Lecture 6: Financial Markets(Cont.)• Current events (FT 09/27/99)• Review Lecture 5– Financial Markets: M and B– Simple model: iEquilibrium 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 - PBPBBanks• Financial intermediation– Institutions (many) that receive money frompeople– Buy stocks, bonds, make loans,...• Banks: Liabilities are money (checkabledeposits can be used to pay for transactions)Key Balance SheetsBanksassets liabilitiesReservesLoansBondsCheckable DepositsCentral BankBonds Central Bank Money= Reserves + CurrencyCentral Bank Money ≠ MoneyBanks in Money Supply• Not all Central Bank Money is held ascurrency by the public.– Some is held as reserves by banks• Why do banks hold reserves– mismatches (depositors, other banks)– legal requirement (about 10% in U.S.)• RESERVE RATIO (reserves to chk.deposits)• Assume no loans (only bonds)Supply and Demand for CentralBank Money Warning: this is non-standard; often done directly on MoneyNeat: This Supply is controlled by Central Bank!Dem for chk depDem for currenDemand for MoneyDemand for Reserves by BanksDem for CBMoney=Sup ofCBMoneyEquilibrium Interest RateMd = P Y L(i)CUd = c MdDd = (1-c) MdR = θ D=>Rd = θ (1-c) MdH = CUd + Rd (supply CB = demand CB)H = [c+ θ (1-c)] MdH = [c+ θ (1-c)] P Y L(i)Equilibrium in M rather thanCentral Bank MMs = 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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