Y(t+1) = Z(t) => (inventories)c0+I+G1-c1*TOther: C(t) = c0+0.5*c1* (Y(t)+Y(t-1))Macroeconomic policy is tricky… lags and leadsSecond Ingredient: FinancialMarkets• Goal: Determine equilibrium interest rate• Short run• Main cyclical instrument (Central Bank)• Monetary policy (as opposed to fiscalpolicy) -- both are (primarily) aggregatedemand 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 dependon 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 -


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MIT 14 02 - Financial Markets

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