The Financial Market

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1 In this presentation, we take a closer look at how the interest rate is determined in the financial market. The financial market consists of a demand for money, which is a positive function of the level of output and a negative function of the interest rate, and an exogenously determined money supply. The interest rate is determined through the interaction of the demand and supply of money and the equilibrium interest rate is set at such a level that the demand for money is equal to the supply of money. Note that on the vertical axis the interest rate is measured and on the horizontal axis the amount of money demanded and supplied is measured. Let s take a closer look at the demand for money. The demand for money is influenced by two factors - namely the level of output Y and the interest rate i. Between the demand for money and the level of output, a positive relationship exists. If the level of output increases, the demand for money increases as well, and if the level of output decreases, the demand for money decreases.

2 Between the demand for money and the interest rate, a negative or inverse relationship exists. An increase in the interest rate decreases the quantity of money demanded, and a decrease in the interest rate increases the quantity of money demanded. Let s first deal with the relationship between the level of output and the demand for money. The level of output and income also represents the number of transactions that are taking place in the economy. And to do transactions people need money. An increase in the level of output implies an increase in the number of transactions, and consequently an increase in the demand for money takes place. As the income of households and firms increase, they can afford to do more transactions for instance, an increase in the income of households implies that they can afford to buy more goods and services - and therefore need more money to finance their increased spending. Between the level of output and the demand for money, a positive relationship therefore exists. An increase in the level of output and income increases the demand for money - and a decrease in the level of output decreases the demand for money. This relationship between output Y and the demand for money M d plays an important role in the IS-LM model, as it provides the link between the goods market (where Y is determined) and the financial market (where the interest rate is determined). Keep this relationship in mind when you deal with the IS-LM model. Let s turn our attention to the relationship between the demand for money and the interest rate. In this financial market model, there are two ways in which financial wealth can be kept - namely in bonds (for instance treasury bills) and/or money. By keeping your financial wealth in the form of bonds, you will earn interest on it. Keeping it in the form of money you earn no interest at all. The opportunity cost of holding your financial wealth in the form of money is therefore the interest that you could have earned by keeping it in bonds. 2

3 The higher the interest rate, the higher the opportunity cost of holding money and the less money people would wish to hold as an asset. At a high interest rate, people will switch from money to bonds - and they therefore demand a lower quantity of money. A negative or inverse relationship therefore exists between the interest rate and the quantity of money demanded. The higher the interest rate, the lower the quantity of money demanded and the lower the interest rate, the higher the quantity of money demanded. Now that you know what the factors are that influence the demand for money, it is time to present it with the aid of a diagram. On the vertical axis the interest rate is measured, and on the horizontal axis the quantity of money demanded. The demand for money curve is downward sloping - indicating that a negative relationship exists between the interest rate and the quantity of money demanded. An increase in the interest rate from i 1 to i 2 causes a decrease in the quantity of money demanded from M d2 to M d1 as people switch from money to bonds, while a decrease in the interest rate causes an increase in the quantity of money demanded as people switch from bonds to money. In other words - a change in the interest rate causes a movement along a given demand for money curve. The position of the demand for money curve is determined by the level of output and income. For a given level of income, for instance Y 1, there is a corresponding demand for money curve M D1 (for Y 1 ). An increase in the level of output and income causes an increase in the demand for money and the demand for money curve M d1 shifts to the right to M d2. At each and every interest rate, people are demanding more money for transaction purposes. 3

4 A decline in the level of output and income causes a decrease in the demand for money and the demand for money curve shifts to the left. At each and every interest rate, less money is now demanded. It is important to distinguish between a movement along a demand for money curve and a shift of the demand for money curve. A movement along a demand for money curve takes place if the interest rate changes - while a shift is caused by a change in the level of output and income. With the demand for money behind us, it is time to take a closer look at the money supply. In this financial market model, we will follow the traditional approach to the supply of money. This implies that the money supply is controlled by the central bank. In South Africa, the Central Bank is the South African Reserve Bank. An exogenously controlled money supply also implies that the money supply is not influenced by the interest rate. The money supply curve M s is therefore presented graphically by a vertically straight line which is entirely inelastic with regard to the interest rate. A change in the interest rate from i 1 to i 2 does not affect the money supply. An increase in the money supply causes a rightward shift of the money supply curve - and at each an every interest rate the supply of money is now higher. A decrease in the nominal money supply causes a leftward shift - and at each and every interest rate the money supply is now lower. With the demand for money and the supply of money behind us, it is time to see how the equilibrium interest rate is determined. Given the demand for money M d1 and supply of money M s, the equilibrium interest is i 1. This is the point where the demand for money is equal to the supply of money and financial market equilibrium exists. At this equilibrium position, there is portfolio equilibrium in the sense that at the equilibrium interest rate of i 1, people are holding the 4

5 amount of money and bonds they want and will only change their holdings of money and bonds if the interest rate or the level of output changes. Let s see what happens in the money market if there is a change in the level of output and income. An increase in the level of output and income increases the demand for money; the demand for money curve M D1 shifts upward to M d2 and the equilibrium interest rate rises to i 2. The reason for the increase in the interest rate is as follows: We start from an equilibrium position in the financial market as presented by point a. At this equilibrium position people are not only holding money in order to do transactions, but some people are also holding money as an asset. An increase in income increases the demand for money for transaction purposes. At the existing equilibrium interest rate i 1, an excess demand for money develops in the economy, as people wish to hold more money for transaction purposes than before. To get hold of this money for transaction purposes, bonds are sold and the supply of bonds increases on the bonds market. On the bonds market, an increase in the supply of bonds decreases the price of bonds and increases the interest rate. At this higher interest rate i 2, there is a decrease in the amount of money people wish to hold as an asset and money market equilibrium is reestablished at point b where the demand for money equals the supply of money. Let us see what happens if the money supply changes. 5

6 An increase in the money supply causes a rightward shift of the money supply curve to M s1 and the equilibrium interest declines from i 2 to i 1. But how do we get a change in the money supply, and why does an increase in the money supply cause the equilibrium interest rate to fall? With the money supply under the control of the central bank, the central bank can make use of an expansionary monetary policy to increase the supply of money and decrease the interest rate. It does this through open market operations - which involves the buying of bonds on the open market from a broker, a commercial bank or individuals. In exchange for bonds, the sellers of these bonds receive money from the central bank. Thus the money supply is increased. This is presented by a rightward shift in the money supply curve. The reason for the decline in the interest rate is the following: If the central bank wishes to increase the money supply in order to change the interest rate, it needs to convince financial market participants to sell their bonds to the central bank. Given the fact that the financial market participants are in equilibrium - in other words, at the equilibrium interest rate of i 2, they are satisfied with the amount of bonds and money they hold - the central bank needs to offer to buy the bonds at a higher price than financial market 6

7 participants paid for it. At a higher price for bonds, the interest rate is lower and financial market participants will be prepared to hold a larger amount of money and fewer bonds at this lower equilibrium interest rate. 7

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