§3 The Financial Market

The Demand for Money

• Monetary policy acts through financial markets.

• Financial markets are very complex; there is a very large number of financial instruments available to investors.

• Central banks normally do not participate in most of these markets, but their actions affect most asset prices.

• We will simplify the portfolio problem of investors to the bare minimum needed to get a sense on how monetary policy works.

  • Suppose investors only have choice between two assets: money and bonds.

• Money is used for transactions, but it pays no interest (currency and checkable deposits).

• Bonds pay a positive interest rate $i$ (the interest rate), but cannot be used for transactions.

• We have a trade-off! Hold more money and you have the ability to do lots of transactions but give up on getting an interest rate on bonds.

• How much of your wealth you hold in the form of money and bonds depends on your level of transactions and on the interest rate

• At the level of the economy, we have:

  $$M^{d}=\$YL(i); \quad L'<0$$

The Equilibrium Interest Rate (simple)

• Suppose the central banks decides to supply an amount of money equal to $M$.

  $$M^s=M$$

• In equilibrium:

  $$M^s = M^d = \$YL(i)$$

• Rather than the money supply, the central bank could have chosen the interest rate, and then adjusted the money supply so as to achieve the interest rate it had chosen.

Open Market Operations

• Central banks typically change the supply of money by buying or selling bonds in the bond market (directly or indirectly) - open market operations.
• Expansionary open market operation: the central bank expands the supply of money by buying bonds.
• Contractionary open market operation: the central bank contracts the supply of money by selling bonds.

Bond Prices and the Interest Rate

• Suppose a bond promises to pay $\$100$ a year from now (and nothing in between; no coupons).

• If the price of the bond today is $\$P_B$, then the interest rate on the bond is:

  $$i=\frac{\$100-\$P_B}{\$P_B}$$

• The higher the price of the bond, the lower the interest rate.

• The higher the interest rate, the lower the price of the bond today.

The Equilibrium Interest Rate (with intermediaries)

• Financial intermediaries: Institutions that receive funds from people and firms and use these funds to buy financial assets and/or to make loans to other people and firms.

• Banks are financial intermediaries that have money, in the form of
  checkable deposits, as their liabilities.

• Banks keep as reserves (deposits at the central bank) some of the
  funds they receive.

• The liabilities of the central bank are the money it has issued, called central bank money (or high power money).

• Assume people hold no currency, so the demand for money is the demand for checkable deposits

  $$M^d=\$YL(i)$$

• The demand for reserves by banks depends on the amount of checkable deposits

  $$H^d=\theta M^d=\theta\$YL(i)$$

  where $\theta$ is the reserve ratio, and $H^d$ is the demand for high-power money (central bank money) or the monetary base

• Let $H$ denote the supply of central bank money, then the equilibrium condition is

  $$H=H^d=\theta\$YL(i)$$

• The federal funds market is an actual market for bank reserves.

• The federal funds rate is the interest rate determined in the federal funds market, and is the main indicator of monetary policy because the Fed controls it by changing $H$.

— Apr 11, 2025

§3 The Financial Market by Lu Meng is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License. Permissions beyond the scope of this license may be available at About.