Chapter One

Why Study Money, Banking, and Financial

Markets ?

We study money because :

• 1. Its growth rate may be a driving force

behind inflation .

• 2. Money plays an important role in generating

the business cycle i.e. upward and downward

movement of aggregate output in the economy

3. Money plays an important role in the fluctuation of interest rate . Therefore :

To see how money create inflation , we need to study the monetary policy .

• Also, we will study the link between the money and the business cycle when we study the monetary policy .

• Also, we will analyze the relationship between money and interest rate when we examine the behavior of interest rate .

• In a later chapter, we will study how central bank can affect the quantity of money in the economy .

Why do we study Banking ?

• Banks are important to our study of money in the economy because :

• 1. They provide a channel for linking those who • wants to save with those who wants to invest. • 2. They play an important role in determining • the quantity of money in the economy. For this

reason we will study how banks decide to make loans and how money supply is determined .

Why do we study financial markets ?

• Financial Markets are markets in which funds are transferred from people who have excess of available funds to people who have a shortage of funds . Examples Bond market or stock market.

• These markets are important in channeling funds from people who do not have a productive use for them to those who do . This process results in

greater efficiency .

Bond Market and interest rates

• The Bond Market is important to economic activities because it enables corporations or governments to borrow to finance their activities

• The interest rate is the cost of borrowing money or the price paid for the rental funds .

• Interest rates have an impact on the overall health of the economy because they affect consumers willingness to spend or save and business investment decisions . Note : We will discuss the fluctuations in interest rate in chapters 4 through 6 .

The Stock Market

• The Stock Market : Is the financial market where the shares of different corporations are traded .

• Issuing stock and selling it to the public is a way for corporations to raise funds to finance their activities

• Higher price for a firm’s shares means that it can raise a larger amount of funds which can be used to buy production facilities and equipment .

• Note : in chapter 2 , we will examine the role of the stock market in the financial system .

The Foreign Exchange MarketFor funds to be transferred from one country to

another, they have to be converted from the currency in the country of origin ( say dollar ) into the currency of the country they are going to ( say euros ) .

The Foreign Exchange Market is where this conversion takes place . It is important because it moves funds between countries and it is the place where the foreign exchange rate is determined . In chapter 17 we will study how exchange rates are determined in the foreign exchange market .

Why Study Financial Markets ?

• 1. Channels funds from savers to investors,thereby promoting economic efficiency.

• 2. Affect personal wealth and behavior of business firms .

Why Study Financial Institutions and Banks ?

• 1. Financial Intermediation helps get funds from savers to investors .

• 2. Banks play an important role in the creation of Money .

• 3. Financial Innovation .

Chapter 2

An Overview of the Financial System

Function of Financial Markets• Perform the essential function of channeling funds

from economic players that have saved surplus funds to those that have a shortage of funds

• Promotes economic efficiency by producing an efficient allocation of capital, which increases production

• Directly improve the well-being of consumers by allowing them to time purchases better

Structure of Financial Markets

• Debt and Equity Markets

• Primary and Secondary Markets– Investment Banks underwrite securities in primary markets

– Brokers and dealers work in secondary markets

• Exchanges and Over-the-Counter (OTC) Markets

• Money and Capital Markets– Money markets deal in short-term debt instruments

– Capital markets deal in longer-term debt and equity instruments

Internationalization of Financial Markets

• Foreign Bonds—sold in a foreign country and denominated in that country’s currency

• Eurobond—bond denominated in a currency other than that of the country in which it is sold

• Eurocurrencies—foreign currencies deposited in banks outside the home country– Eurodollars—U.S. dollars deposited in foreign banks

outside the U.S. or in foreign branches of U.S. banks

• World Stock Markets

Function of Financial Intermediaries: Indirect Finance

• Lower transaction costs– Economies of scale– Liquidity services

• Reduce Risk– Risk Sharing (Asset Transformation)– Diversification

• Asymmetric Information– Adverse Selection (before the transaction)—more likely to select

risky borrower– Moral Hazard (after the transaction)—less likely borrower will

repay loan

Function of Financial Markets

• The basic function of financial market is to move the funds from those who have surplus funds ( Savers – Lenders) to those who have shortages of funds ( borrowers or spenders ) .

• The fund can be transferred either through :

1. Direct Finance ( Financial Market )

2. Indirect Finance (Financial Intermediaries)

Direct Finance

• Borrowers borrow money directly from the lenders in the financial market by selling securities (Bonds).

Indirect Finance

• Funds can move from lenders to borrowers by a second route through the financial intermediaries who borrow funds from the lenders-savers and then make loans to borrowers or spenders .

Structure of Financial Market

• There are two ways a firm or an individual can obtain funds in the financial market .

• 1. By issuing Debt Instruments

( Bonds )

• 2. By issuing Equity Instruments

( Common Stock )

Bonds

• Pay fixed interest rate and has a maturity date .

• Bonds, can be classified as :

• 1. Short-Term Bonds: maturity less than one year

• 2. Intermediate-Term Bond (maturity 1-10 years )

• 3. Long-Term Bond : maturity more than 10 years

Money Market

• Financial Market in which only Short-Term Debt Instruments are traded . Such as :

• U.S. Treasury bills

• Negotiable bank certificates of deposit

• Commercial Paper

• Banker’s acceptance , etc.

Capital Market

• Financial market in which Intermediate as well as Long-Term instruments are traded .

• Example : • Corporate Stocks • Corporate Bonds • Government Bonds • Bank commercial loans . etc.

Primary Market

• Is a financial market in which new issues of securities such as Bonds or Stocks are sold to initial buyers by corporation or government agency borrowing the funds .

Secondary Market

• Is a financial market in which the securities that have been previously issued can be sold .

• The secondary market can be divided into two types :

1. Organized Exchange Market

2. Over-the-counter (OTC) Market

Organized Exchange Market

• Is a financial market where buyers and sellers of securities meet at one central location to conduct trade. Example :

• New York Exchange Market .

• Tokyo Exchange Market … etc.

Over-the-counter Market

• Is a financial market where dealers at different locations buy and sell securities over the counter . Example :

• The current financial market in Saudi Arabia .

Function of Financial Intermediaries

• The Basic function of financial intermediaries is to move funds from lenders to borrowers through the indirect finance .

Types of Financial Intermediaries

• 1. Depository Institutions such as Banks .

• 2. Contractual Saving Institution such as Life

Insurance Company .

• 3. Investment Intermediaries such as Mutual

Funds or Money Market Mutual Funds .

I. Depository Institutions

• Example :

• A. Commercial Banks .

• B. Saving & Loan Associations .

• C. Mutual Saving Banks .

• D. Credit Union .

Commercial Banks

• Raise Funds by issuing Deposits accounts Such as -Demand deposits - Saving Deposits - Time Deposits • And then use these funds to : - Make consumer loans - Make Business loans - and buy securities .

Saving & Loan Associations

• Before 1980 they Raise Funds by making Saving deposits only

• And use the funds to make Mortgage loans only .

• Since 1980 they open all kinds of deposits

• And make consumers & business loans and buy securities .

Mutual Saving Banks

• Since 1980 they raise funds by opening all kinds of deposits and make consumers and business loans and buy securities .

• The difference between Mutual Saving banks and Saving & Loans Association is that Mutual Saving banks function as mutual which means cooperation where depositors own the bank .

Credit Union

• Raise Funds as deposits from the union’s members or employees of particular firm

• And use the Fund to make consumer loans only to its members .

II. Contractual Savings Institutions

• Example:

• 1. Life Insurance Company .

• 2. Pension Funds .

• 3. Fire & Casualty Insurance companies .

• They raise funds on a contractual basis and use these funds by investing them in Long-term securities such as corporate bonds and stocks .

III. Investment Intermediaries

• Such as :

• 1. Mutual Funds

• 2. Money-Market Mutual Funds

• 3. Finance Companies

Mutual Funds

• Raise Funds by issuing shares to many individuals .

• And use the Funds to buy stocks and bonds of long-term securities

Money-Market Mutual Funds

• Raise Funds by issuing shares to many individuals .

• And use the Fund to buy money market instruments such as commercial papers, Treasury bills ,etc. that are both safe and very liquid .

Finance Companies

• Raise Funds by selling commercial papers , stock, and bonds .

• And use the Funds to make consumers and business loans .

CHAPTER 3

What is Money?

Definition of Money

• Economists define money as :

• “ Anything that is generally accepted in payment for goods or services or in the repayment of debts .

Barter Economy

•Is an economy where one good is being exchanged directly for another good .

Wealth and Money

• Wealth is much broader concept than money. It includes money plus all other assets owned by the individual such as Bonds , Stock, Land, Furniture, Cars, Houses, etc.

Income VS. Money• Income is a Flow of earning per

unit of time ( day, week, month, year, etc. ) .

• Money is a Stock , i.e. certain amount at a given point in time .

Functions of Money

• 1. Act as a medium of exchange .

• 2. Act as a unit of Account . • 3. Act as a store of value .

1. Money act as a medium of Exchange

• This means that money is used to pay for goods and services.

•Goods Money Goods • The use of money as a medium of exchange

promotes economic efficiency by reducing the transaction cost .

Barter Economy• Exchanging one good for another good .• In this economy, the Transaction cost is very

high because people have to satisfy what is called “ Double Coincidence of Wants “ which means that : “ They have to find someone who has what they want, and in the same time he wants what they have . “ But , in money economy , you can sell what you have for money and then use the money to buy what you want .

II. Money Act as a Unit of Account

• Money is used to measure the value in the economy .

• We measure the value of goods and services in terms of money .

III. Money act as a Store of Value

• Money is a store of purchasing power over time.

• You can sell what you have for money and then store your money until you have the time and desire to buy .

• Money is not the only asset that has this function. Other assets such as Bonds, Stocks, Houses, Land, etc. have this function as well .

Why people do hold money ?

• Money is the most liquid asset • Money is the medium of exchange .• Money does not have to be converted to

anything else to make the purchase . • How good money as a store of value ? • This depends on the price level , so if • Price level double , the value of money dropped

in half . So money losses value during inflation when the price level rises .

Evolution of the Payments System

• Commodity Money

• Fiat Money

• Checks

• Electronic Payment

• E-Money

Commodity Money

• Money made up of precious metals or another valuable commodity is called commodity Money .

• Commodity money functioned as the medium of exchange in all but the most primitive societies .

• Such form of money is very heavy and hard to transport from one place to another .

Fiat Money• This is a paper currency decreed by government

as legal tender .

• It must be accepted as payment for debt,but not convertible into coins or precious metal .

• Major drawbacks of paper currency that they are easily stolen. This problem took us to another step in the evolution of payment system, the invention of checks .

Checks• It is an instruction from you to your bank to

transfer money from your account to someone else’s account when he deposits the check.

• Checks allow transactions to take place without the need to carry around large amounts of currency . This improved the efficiency of the payment system

Electronic Payment• Banks now provide a web site in which you

just log on, make a few clicks and thereby transmit your payment electronically.

E-Money

• Electronic payments technology can not only substitute for checks, but can substitute for cash as well in the form of electronic money or e-money.

• E-money is money that exists only in electronic form such as debit card which look like the credit card .

• Debit card transfer funds directly from the consumer bank account to a merchant’s bank account.

Measuring Money• To measure money, we need a precise

definition that tells us exactly what assets should be included .

• There are different definitions for money or money supply. These definitions vary in terms of what deposits are included.

• There is Narrow definition as well as broad definition of money .

Narrow definition of Money,M1

• M1 = currency in circulation + Any checkable Deposits

•

• M1 = C + DD + NOW deposits + ATS deposits

• + Traveler’s Checks + any other checkable deposits

• Where :

• NOW deposits= Negotiable Order of Withdrawal

• ATS = Automatic Transfer Service .

Broader Definition of Money,M2 and M3

• M2 = M1 + Saving deposits +Small Time deposits

• M3 = M2 + Large denomination of Time deposits

CHAPTER 4

Understanding Interest Rate

Definition

• Interest rate is defined as : The cost of borrowing . Economists usually call it “ Yield to Maturity “

Measuring Interest Rate

• In the credit market, there are four types of credit instruments . These are :

• 1. Simple Loan

• 2. Fixed Payment Loan

• 3. Coupon Bond

• 4. Discounted Bond

Yield to Maturity• It is the interest rate that equates the present

value of payments received from debt instrument with its value today.

• Therefore, it is the interest rate that makes :• PV of future cash flow = Net investment • ( value today ) • Therefore, How the yield to maturity is

calculated for the 4 types of credit market instruments ?

Simple Loan• Assume you are given the following :

• Net investment = $ 10,000

• Future value after one year = $ 11,000

• Find the yield to maturity for this investment ?

The Answer

• The yield to maturity can be calculated as :• PV of net investment = PV of Future • payment • 10,000 = 11,000 . 1 ( 1 + i ) 10,000 + 10,000 i = 11,000 10,000 i = 1,000 Therefore i = 1000 . = 10% 10,000

Conclusion• Therefore, for a simple loan, the yield to

maturity equals the simple interest rate because :

• The simple interest rate = amount of interest

• amount of the loan

• The simple interest rate = 1000 . = 10 %

• 10,000

Fixed Payment Loan• Assume you are given the following data :

• The amount of loan at t=0 is $ 1000

• Fixed payment = $ 126 per year

• n = 25 years

Required : Find the Yield to maturity or i ?

The Answer

• PV of net Investment = PV of future payments

• 1000 = 126 + 126 + 126 + ……….. + 126

• 1 2 3 25

• (1+i ) (1+i ) (1+i ) ………… (1+i )

• By trial and error, we see that i = 12 %

• Or by using the table of PVIFA as follows :

The Answer continue

1000 = A ( PVIFA, i , n )

• 1000 = 126 ( PVIFA, i , 25 )

• 1000 = ( 7.9365 )

• 126

• Looking for this factor (7.9365) cross n = 25

• we see that i fall between 11% and 12%

• By interpolation we see that i = 11.84%

• i = 11 % + 8.422 – 7.9365 (0.01) = 11.84 %

• 8.422 – 7.843

Coupon Bond• To calculate the yield to maturity for a coupon

bond, we have to equate :

• Net investment = PV of all + PV of

• of the Bond coupon payment Face value• Example : Given that Face value = $ 1000

• Coupon rate 6% compounded semiannually,• market price = $900 , Maturity = 7 years .

The Answer

• PV of net = PV of all + PV of face value• Investment coupon payment of the bond • 900 = A ( PVIFA, i , 14) + F ( PVIF, i ,14) • since we have two different factors, the solution to i

must be by Trial and Error : Example if we try 3%• 900 = 30 ( 11.296 ) + 1000 ( 0.661 ) • 900 = 338.88 + 661 • 900 999.8 or approximately 1000

Answer continue

• Now, if we try 4 % , then

• 900 = 30 (PVIFA, 4%, 14) + 1000 (PVIF, 4%,14)

• 900 = 30 ( 10.563 ) + 1000 ( 0.577 ) • 900 = 316.89 + 577 • 900 893.89 approximately 894 • Therefore, the value of the interest rate or the yield

to maturity fall between 3% and 4% and by interpolation i = 3% + 1000 – 900 (0.01 ) = 3.94%

• 1000 - 894

Note

• There are Bonds Tables that have been created which allow you to read off the yield to maturity for a bond given its coupon rate and its years to maturity as well as its market price .

Yield to Maturity on a 10% coupon rate ,Bond maturing in 10 years with face value $1000

• Price of Bond Yield to Maturity

• $ 1200 7.13 %

• 1100 8.48 %

• 1000 10.00 %

• 900 11.75 %

• 800 13.81 %

• and so on .

Note

• There are 3 facts shown by the Table : • 1. When coupon bond is priced at its face value, then• the yield to maturity = the coupon rate • 2. The price of a coupon bond and the yield to

maturity are negatively related . • 3. When the the bond is priced below the face value,

then the yield to maturity > the coupon rate and when the bond priced above the face value, then

• the yield to maturity < the coupon rate

Perpetual Bond ( Consol )

• This is a bond with no maturity date and no repayment of principal .

• To calculate the yield on this bond , i :

• i = C where C = fixed payment

• Pc Pc = price of consol

• Also, to find the price of this bond , Pc

• Pc = C where i = the yield or the

• i market interest rate

Example

• Given the following data : • The fixed payment or C = $100 per year for ever • The market interest rate, i = 10% • Find the market price of this bond or • Find the present value of this bond ? • Price of the Bond = $100 = $ 1000 • 0.10 and if ( i ) rises to 20% • Price of bond = $ 100 = $ 500 • 0.20

Discount Bond• The yield to maturity for a discount bond

is similar to that for a simple loan , so we need to equate PV of bond with PV of the future cash flow as follows :

• PV0 = FV

• n

• ( 1 + i )

Example

• If a discounted bond ( with 1 year maturity ) pays off face value of $1000 in one year and the current purchase price is $ 900 , what is the yield to maturity ?

• PV = FV or i = F - Pd

( 1 + i ) Pd

900 = 1000 or i = 1000 – 900 =11.1%

1 + i 900

900 + 900 i = 1000 therefore i = 11.1%

Other Measures of Interest Rates

• 1. Current Yield

• 2. Yield on a Discount Basis

• 1. Current Yield, or ic :

• It is the yearly coupon payment divided by

• the price of the bond . Therefore, • ic = C Where C = coupon payment

• Pb Pb = price of bond

Example

• Given the following data :

• Pb = $ 930 ; C = $ 100 Find ic ?

• Since ic = C = 100 = 10.75 %

• Pb 930

• When Pb = Par value , then

• Current yield, ic always equals to coupon rate

Example

• Given the following data below, find the current yield ? Price of Bond = $ 1000

• Coupon Rate = 5 % • Therefore, the current yield = C = 50 = 5% • Pb 1000 • Since yield to maturity = coupon rate when Pb = F• Since coupon rate = current yield also when Pb = F• Therefore, Yield to maturity = current yield when Pb = F

Current yield - continue

• Current yield is negatively related to the price of the bond . Example : Given the following data below :

• Price of Bond = $1000 ; Par value $1000 , and • the coupon bond = 10 % ; Find the current yield? • Current yield = C . = 100 = 10% • Pb 1000 • Now if price of bond rises from $ 1000 to $1200 ,

what is the current yield ? • Current yield = 100 = 8.33 %• 1200

Yield on Discount Basis or (Discounted Yield )

• This yield is defined as : idb

• idb = F – Pd X 360 .

• F # of days to maturity • Where idb = yield on discount basis • F = Face value • Pd = purchase price of discount bond

Example

• Given the following data below, calculate the yield on discount basis ?

• Face value of the bond = $1000

• Purchase price = $ 900

• Maturity = 1 year ( 365 days )

• idb = 1000 – 900 X 360 = 0.0986 or 9.86%

• 1000 365

The Distinction Between Interest rate and Returns

• The rate of return for any security is : • The payment to the owner Plus • The change in its value expressed as a ratio to its

purchase price . • RET = C + ( Pt+1 – Pt ) = C + Pt+1 – Pt • Pt Pt Pt RET = ic + g where : Pt+1 = the price at time t+1 Pt = the price at time t ; ic = current yield• g = rate of capital gain

Example

• Given the following data below, calculate the rate of return , RET ?

• Face value of the bond = $ 1000 • Coupon rate = 10% • Purchase price at time t = $ 1000 • Held for one year and sold at t+1 for $ 1200• RET = 100 + ( 1200 – 1000 ) = 300 = 30 %• 1000 1000

The Distinction Between Real and Nominal Interest Rates

• Nominal interest = Real interest + Expected rate • rate rate of inflation

• Real interest rate = Nominal interest – Expected rate• rate of inflation • For real interest rate to remain constant, the

nominal interest rate must change by the same percentage as the expected rate of inflation .

CHAPTER 5

The Behavior of Interest Rates

Note• In this chapter , we will discuss :

• 1. How the interest rate is determined ?

• 2. What factors influence the interest rate

• behavior .

• 3. Why bond prices change .

• 4. The use of supply & demand analysis

• for bond markets and money markets

• to examine how interest rates change.

Note

• Since we know that there is a negative relationship between the interest rate and the price of the bond , we can explain why interest rate fluctuate by explaining why bond prices change .

• Therefore, our first approach to the analysis of interest rate determination looks at supply and demand in the Bond market .

Supply & Demand in the Bond Market

• Assume you are given the following demand and supply schedule for one-year discounted bond with face value of $ 1000 .

• Price of bond Quantity demanded Quantity supplied

• of Bond of Bond

• $ 950 100 500

• 900 200 400

• 850 300 300

• 800 400 200

• 750 500 100

Market Equilibrium• Occurs when the amount that people are willing to

buy (demand) equals the amount that people are willing to sell (supply) at a given price

• When Bd = Bs the equilibrium (or market clearing) price and interest rate

• When Bd > Bs excess demand price will rise and interest rate will fall

• When Bd < Bs excess supply price will fall and interest rate will rise

Notes

• The equilibrium point is where • Quantity demand of Bonds = Quantity Supplied of Bonds

• 300 300

• If Actual Price of bond < Equilibrium price ,then

• Quantity demanded > Quantity supplied

• of bonds of bonds

• This will create Excess demand for bonds and put pressure on prices of bonds to go up .

Notes - continue

• If the actual price > equilibrium price of bond • $ 900 $ 850• This will create Excess supply of Bonds, and this

will put pressure on prices of bonds to go down . • Only when actual price = equilibrium price • $ 300 $ 300 • There is no pressure on prices to go up or

down . ( excess demand & supply = zero )

Equilibrium Interest rate

• Given the demand & supply schedule of bonds, we can find the equilibrium interest rate :

• Price of Quantity demanded Quantity supplied interest rate • $ 950 100 500 5.3 % • 900 200 400 11.1% • 850 300 300 17.6% • 800 400 200 25 %• 750 500 100 33 % • The equilibrium interest rate = 17.6% • Because at that point Quantity demanded of bonds = quantity

supplied of bonds = 300 .

i = RET = F- P P

• Example : Price of Quantity Quantity

• bond demanded supplied

• $ 950 100 500

• Since the face value of this bond = $ 1000

• Therefore, i= 1000 – 950 = 0.053 = 5.3%

• 950

• And so on .

Interest rate and Quantity Exchanged of Bonds

• We can show the relationship between interest rate and quantity demanded and quantity supplied ( quantity exchanged ) of bonds as follows :

• Interest rate Quantity demanded Quantity supplied• 5.3 % 100 500 • 11.1% 200 400 • 17.6 % 300 300 • 25.0 % 400 200 • 33.0 % 500 100

Changes in equilibrium interest rate

• Any shift in supply or demand curves of bonds create new equilibrium value of interest rate .

• Therefore, what causes the shift in demand or supply curves ?

Factors that causes shift in Demand Curve for Bonds

• 1. Wealth

• 2. Expected Returns

• 3. Expected inflation

• 4. Risk

• 5. Liquidity

Shifts in the Demand for Bonds• Wealth—in an expansion with growing wealth, the demand

curve for bonds shifts to the right

• Expected Returns—higher expected interest rates in the future lower the expected return for long-term bonds, shifting the demand curve to the left

• Expected Inflation—an increase in the expected rate of inflations lowers the expected return for bonds, causing the demand curve to shift to the left

• Risk—an increase in the riskiness of bonds causes the demand curve to shift to the left

• Liquidity—increased liquidity of bonds results in the demand curve shifting right

Factors that shift the supply curve of bonds

• 1. Expected profitability of investment .

• 2. Expected inflation .

• 3. Government deficit .

Shifts in the Supply of Bonds

• Expected profitability of investment opportunities—in an expansion, the supply curve shifts to the right

• Expected inflation—an increase in expected inflation shifts the supply curve for bonds to the right

• Government budget—increased budget deficits shift the supply curve to the right

Change in Equilibrium Interest Rate

• Shift in the demand curve of bond to the right, holding the supply curve constant , causes the interest rate to fall .

• Shift in the demand curve to the left, holding the supply curve constant, causes interest rate to rise

• Shift in the supply curve to the right, holding the demand curve constant, causes interest rate to rise.

• Shift in supply curve of bond to the left , holding the demand curve constant, causes the interest rate to fall .

Change in Expected Inflation ( Fisher’s Effect )

• Since real interest = Nominal – Expected Inflation • rate interest rate rate • As expected inflation rises, real interest rate falls , so

cost of borrowing falls and supply of bond increases which shift supply curve to the right .

• But , also, as expected inflation rises, and real interest rate falls, expected return on bonds falls , so demand on bond will decrease , and that shift the demand curve to the left . So What will happen to the interest rate ?

Case # 1 : If No One Curve Dominate

• This means If supply curve shift exactly by same size as the shift in demand curve, then interest rate will increase, but the quantity exchanged of bonds will not change .

Case #2 If supply curve dominate the shift

• This means that :

• Shift in supply curve > shift in demand curve

• In this case both the interest rate and the quantity of bond exchanged will rise .

Case #3 If the demand curve dominate the shift

• This case means : as expected inflation rises• Shift in demand curve > the shift in supply curve• to the left to the right

• In this case, interest rate will increase , but the quantity of bond exchanged will decrease .

Conclusion

• When expected inflation rise , we see that interest rate rises in all three cases . This result has been named as Fisher’s Effect.

• While the quantity of bond exchanged could rise, fall , or remain constant depending on which curve (supply or demand ) will dominate the shift .

The effect of Business cycle expansion on interest rate

• During Business cycle expansion (Booms ) :

• - Production of Goods & Services increase

• - This increase National income , and

• - encourage firms to borrow to finance new investment . Therefore :

• During Booms activities both demand and supply of bonds increase , so demand and supply curves of bonds shift to the right .

What will happen to interest rate ?

• During the business cycle expansion both demand & supply curves shift to the right

• This will increase quantity exchanged of bonds .

• But, interest rate could rise , fall, or remain constant depending on which curve dominate the shift .

Conclusion

• During Booms activities or Business cycle expansion both demand curve for bonds and supply curve of bonds will shift to the right .

• This shift will increase quantity exchanged of bonds, but the interest rate could rise , fall , or remain constant depending on which curve will dominate the shift .

Liquidity Preference Framework or (supply & demand in the money market)

• This model is developed by John Maynard

Keynes .

• This model determines the equilibrium interest rate in terms of supply & demand of money.

• Keynes made the following assumptions :

Keynes Assumptions

• There are only 2 assets (money & Bonds) that people use to store their wealth .

• W = M + B ……………….. ( 1 )

• The quantity of Bonds & Money supplied must equal quantity of Bonds & Money demanded s s d d

• B + M = B + M ….. (2 )

Keynes assumption-continue

• Equation # 2 can be written as :

• s d d s

• B - B = M - M ………………….. ( 3 )

• Equation # 3 tells us that : s d

• If money market is in equilibrium (M = M )

• This implies that Bonds market is also in equilibrium .

Keynes Assumptions

• Keynes assume that money has zero rate of interest and bonds have expected rate of return equal to the market interest rate .

• As the market interest rate rises, other things being equal, the expected return on money falls relative to expected return on bond . This causes demand for money to fall . Therefore , there is negative relationship between interest rate and the demand for money .

Changes in equilibrium interest rate

• Any shift in the demand for money or in the supply of money curves will change the equilibrium interest rate.

• So, what causes the shift in the demand or supply of money ?

Shift in Demand for Money

• Based on Keynes Liquidity Preference analysis , there are two factors that shift the demand curve for money :

• 1. Income

• 2. Price level

Shift in Supply Curve of Money

• An increase in the money supply shift the supply curve of money to the right , and that decreases the interest rate .

• Therefore :

• Does a higher rate of growth in the money supply lower the interest rate ?

Does a higher rate of growth in money supply lower the interest rate ?

• The Liquidity Preference Analysis seems to lead to this conclusion that :

• As money supply rises , interest rate falls • But, Milton Friedman said, the above

conclusion would be true only if everything else held constant. And he said that as money supply rises may create other effect (such as Income , price level , expected inflation ) which could lead to higher interest rate .

CHAPTER 6

Risk and Term Structure of Interest Rate

In this Chapter we will study

• 1. Why Bonds with the same term to maturity • have different interest rate ?• 2. Why Bonds with different term to maturity • have different interest rate ? • 3. Sources and causes of fluctuations in interest • rate relative to one another .• 4. a number of theories that explain these• fluctuations .

Risk Structure of Interest Rates

• The relationship among different interest rates on bonds with the same maturity is called :

• “ Risk Structure of Interest rate”

Factors that causes the interest rates to be different among bonds with same maturity

• 1. Default Risk

• 2. Liquidity

• 3. Income tax considerations .

Default Risk

• A risk that the issuer of the bond might not be able to make the interest payment or pay off the face value of the bond at the maturity date .

• Bonds with no default risk are called

• “ Default-Free Bonds “

Risk Premium

• Risk = Interest on - Interest on

• Premium Bonds with Default – Free

• Default risk Bonds

• 5 % = 15 % - 10 %

Liquidity• How quickly and cheaply can an asset be

converted into cash is called “Liquidity”.

• The more liquid an asset is , the more desirable it is . Therefore :

• The less liquid a bond, other things being equal, the higher its interest rate will be relative to more liquid securities .

Income Tax Consideration

• Why some bonds have lower interest rate than others ?

• Because, interest payment on some bonds Example ( Municipal Bonds ) are exempted from income tax which has some effect on increasing the expected return .

Term Structure of Interest Rates

• Bonds with identical risk, liquidity , and

• Tax considerations may have different interest rate because of different terms to maturity .

• Showing the yield on bonds with different terms to maturity , but with same risk, liquidity, and tax considerations, give us what is called “ Yield curve “ .

The Yield Curve

• The yield curve can be :

• 1. Upward sloping

• 2. Downward sloping

• 3. Flat curve .

Why the Yield curve differ ?

• Why do we most often see an upward sloping yield curve ? And sometimes we see other shapes ?

• There are 3 theories that explain the Term Structure of Interest Rates :

• 1. Expectations hypothesis theory

• 2. Segmented market theory

• 3. Preferred habitat theory

Expectations Theory

• Based on this theory :• The interest rate on a long-term bond will equal an

average of short-term interest rates that people expect to occur over the life of the long-term bond.

• The key assumption behind this theory that• 1. Both L-T & S-T Bonds are perfect substitutes , so

buyers of bonds do not prefer bonds of one maturity over another . 2. Expected return on these bonds must be equal .

The Yield Curve

• When the yield curve is upward sloping, then the Expectation hypothesis suggest that :

• S-T interest rate are expected to rise in the future , therefore :

• Long-Term interest > Current S-T interest

• Example: If the interest on one-year b ond is expected as follows : 3% ; 7% ; 8% , 10% what is the L-T interest on 2 , 3, and 4 years?

Downward Sloping Yield Curve

• When the short-term interests are expected to fall in the future, then the yield curve slope downward indicating that :

• Long-Term interest < Current S-T interest

• Example: If the interest on one-year bond is expected as follows : 8% ; 7% ; 6% ; 3%

• What is the L-T interest for 4-year Bond ?

Flat Yield Curve

• In this case , the expectation hypothesis suggest that short-term interests are not expected to change in the future , therefore :

• Long-term interest = Current S-T interest • Example: If the short-term interest on 1 year

bond is expected as follows : 8% ; 7%; 9% ; and 8% what is Long-T interest on 4 year bond ?

Term Structure Facts

• 1. Fact # 1 : • Short and Long rates move together• 2. Fact # 2 : • Yield curve tend to have upward slope • when short rates are low , and downward• when short rates are high . • 3. Fact # 3 : Yield curve is usually upward • sloping .

Expectations Hypothesis

• 1. It explains Fact # 1 that short and long • rates move together .• 2. It explains Fact # 2 that the yield curve • tend to slope upward when short rates • are low and slope downward when • short rates are high .• 3. It Does not explain Fact # 3 that yield • curve usually has upward slope .

Segmented Market Theory

• Market for different maturity bonds are completely separate and segmented.

• Interest rate for each maturity bond is determined by supply & demand for that maturity bond.

• Bonds of different maturity are not substitute at all .

Assumption of Segmented Market Theory

•Bonds of different maturities are not substitutes at all .

Implication

• Markets are completely segmented .

• Interest rate at each maturity determined separately .

Segmented Markets Theory

• 1. Explains Fact # 3 that yield curve is usually upward sloping , because people prefer short-term bonds relative to long-term bond . This make higher demand for short-term bonds which have higher price and lower interest rate than the long-term bonds . Hence the yield curve will slope upward .

The Segmented Theory: Does not explain Fact 1 & 2

• 2. This theory does not explain why interest rates • on bonds of different maturity tend to move • together ( Fact # 1 ) . • 3. This theory can not explain why yield curve s • tend to slope upward when short-term • interest rates are low and to slope downward • when short-term interest rates are high because

it assumes long-t and short –t rates are determined independently .

Liquidity Premium and Preferred Habitat Theories

• This theory of term structure states : • “ Interest rate on Long-term bonds

will equal an average of short-term interest expected to occur over the life of the long-term bond Plus a liquidity premium that responds to supply & demand conditions for that bond .

Key Assumptions

• 1. Bonds of different maturities are substitutes ,

• but are not perfect substitutes .

• 2. Expected return on one bond does influence

• the expected return on a bond of a different

• maturity .

• 3. Investors prefer short-term bonds , so they must be offered a positive liquidity premium to induce them to hold long-term bonds .

Numerical Example

• Given the following interest rate for a One-year bond over the next five year s :

• 5 % ; 6% ; 7 % ; 8% ; and 9 % • Also, you are give the term premium for One to

Five –year bonds : • 0 % ; 0.25 % ; 0.5 % ; 0.75 % ; 1 % • Find the interest rates on One to Five- year bonds • Answer : 5% ; 5.75 % ; 6.5% ; 7.25% ; and 8% .

Preferred Habitat Theory or ( Liquidity Premium Theory )

• This theory explains all 3 facts .

• 1. It explains Fact # 3 which says that Yield curve usually slope upward because it assume investors prefer short-term bonds .

• 2. It explains Fact 1 & 2 using same expectations as expectations hypothesis .

Liquidity Premium Theory

int

it i

t1e i

t2e ... i

t(n 1)e

n l

nt

where lnt

is the liquidity premium for the n-period bond at time t

lnt

is always positive

Rises with the term to maturity

Preferred Habitat Theory

• Investors have a preference for bonds of one maturity over another

• They will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return

• Investors are likely to prefer short-term bonds over longer-term bonds

Liquidity Premium and Preferred Habitat Theories, Explanation of the

Facts• Interest rates on different maturity bonds move together

over time; explained by the first term in the equation

• Yield curves tend to slope upward when short-term rates are low and to be inverted when short-term rates are high; explained by the liquidity premium term in the first case and by a low expected average in the second case

• Yield curves typically slope upward; explained by a larger liquidity premium as the term to maturity lengthens

CHAPTER 13

Multiple Deposit Creation and the Money supply Process

Note

• This chapter will focus on :

• - How the banking system creates deposits?

• - The basic concepts needed to understand

how the money supply is determined ?

The Players in the Money Supply Process

• 1. The Central Bank

• 2. Banks ( Depositary Institutions )

• 3. Depositors

• 4. Borrowers

1. The Central Bank

• Is the Government Agency that regulate the banking system .

• It is owned and operated by the government .

• It is responsible for conducting the monetary policy .

2. Banks

• These are financial intermediaries that accept deposits from individuals , firms and government , and use these deposits to make loans .

3. Depositors

• Individuals , firms , and government who hold deposits in the banks .

4. Borrowers

• Individuals , and institutions that borrow from the depository institutions . Or

• Institutions that issue Bonds that are purchased by depository institutions .

The Central Bank Balance Sheet and The Monetary Base

• The central bank has its own balance sheet as any other bank .

• The Balance Sheet consist of Assets and Liabilities .

• We will focus on 4 items that are essential for the money supply process .

Central Bank Balance Sheet

• Assets Liabilities

• _________________________________________

• Government Bonds Currency in circulation

• Discount Loans Reserves

The Liabilities

• Currency in circulation Plus Reserves are called “ Monetary Base “

• MB = C + R

• Reserves : include deposits at the central bank plus currency held by bank ( Vault cash ) .

The Assets

• Any change in the Assets leads to change in reserves and in turn leads to change in money supply . Example :

• If the central bank purchase government bonds , it will increase its holding of government bonds and in the same time it will increase The Reserves , so that will increase the money supply .

Example

• If the central bank purchase government bonds worth of $ 100 million from commercial bank , then :

• Central Bank Balance Sheet

• Assets Liabilities .

• Government Bonds + 100 Reserves + 100

Control of Monetary Base

• MB = C + R • The central bank can control the

MB by using two factors : • 1. Open market Operations .• 2. Making Discount Loans to

Banks .

1. Open Market Operations

• Is the process of Buying or Selling government bonds in the financial market . This process can be divided into

• A. Open market purchase Increase MB

• B. Open market sale Decrease MB

Example

• If central bank purchase government bonds from a bank ( say NCB ) or from Non-bank public ( individual or a firm) who deposit the proceeds in a bank, then

• Reserves will increase and Currency in circulation will remain constant, but MB will increase

• If the Non-bank public cashes the check, then Currency in circulation will rise and Reserves will remain constant, but MB will rise .

Therefore

• If the central bank would like to increase the monetary base, it should conduct open market purchase .

• If the central bank would like to decrease the monetary base, it should conduct open market sale .

II. Making Discount Loans

• Assume the central bank made a loan of SR 100 million to NCB. What will happen to the balance sheet of NCB ? And to the balance sheet of the central bank ?

• Since MB = C + R

• Thus as DL rises , R rises , so

• MB will rise as well .

Balance sheet of NCB

• Assets Liabilities .

• Reserves + 100 Discount loan + 100

Monetary Base, MB

• MB = C + R

• Or MB = MB n + DL

• Where :

• MB = Monetary Base

• MB n = Non-borrowed Monetary Base

• DL = Discount Loans

Shift From Deposits into Currency

• A shift from Deposits into Currency will affect the Reserves , but it has no effect on the Monetary Base .

• MB = C + R

Example

• Assume an Individual withdraw SR 100,000 from his bank account and never deposited that amount again in any bank .

• The effect of this transaction on the balance sheet of :

Non-bank public , Banking system , and the central bank is as follows :

Balance Sheet of Non-bank Public

• Assets _________________Liabilities____

• Checkable - SR 100

• Deposits

• Currency + SR 100

Balance Sheet of Banking System

• Assets______________ Liabilities__________

• Reserves - SR 100 Checkable

• Deposits - SR 100

Balance Sheet for Central Bank

• Assets______________Liabilities______________

Currency in Circulation +100

Reserves of Banks - 100

Multiple Deposit Creation: A Simple Model

• When the Central Bank provides the commercial banks with additional reserves, then the Deposits of the commercial banks will increase by multiple times of that amount . This is called “ Multiple Deposit Creation . “

How the central bank provides additional reserves to commercial banks ?

• There are two ways :• 1. It can make Loans to Banks.• 2. It can purchase government

Bonds ( Securities ) from the financial market .

• Both will increase the Reserves of commercial banks .

Deposit Creation: The Banking System

Bank A Bank A

Assets Liabilities Assets Liabilities

Reserves +$100 Checkable deposits

+$100 Reserves +$10 Checkable deposits

+$100

Loans +$90

Bank B Bank B

Assets Liabilities Assets Liabilities

Reserves +$90 Checkable deposits

+$90 Reserves +$9 Checkable deposits

+$90

Loans +$81

The Formula for Multiple Deposit CreationAssuming banks do not hold excess reserves

Required Reserves ( ) = Total Reserves ( )

= Required Reserve Ratio ( ) times the total amount

of checkable deposits ( )

Substituting

=

Dividing both s

RR R

RR r

D

r D Rides by

1 =

Taking the change in both sides yields

1 =

r

D Rr

D Rr

Critiques of The Simple Model

• The Critiques of the simple model says :

• 1. Commercial Banks usually hold excess

• reserves .

• 2. Usually, there is cash drain in the

• system.

• Therefore, the multiplier will be smaller and the effect on deposits and Loans will be smaller than that of the simple model.

Chapter 14

Determinants of The Money Supply

How the central bank control the level of deposit in the banking system ?

• Since in the simple model we have :• Change in Deposit = 1 X change in Reserves• r • Therefore, the central bank can control the

deposits by : • 1. Setting the required reserve ratio , r • 2. Setting the level of reserve [change in R ]

The Critiques of the Simple Model

• The Money supply or the creation of money will be affected by :

• 1. The required reserve ratio

• 2. The level of Reserves

• 3. Decisions made by depositors about

• their holding of currency .

• 4. Banks decisions about their holding of

• excess reserves ,

Therefore

• In this chapter , we will develop a money supply model in which depositors and Banks assume their important role .

Money Supply Model and the Money Multiplier

• Since R = RR + ER …………. ( 1 )

• RR = r X D ………………. ( 2 )

• ER = ER X D ……………… ( 3 )

• D

• Substituting equation ( 2 & 3 ) into ( 1)

• R = ( r X D ) + { ER X D }

• D

• R = ( r + ER ) D ……………………( 4 )

• D

Monetary Base , MB

• Since MB = C + R ………….. ( 5 )

• C = C . X D ………… ( 6 )

• D

• R = ( r + ER ) D

• Therefore : D

• MB = (C X D ) + ( r + ER ) D

• D

• MB = ( r + ER + C ) D ………….. ( 7 )

• D D

Monetary Base , MB continue

• Since MB = ( r + ER + C ) D • D D • Let e = ER and c = C • D D • Therefore, MB equation can be written as

MB = ( r + e + c ) D …….. ( 7 ) • Dividing both sides of equation (7) by • r + e + c , we get : MB . = D ……… ( 8 ) • r + e + c •

The Money Multiplier , m

• Equation # 8 , can be re-written as :

• 1 . MB = D ………….. ( 8 )

• r + e + c

• Since M = C + D and C = C X D

• D

• Therefore M = ( C X D) + D

• D

• So M = ( 1 + C ) D …….. ( 9 )

• D

Money Multiplier - Continue

• Since D = 1 . MB

• r + e + c

• Since M = ( 1 + C ) D

• D

• Thus M = ( 1 + C ) ( 1 . MB )

• D r + e + c

• Therefore M = 1 + C

• D___ MB

• r + e + c

Money Multiplier – continue

• Let m = 1 + C

• D = money multiplier

• r + e + c

• Therefore M = m X MB

• Where M = Money Supply

• m = Money multiplier

• MB = Monetary Base

Example

• Given the following data :

• r = 10% ; C = SR 400 million

• D = SR 800 million ; ER = SR 0.8 million

• M = C + D = 1200 million

• A. Find the money multiplier , m ?

• B. If MB rises by SR 100 million, by how much the money supply will change ?

The Answer

• A. m = 1 + 400

• 800_____ = 1.5 . = 2.5

• .10 + .8 + 400 .10 +.001 + .5

• 800 800

• B. Change in M = 2.5 X 100 = SR 250 million

Factors that Determine the Money Supply Multiplier

• Since m = 1 + c___ • r + e + c • So, the factors that determine m are :• 1. Change in required reserve ratio , r • 2. Change in currency-deposit ratio, C =c • D• 3. Change in excess reserve ratio, ER = e• D • Both M and m are negatively related to r, e, c .

Determinant of Excess Reserve Ratio , e

• There are 2 factors that affect the cost and benefit of holding excess reserves . These factors are :

• 1. Market interest rate , i

• 2. Expected deposit outflows

1. Market Interest rate, i

• As the market interest rate rises , then the• Opportunity cost of holding excess reserve rises • Banks try to decrease their holding of excess

reserves . • Therefore, there is negative relationship

between the market interest rate and the excess reserve to deposit ratio ( ER = e )

• D

2. Expected Deposit Outflows

• If Banks expect deposit outflow to rise, then

• They will increase their holding of excess reserves , so ER will rise .

• D

• Therefore,

• There is positive relationship between the excess reserve ratio and expected deposit outflows .

Additional Factors that Determine the Money Supply

• Since M = m X MB

• MB = MB n + DL

• So M = m X [ MB n + DL ]

• Where : M = Money Supply

• m = Money Multiplier

• MB n = Non-borrowed monetary base

• DL = Discount Loans

• So Money supply is affected by MBn , DL, r , e, and c .

Changes in Non-borrowed monetary base, MB n

• Since MB = MB n + DL

• Any increase in MB n , holding DL constant, will increase the MB .

• And since M = m X MB

• Any increase in MB , holding the money supply multiplier ( m ) constant will increase the Money supply. Therefore :

• Open Market purchase increase MBn which increases MB and in turn increases M .

• Open Market Sale decreases MBn, MB & M

2. Change in Discount Loans, DL or Borrowed Money

• Holding MBn constant , a rise in DL provides more reserves for commercial banks which increase Loans and Deposits and in turn the Money supply.

• Or As DL rises , MB rises , holding m constant, the money supply ( M ) will rise.

• Therefore, Money supply is positively related to the change in Discount Loans .

What Determine the Discount Loans ?

• There are two factors :

• 1. Market interest rate , i [ Benefit ]

• 2. Discount rate , id [ Cost ]

• The greater the difference between benefit and cost ( i – id ) , the greater is the borrowing by commercial banks from the central bank . Therefore ,

• DL is positively related to i

• DL is negatively related to id

Complete Money Supply Model

• Since M = m X MB ……………….. ( 1 )

• MB = MBn + DL ……………….. ( 2 )

• m = 1 + C/D ……………….. ( 3 )

• r + ER/D + C/D

• Therefore :

• M = 1 + C/D_____ X [ MBn + DL ] ……… ( 4 )

r + E/D + C/D

chapter 15

Tools of Monetary Policy

Monetary Policy

• Is the policy used by the central bank to change the money supply in order to stabilize the economy .

Tools of Monetary Policy

• There are three tools available to central bank to change the money supply :

• 1. Open Market Operations • 2. Discount Rate , rd • 3. Required Reserve Ratio , r

Lender of Last Resort

• The Central Bank act as lender of last resort , which means :

• The Central Bank must provide reserves to the banking system during any banking crises .

Disadvantages of DL

• 1. It is not completely controlled by the central bank .

• 2. Can not be reversed easily .

Proposed reform of discount policy

• Should the id be tied to a market interest rate?

• This proposed suggested that :

• 1. The discount rate, id should be tied to the

• market interest rate , i .

• 2. Penalty discount rate : setting id at a fixed rate

• above i and then allowing commercial banks

• to borrow all they want at that rate .

Should id be abolished ?

• Milton Friedman proposes that :

• The Central Bank should terminate its Discount Loans Policy to have better control over the money supply because that will eliminate fluctuation in the monetary base due to the change in DL .

Tools of Monetary Policy

• Open market operations– Affect the quantity of reserves and the monetary base

• Changes in borrowed reserves– Affect the monetary base

• Changes in reserve requirements– Affect the money multiplier

• Federal funds rate—the interest rate on overnight loans of reserves from one bank to another– Primary indicator of the stance of monetary policy

Demand in the Market for Reserves

• What happens to the quantity of reserves demanded, holding everything else constant, as the federal funds rate changes?

• Two components: required reserves and excess reserves– Excess reserves are insurance against deposit outflows– The cost of holding these is the interest rate that could have been

earned

• As the federal funds rate decreases, the opportunity cost of holding excess reserves falls and the quantity of reserves demanded rises

• Downward sloping demand curve

Supply in the Market for Reserves• Two components: non-borrowed and

borrowed reserves

• Cost of borrowing from the Fed is the discount rate

• Borrowing from the Fed is a substitute for borrowing from other banks

• If iff < id, then banks will not borrow from the Fed and borrowed reserves are zero

• The supply curve will be vertical

• As iff rises above id, banks will borrow more and more at id, and re-lend at iff

• The supply curve is horizontal (perfectly elastic) at id

Affecting the Federal Funds Rate

• An open market purchase causes the federal funds rate to fall; an open market sale causes the federal funds rate to rise shifting the supply curve

• If the intersection of supply and demand occurs on the vertical section of the supply curve, a change in the discount rate will have no effect on the federal funds rate

Affecting the Federal Funds Rate (cont’d)

• If the intersection of supply and demand occurs on the horizontal section of the supply curve, a change in the discount rate shifts that portion of the supply curve and the federal funds rate may either rise or fall depending on the change in the discount rate

• When the Fed raises reserve requirement, the federal funds rate rises and when the Fed decreases reserve requirement, the federal funds rate falls shifting the demand curve

Open Market Operations

• Dynamic open market operations

• Defensive open market operations

• Primary dealers

• TRAPS (Trading Room Automated Processing System)

• Repurchase agreements

• Matched sale-purchase agreements

Advantages of Open Market Operations

• The Fed has complete control over the volume

• Flexible and precise

• Easily reversed

• Quickly implemented

Discount Policy

• Discount window

• Primary credit—standing lending facility

• Secondary credit

• Seasonal credit

• Lender of last resort to prevent financial panics– Creates moral hazard problem

Advantages and Disadvantages of Discount

Policy• Used to perform role of lender of

last resort

• Cannot be controlled by the Fed; the decision maker is the bank

• Discount facility is used as a backup facility to prevent the federal funds rate from rising too far above the target

Reserve Requirements

• Depository Institutions Deregulation and Monetary Control Act of 1980 sets the reserve requirement the same for all depository institutions

• 3% of the first $48.3 million of checkable deposits; 10% of checkable deposits over $48.3 million

• The Fed can vary the 10% requirement between 8% to 14%

Disadvantages of Reserve Requirements

• No longer binding for most banks

• Can cause liquidity problems

• Increases uncertainty

• Recommendations to eliminate

CHAPTER 16

What Should Central Bank do ? Monetary Policy: Goals, Strategy, and

Tactics

Note• In this chapter we will see how

monetary policy is actually conducted by the central bank, but first we will look at the goals that the central bank establishes for monetary policy and its strategies for attaining them .

Goals of Monetary Policy

• There are six basic goals for the central bank when it conduct the monetary policy. These goals are :

• 1. High employment .• 2. Economic Growth .• 3. Price Stability .• 4. Interest Rate Stability . • 5. Stability of Financial Markets . • 6. Stability in Foreign Exchange Markets.

High Employment

• High employment is a worth goal because the alternative situation , High unemployment which causes human suffering and economic waste of resources resulting in a loss of output or lower GDP .

• Full employment does not mean zero unemployment. The economy will be at full employment when the only unemployment that exist are only Frictional or Structural unemployment .

Frictional Unemployment

• Represent the Normal turn over of the labor force ( some people entering and some people leaving the labor force ) . Therefore always there are businesses with unfilled jobs and people seeking jobs .

Structural Unemployment

• Is the unemployment that arises when changes in technology or international competition change the skills needed to perform jobs or changes the location of jobs.

• Structural unemployment arises because of mismatch between job requirements and the skills of local workers or mismatch between demand and supply of labor . Therefore, the goal for high employment should not seek zero unemployment , but rather a level above zero.

Natural rate of unemployment

• the rate of unemployment when the economy is operating at full employment is called Natural rate of unemployment currently this rate is estimated at 4.5 % to 6 % .

II. Economic Growth

• The Goal of Economic Growth is closely related to the high-employment goal because businesses are more likely to invest in capital equipment to increase productivity and economic growth when unemployment is low.

• The central bank can promote economic growth by directly encouraging firms to invest or people to save by providing tax incentive for businesses and for taxpayers.

III. Price Stability

• Policy makers are more concerned with a stable price level as a goal of economic policy .

• Price stability is desirable because a rising price level ( inflation ) create uncertainty in the economy ( Inflation makes it hard to plan for the future ) .

IV. Interest Rate Stability

• Interest rate stability is desirable because fluctuations in interest rates can create uncertainty in the economy and make it harder to plan for the future .

V. Stability of Financial Markets

• Promotion of more stable financial system in which financial crises are avoided is an important goal for central bank.

• The stability of financial markets is also promoted by interest rate stability because fluctuation in interest rate create great uncertainty for financial institutions .

VI. Stability in Foreign Exchange Market

• With the increasing importance of international trade , the value of domestic currency relative to other currencies has become a major consideration for the central bank .

• A rise in the value of domestic currency makes the domestic goods less competitive with those abroad , and a decline in the value of domestic goods stimulate inflation in the country. Therefore stability is a worthy goal.

Central Bank Strategy : Use of Targets

• There are two types of target variables :• 1. Interest rates • 2. Money aggregates and reserves aggregates.• Can the central bank choose to pursue both of

these targets at the same time when the demand for money fluctuate ?

• The answer is no . The central bank must choose one or the other .

1. Targeting on the Money Supply

• If the central bank chooses the money supply as the intermediate target, then it should accept fluctuation in the interest rate.

2. Targeting on the interest rate

• If the central bank chooses the interest rate as the intermediate target, then it should accept the fluctuation in the money supply.

Criteria for choosing the Intermediate Targets

•1. Measurability •2. Controllability •3.Predictable Effect on Goals .

I. Measurability

• Data on interest rate are available more quickly than on monetary aggregate .

• Data on the monetary aggregate are obtained after a two-week delay, while interest rate data are available almost immediately .

• Moreover, interest rates are also measured more precisely and are rarely revised. While the monetary aggregates are subject to fair amount of revision.

Therefore

• At first glance, interest rate seem to be more measurable than monetary aggregate , and more useful as an intermediate target .

• However, the nominal interest rate that is quickly and accurately measured is a poor measure of the real cost of borrowing.

• Real cost of borrowing is more accurately measured by the real interest rate which is adjusted for expected inflation.

Conclusion

• Since real interest rate is extremely hard to measure because we have no direct way to measure expected inflation , Therefore, we see that both interest rate and monetary aggregates have measurability problem, and it is not clear whether one should be preferred to the other as an intermediate target .

II. Controllability

• The central bank must be able to exercise effective control over a variable if it is to function as a useful target .

• The central bank does have the ability to exercise a powerful effect on the money supply , but this control is not perfect .

• The central bank can set interest rates directly by using open market operations which affect directly the price of bonds .

Therefore

• It might appear that interest rates dominate the monetary aggregate on the controllability criteria .

• However , central bank can not set real interest rates, because it does not have control over the expected inflation .

• Therefore, there is no –clear –cut case that interest rates are preferable to monetary aggregate as intermediate target or vice versa.

CHAPTER 17

The Foreign Exchange Market

Foreign Exchange Market

•Is the financial market where exchange rates are determined

The Exchange Rate

• Is the price of one currency in terms of another .

• Most countries of the world have their own currencies : Example

• Saudi Arabia Riyal • Kuwait Dinar • U.S.A. Dollar • European Monetary Union Euro • India Rupee

What are Foreign Exchange Rates?

• There are two kinds of exchange rate transactions :

• 1. Spot Transaction:• This involve the immediate ( two-day)

• exchange of bank deposits .

• 2. Forward Transactions:• This involve the exchange of bank deposits at

• some specified future date .

Appreciation of Currency

•When a currency increases in value , it experience an Appreciation .

Depreciation of a Currency

•When a currency falls in value , it experience Depreciation

Example

• Year Exchange Rate• 1999 1 Euro = $ 1.18 or 1 $ = 0.85 Euro• 2000 1 Euro = $ 0.99 or 1 $ = 1.01 Euro • Therefore, in year 2000 the Euro worth fewer

U.S. dollars, so the Euro depreciated by 16 %• ( 0.99 – 1.18) / 1.18 = 16% • In the same time the value of U.S. dollar relative

to the Euro Appreciate in year 2000 by 19 % • ( 1.01 – 0.85 ) / 0.85 = 19 %

Why Exchange Rate Important

• Exchange rates are important because they affect the relative price of domestic and foreign goods in the economy .

Example

• Suppose an American decided to buy a French commodity ( say X ) which has price of 1000 Euro in France and the exchange rate is :

• 1 Euro = $ 0.99

• Therefore , the cost of French good ( X ) to the American = 1000 Euro * $.99 = $ 990

• Now if the American delays his purchase by two months and during that period the Euro has appreciated to $ 1.20 per Euro, what happen ?

Example – continue

• If the domestic price in France remain at 1000 Euro, then the cost of that good ( X ) to the American will be :

• 1000 Euro * $ 1.20 = $ 1200

• Therefore, as the exchange rate rises from

• $ 0.99 = 1 Euro to $ 1.20 = 1 Euro , the cost of French good to the American rises from $ 990 to $ 1200 .

Note

• The appreciation of the French currency ( Euro ) relative to the foreign currency (U.S. $ ) makes the price of the American goods in France less expensive .

• The depreciation of the French currency• (Euro ) relative to the foreign currency

(U.S. $ ) lowers the cost of French goods in America , but increases the cost of American goods in France .

Example

• An American computer priced at $ 2000 .

• Required:

• 1. How much this American computer will cost a

• French programmer in Euro if the exchange

• rate is $ 0.99 = 1 Euro ?

• 2. How much the American computer will cost

• the French programmer in Euro if the

• exchange rate increases to $ 1.2 = 1 Euro ?

The Answer

• 1. If the exchange rate is $ 0.99 = 1 Euro , then

• the American computer priced $2000 will cost

• a French programmer 2020 Euro as follows :

• ( $ 2000 / 0.99 ) = 2020 Euro .

• 2. If the exchange rate increases to $ 1.2 = 1 Euro

• then the American computer will cost only

• 1667 Euro as follows ( 2000/1.2 ) = 1667 Euro

Conclusion

• 1. When a country’s currency appreciate or rises • in value relative to other currencies , then • The country’s goods abroad become more • expensive . This decrease exports of domestic • goods . • The foreign goods in that country become • cheaper (holding the domestic prices constant• in the two countries) . This increase imports of • foreign goods .

Appreciation of a Currency

• 1. Can make it harder for domestic manufacturers to

• sell their goods abroad because it is relatively

• more expensive .

• 2. Increase competition at home from foreign goods

• because they cost less .

• 3. Benefit the domestic consumers because foreign

• goods were less expensive .

Depreciation of a Currency

• When a country’s currency depreciates,

• Then :

• 1. Its goods abroad become cheaper , so

• exports will rise .

• 2. Foreign goods in that country become

• more expensive , so imports will fall .

How is Foreign Exchange Traded

• The foreign exchange market is organized as an over-the –counter market in which many dealers ( mostly banks ) stand ready to buy and sell deposits denominated in foreign currencies .

Exchange Rate in the Long-run

• Exchange rates are determined by the interaction of supply and demand .

• Therefore : • We will study how the exchange rates are

determined in the long-run, then we will see how they are determined in the short-run .

• The starting point for understanding how the exchange rate is determined is a simple idea called “ The law of one price “

The Law of One Price

• If two countries produces an identical good, and transportation cost and trade barriers are very low, then the price of the good should be the same throughout the world no matter which country produces it .

Example

• Assume that the price of American steel is $ 100 per ton , and price of Japanese steel is 10,000 yen per ton .

• If E = 50 yen / $ , then prices are as follows : • Prices of American Prices of Japanese • steel per ton steel per ton • In U. S. A. $ 100 $ 200 • In Japan 5000 yen 10,000 yen • Here, the price of Japanese good is twice as the

American good in both countries .

Example – continue

• If E = 100 yen / $ , then prices are : • Prices of American Prices of Japanese

• steel per ton steel per ton • In U.S.A. $ 100 $ 100 • In Japan 10,000 yen 10,000 yen • Therefore , the Law of one price suggest that the

exchange rate between U.S.A and Japan should be 100 yen / $

The Law of One Price

• Suggests that the exchange rate between the yen and the dollar must be 100 yen/$ or $ 0.01 per yen , in order for one ton of American steel to sell for 10,000 yen in Japan which is equal to the Japanese steel price. And one ton of Japanese steel to sell for $ 100 in U.S.A which is equal to the price of the U.S steel .

Theory of Purchasing Power Parity ( PPP )

• This theory states that exchange rates between any two currencies will adjust to reflect changes in the price level of the two countries .

• The theory of PPP suggests that :• If one country’s price level rises relative to

another’s , then its currency should depreciate (and other country’s currency should appreciate)

• The PPP theory is an application of the Law of One price to national price level rather than to individual prices .

Example

• Suppose that yen price of Japanese steel rises by 10% ( from 10,000 to 11,000 yen ) relative to the dollar price of American steel ( unchanged at $100 ) .

• For the Law of one price to hold, the exchange rate must rise to 110 yen / dollar , a 10% appreciation of the dollar

• Applying the law of one price to the price levels in the two countries produces the theory of purchasing power parity .

• PPP maintains that if the Japanese price level rises by 10% relative to the U.S. price level, then the dollar will appreciate by 10% and the Japanese yen will depreciate by 10% .

Why the theory of PPP can not fully explain the exchange rates ?

• The theory of PPP states that :

• “ exchange rate between any two currencies will adjust to reflect changes in the price level of the two countries .

• This conclusion of PPP suggests that exchange rates are determined solely by changes in relative price level is based on the assumption that all goods are identical in both countries and that the transportation cost and trade barriers are very low. But this is not always true .

Factors that affect Exchange rates in the Long-run

• 1. Relative price levels [ domestic Vs. Foreign ]

• 2. Tariffs and Quotas

• 3. Preferences for Domestic Vs. Foreign goods .

• 4. Productivity

Exchange Rate in Short-Run

• How the current exchange rates or the spot exchange rates are determined in the short-run ?

• Based on the theory of Asset demand :• The most important factor affecting the

demand for domestic deposits ($) and the foreign deposits (euro) is the expected return on these assets relative to each other .

Therefore

• If Domestic residents or foreigners expect the return on domestic deposits ($) to be higher relative to the return on foreign deposits (euro), then there is high demand for domestic deposits and low demand for foreign deposits . To understand how the demand for domestic and foreign deposits change, we need to compare the expected returns on domestic & foreign deposits .

Example

• Assume that : D

• Expected return on domestic deposit ($) = i ,

• F

• Expected return on foreign deposit (euro) = i,

• To compare the expected return on $ deposits and foreign deposits, investors must convert the return into the currency unit they use.

How a foreigner compares the return on dollar deposits and foreign deposits

denominated in his currency ?

• In this case :• The expected return on $ deposits in

terms of Euro, must be adjusted for any expected appreciation or depreciation of the dollar . Example: D

• If interest on dollar deposits , i = 10 % • Expected appreciation in $ = 7% • Expected return on $ in terms of euro is

17% ( 10% + 7% )

Therefore for a Foreigner

• D

• Expected return on dollars in terms of euro= R

• D D

• R in term of euro = i + Et+1 - Et

• Et F

• Expected return on foreign deposits (euro) = R

• Therefore : F F

• R in terms of euro = i ,

Relative expected return for foreigner

• Is the difference between expected return on dollar and expected return on the euro , which means :

• D F• Relative return on deposit = R - R • D• So Relative R in terms of euro equal :• D F D F• i + Et+1 – Et ) - i, = i, - i, +Et+1 –Et … (1) • Et Et

Note

• As the Relative expected return on dollar deposits increases, then foreigners will want to hold more dollar deposits and fewer foreign deposits .

• What about the decision made by the domestic residents (Americans ) to hold dollar deposits versus euro ?

Decision to hold $ deposits Versus Euro deposits by Domestic residents

• Since : F F e

• R in term of $ = i - Et+1 – Et

• Et

• And expected return on domestic currency ($) is

• D D

• R in terms of $ = i , Therefore :

• D D F e

• Relative R = i, - ( i , - Et+1 – Et ) …… ( 2 )

• Et

Relative Expected Return on $

• D D F e• Relative R = i , - i , + Et+1 – Et … ( 2 ) • Et • Equation # 2 is the same as equation # 1

Which means that the relative expected return on deposits is the same whether it is calculated by domestic residents or by foreigners .

Conclusion

• If the relative expected return on dollar deposits increases , then both foreigners and domestic residents responds in exactly the same way, so both will want to hold more dollar deposits and fewer foreign deposits .

Interest Parity Condition

• Since Foreigners can buy dollar deposits , and

• Since domestic residents (Americans) can buy foreign deposits (euro), and

• Since foreign deposits & dollar deposits have similar risk and liquidity , therefore this theory assume both deposits (foreign & domestic ) are perfect substitutes ( equally desirable )

Therefore

• If expected return on $ > expected return on euro• Both Foreigners & Americans will want to hold

only dollar deposits and No foreign deposits .• If expected return on > expected return on dollar• foreign deposits deposits • Both Foreigners & Americans will want to hold

only foreign deposits (euro) and No dollar deposit • When will Foreigners & Americans will hold

both deposits ( dollar and foreign deposits ) ?

Condition for holding both deposits

• There is no difference in their expected returns .

• Relative expected return must be zero . Therefore expected return on both deposits must be equal . This condition can be written as :

• D F e

• i , = i , - Et+1 – Et

• Et

This condition is called “ Interest Parity condition”

Interest Parity Condition

• D F e

• i , = i , - Et+1 – Et This condition states that :

• Et • Domestic = foreign interest – expected appreciation of • Interest rate rate domestic currency • Or equivalently , this condition can be written as : • Domestic = Foreign interest + expected appreciation of• interest rate rate foreign currency

Note

• If domestic interest rate > foreign interest rate

• There is positive expected appreciation of foreign currency which compensates for the lower interest rate . Example : D

• If domestic interest rate , i , = 18.6 %

• foreign interest rate = 10 %

• This means that expected appreciation of foreign currency must be 8.6% . (depreciation in dollar)

Example

• D F e

• i , = i , - Et+1 – Et

• Et

• 18.6% = 10 % - ( 0.85 – 0.93)

• 0.93

• 18.6% = 10% - ( - 8.6% )

Conclusion

• The interest parity means that :

• Expected returns are the same on both domestic deposits ( dollars ) and on foreign deposits ( euro ) .

CHAPTER 19

The Demand For Money

This Chapter

• Discusses the theories of the demand for money such as :

• 1. Classical theories developed by :

• - Irving Fisher ; Alfred Marshall and

• A.C. Pigou .

• 2. Keynesian theories of demand for money .

• 3. Milton Friedman’s modern quantity theory

Quantity Theory of Money

• This theory is developed by the classical economists in the nineteenth and early twentieth centuries .

• This theory focus on how the nominal value of aggregate income ( PY ) is determined .

• It also tell us how much money is held for a given amount of aggregate income , so it is called “ theory of demand for money .

Velocity of Money & Equation of Exchange

• Irving Fisher examined the link between total quantity of money ( M ) or Money Supply and total amount of spending on final goods and services produced in the economy ( PY )

• PY = Nominal income ( or total spending )

• P = Price Level

• Y = Aggregate Output

Velocity of Money, V

• This concept provide a link between the money supply & the Nominal Income or (between M and PY ) .

• Velocity is the rate of turnover of money or it is the average # of times per year that a dollar is spent in buying goods & services produced in the economy .

• V = PY ……………….. ( 1 ) • M

Example

• If the Nominal Income or GDP = $ 5 million • And the quantity of money , M = $ 1 million • Then , Velocity , V is :

• V = PY = 5 . = 5 • M 1 • It means that on average a dollar bill is spent

5 times in purchasing goods & services in the economy .

Equation of Exchange

• Since V = PY …………………. ( 1 )

• M

• Multiplying both sides of equation (1) by M

• We get MV = PY ……………… ( 2 )

• Equation No 2, is called Equation of Exchange which states that quantity of money multiplied by # of times this money is spent (velocity) in a given year must equal the Nominal Income or PY .

Quantity Theory of Money

• Fisher assume that velocity is fairly constant in the short-run , therefore , Fisher transformed the equation of exchange into quantity of money.

• Since ----• M V = PY ………………….. ( 3 ) • Where V is constant , then • If money , M double , then PY must double • Therefore, Nominal income is determined by the

quantity of money or M .

Example

• Given that :

• PY = $ 5 million ; M = $ 1 million

• Then V = PY = 5 = 5

• M 1

• Now if M double from $ 1 million to 2 then MV = PY

• 2 X 5 = $ 10 million

• As M double , PY double as well .

The Implication of the Quantity of Money

• The Classical Economists including Fisher thought that wages and prices completely flexible and they believe that the level of aggregate output produced in the economy,Y during normal time would remain at full employment , so

• Y in the equation of exchange could be treated as constant in the short-run.

Implication - continue

• Since MV = PY ………………. ( 1 )

• Since V and Y could be assumed constant

• Therefore __ __

• M V = P Y

• Therefore, the quantity theory of money implies that as M double , the price level, P must double as well .

Example

• Given that M = $ 2 million ; P = 1 ; V = 5 • Y = 10 • Since M X V = P X Y • 2 X 5 = 1 X 10 • 10 = 10 • Now if M double from 2 to 4 million, holding V = 5

and Y = 10 , then since MXV = PX Y • 4 X 5 = 2 X10• 20 = 20 • Therefore as M rises from 2 to 4 ( by 100%)• P also rises from 1 to 2 ( 100 % ) as well .

Conclusion

• For Classical Economists :

• Movement in the price level result from the change in the quantity of Money

The Theory of Demand for Money

• Since the equation of exchange is : • MV = PY ……………. ( 1 )• Dividing both sides of this equation by V• We get : MV = PY • V V • M = 1 . PY …….. ( 2 )• V • Equation # 2 is called theory of demand

for money .

Fisher’s Quantity theory of Money

• Since M = 1 . PY • V • Let k = 1 . • V d• Therefore M = k PY …………. ( 3 ) • Equation # 3 is called Fisher’s quantity theory of

demand for money which suggest that : • The demand for money is purely a function of

income , and interest rate has no effect on the demand for money.

Keynes’s Liquidity Preference Theory

• John Maynard Keynes developed a demand for money theory that emphasized the importance of interest rate . His theory is called “ the liquidity preference theory “ .

• Keynes started with the following question : Why do individuals hold money ? Then he suggested 3 motives for holding money . These are : 1. Transactions Motive

• 2. Precautionary Motive

• 3. Speculative Motive

I. Transactions Motive

• Keynes emphasized that people hold money because it can be used as medium of exchange to buy goods and services .

• d

• M = f ( T )

• T = f ( Y ) d

• Therefore M = f ( Y )

II. Precautionary Motive

• Keynes said that people hold additional money as a cushion against unexpected need such as accident, hospitalization, etc.

• Or because of uncertainty of timing of cash flow

• Keynes believe that the amount of money held for this purpose is determined by the level of transaction that people expect to make in future, which is a function of income .

III. Speculative Motive

• Keynes agree with classical economists that money is a store of wealth and called this motive “ Speculative Motive for holding Money “ .

• Keynes divided the assets that can be used as a store of value into two categories ( Money & Bonds ) , W = M + B

• Then he asked why would individuals decide to hold their wealth in the form of money ?

Speculative Motive-continue

• From the theory of Asset demand, we know that people hold money if :

• Expected return on > expected return on

• Money Bonds

• Keynes assumed that rate of return on money is zero , and rate of return on Bonds > 0 , so

• If i rises, PB falls, and it may cause negative capital gain ( Loss ) .

Continue

• So if you expect i to rise substantially , the capital loss might overweight the interest payment , and your expected return from Bonds would be negative.

• In this case you want to store your wealth as Money because :

• expected return on money is 0 > negative return

• on Bonds

• Keynes wrote the following equation for demand for money :

Keynes’s Demand for Money

• Keynes’s Demand for money equation is

• d - +

• M = f ( i , Y )

• P

• Keynes conclusion that demand for money is not related to income only , but also to interest rate as well .

Friedman’s Modern Quantity theory of Money

• Friedman developed a theory of demand for money in 1956 .

• Friedman started with the following question :

• Why people choose to hold Money ?

• Friedman stated that the demand for money must be influenced by same factors that influence the demand for any asset. Therefore, he applied the theory of asset demand to money .

The Theory of Asset Demand

• This theory indicate that the demand for money should be function of :

• - Resources available to individual ( or Wealth)

• - Expected rate of return on money relative to expected rate of return on other assets .

• - Expected rate of inflation .

Friedman’s equation for the demand for money

• Friedman expressed his formulation of the demand for money as follows :

• d

• M = f ( Yp , rb- rm ; re – rm ; Exp. Inf – rm )

• P + - - -

• Where d

• M = demand for real money balances

• P

Where

• Yp = Friedman’s measure of wealth known as

• permanent income , which is present

• discounted value of all expected income .

• rm = expected return on money .

• rb = expected return on bonds .

• re = expected return on equity (Common stock )

• Exp. Inf = expected rate of inflation .

Note

• Friedman said that an individual can hold wealth in several forms besides money such as :

• Bonds ; Equity ; and Goods ) in addition to Money .

• The incentive for holding these assets rather than money are represented by the expected return on each of these assets relative to expected return on money .

Distinguishing between Friedman’s and Keynesian theories

• 1. Friedman , includes many assets as an alternative to money W = M + B + E + G

• While Keynes, includes only one asset as an alternative to money W = M + B

2. Interest rate

• 2. Friedman recognize more than one interest rate as important to the aggregate economy . He uses rb, re , and rm .

• While Keynes uses only one interest rate rb

3. Money as substitute for goods

• Friedman viewed money and goods as substitute.

• While Keynes did not consider goods as substitute for money .

4. Expected Return on Money

• Friedman did not take expected return on money to be constant .

• While Keynes did take expected return on money to be constant and equals to zero .

5. The effect of interest rate on the determination of demand for money

• Friedman’s theory suggest that interest rate should have little effect on the demand for money and he emphasizes the permanent income as the primary determinant of money demand.

• While in Keynes’s theory , interest rate is the most important determinant of the demand for money .

CHAPTER 20

The Keynesian Framework and the ISLM Model

The ISLM Model

• An economic model developed by Sir John Hicks in 1937 based on Keynes’s model .

• It explain how interest rates and total output produced in the economy are determined given a fixed price level .

Determination of Aggregate Output

• Keynes anaysis started with the recognition that total quantity demanded of output for an economy is the sum of four types of spending . These are :

• 1. Consumer Expenditure , C

• 2. Planned Investment Spending , I

• 3. Government Spending , G

• 4. Net Exports, NX

The Aggregate Demand, Yad

• The total quantity demanded of an output is called “ Aggregate Demand “

•

• Y ad = C + I + G + NX

• Keynes recognized that at equilibrium in the economy, the quantity supplied of output must equal quantity demanded , Therefore Y = Y ad

Equilibrium Point

• When Y = Y ad • Where Y = Aggregate output produced• Y ad = Aggregate output demanded • When this equilibrium condition is satisfied,

producers are able to sell all of their output . • Keynes analysis assume that price level is fixed,

so output could change without causing change in prices .

•

Simple Model of Aggregate Output Determination

• In this model, the role of government , net export, and the effect of money and interest rates are ignored. Therefore, we need only consumer expenditure and investment spending .

• Since G = 0 ; and NX = 0 , therefore

• Y ad = C + I

• So what determine C and I ?

Consumer Expenditure and Consumption Function

• Keynes stated that consumer expenditure is a function of disposable income , Y d

• ( Y d = Y – T ) .• Keynes called the relationship between

disposable income and consumer expenditure “ Consumption Function “

• C = a + mpc Y d • Where a = autonomous expenditure • mpc = marginal propensity to consume

Example

• Assume that mpc = .5 and a = 200

• Point Y d Change in Change in C = 200 +.5Y d

• Y d C

• E $ 0 0 0 $ 200 ( a )

• F $ 400 $ 400 $ 200 $ 400

• G $ 800 $ 400 $ 200 $ 600

• H $ 1200 $ 400 $ 200 $ 800

• C = 200 + 0.5 Y d

Investment Spending

• There are two types of investment : • 1. Fixed investment : spending by firms • on equipment (such as machines , computers ) , • factories , offices , building , etc . • 2. Inventory investment : spending by firms on • additional holding of raw materials , parts and • finished goods. The inventory is calculated as

the change in holding of these items for a given time period .

Example

• If XYZ co. that produces personal computer has at the end of 2003 100,000 computers sitting in its warehouses on Dec. 31, 2003 and the price of each computer is $ 1000 , then

• XYZ Co. has inventory investment in year 2003 • = 100,000 X $ 1000 = $ 100,000,000 • If at end of year 2004 , XYZ Co, has inventory

of $ 150,000,000 , then XYZ Co, has inventory investment in year 2004 = $ 50,000,000

Inventory Investment

• Is the change in the level of the inventory over the period . Therefore :

• Inventory = Inventory at - Inventory at

• Investment end of year big. of year

• = 150,000,000 – 100,000,000

• = $ 50,000,000

Equilibrium & Keynesian Cross Diagram

• Since Y ad = C + I , then given that :

• C = 200 + 0.5 Y , and I = 300 , then

• Y ad = ( 200 + .5 Y ) + 300

• Y ad = 500 + 0.5 Y

• And since Y ad = Y at the equilibrium , then

• Y = 500 + 0.5 Y

• 0. 5 Y = 500 , therefore Y = 1000 this is how the aggregate output is determined .

The ISLM ModelThe ISLM model will help you

understand how monetary policy affect economic activity and interacts with fiscal policy ( Change in Govt. Exp.

And Taxes) to produce a certain level of aggregate output.

Constructing the ISLM model

• First step, we need to examine the effect of interest rates on planned investment spending, and hence, on aggregate demand.

• Next step, we use a Keynesian cross diagram to see how the interest rate affects the equilibrium level of aggregate output .

The IS Curve

• The resulting relationship between equilibrium aggregate output and the interest rate is known as IS curve . Therefore, the IS curve shows the combinations of interest rates and the equilibrium aggregate output for which aggregate output produced equals aggregate demand .

Equilibrium in the Goods Market ( IS curve)

• In Keynesian analysis, the primary way that interest rates affect the level of aggregate output is through their effect on planned investment spending and net export ( NX )

Interest rates and planned investment spending

• Businesses make investment in physical capital (machines, factories, and raw materials) as long as they expect to earn more from the physical capital than the interest cost of a loan to finance the investment , therefore, when interest rate is high, only few investment in physical capital will take place, so planned investment spending is low . And when interest rate is low, more investment will take place. Therefore, there is a negative relationship between interest rate and planned investment .

Interest rate and Net Exports , NX• When interest rate rise (with price level fixed)

the demand for bank deposits in the domestic currency will rise relative to deposits denominated in foreign currency. This will cause the domestic currency to appreciate and increase the exchange rate. This appreciation makes the domestic goods more expensive then foreign goods, so export will fall and import will rise, so net export will fall. Therefore , there is a negative relationship between interest rate and net exports .

Conclusion

• As interest rate rises, the planned investment and net exports both will fall and that will cause the aggregate demand, Yad to fall and the aggregate demand schedule to shift downward which decrease the equilibrium output or ( Y= Yad ).

The IS curve• The IS curve describe the points at which the

Goods market is in equilibrium ( Y=Yad) .• For each given level of the interest rate, the IS

curve tells us what aggregate output must be for the goods market to be in equilibrium .

• To the right of the IS curve we have excess supply of goods and to the left of the Is curve we have excess demand for goods .

Excess Supply of Goods ( Y>Yad )

• This excess supply of goods results in unplanned inventory accumulation which causes output to fall toward the IS curve. This decline stop only when output is again at its equilibrium level on the IS curve .

Excess Demand for Goods ( Y < Yad )

• If the economy is located in the area to the left of the IS curve, it has an excess demand for goods, so Yad > Y example point A on the diagram.

• This excess demand for goods results in unplanned decrease in inventory ( Shortages ) which causes output to rise toward the IS curve, and it will stop only when aggregate output is again at its equilibrium level on the IS curve .

Note

• To complete our analysis of aggregate output determination , we need to introduce another market that produces an additional relationship between output and interest rates. This market is the money market ( LM curve ) .

Equilibrium in the Money Market ( The LM curve)

• In Keynes’s analysis, the level of interest rate is determined by the equilibrium in the money market ( where Md = Ms ) .

• The Md is affected by the aggregate output or national income ( Y ) which means as Y rises the Md will rise and Md schedule will shift to the right and that will cause interest rate to rise .

The LM curve

• The LM curve describe the combinations of interest rates and aggregate output for which the quantity of money demanded equals the quantity of money supplied.

• For each given level of aggregate output , Y the LM curve tells us what interest rate must be to have an equilibrium in the money market .

Note• As aggregate output rises , then the demand for

money increases and the interest rate rises so that the money demanded equals the money supplied, so the money market is in equilibrium.

• If the economy is located in the area to the left of the LM curve , such as point A, then there is an excess supply of money .

• Because of the excess supply of money, people use this excess to buy bonds, so price of bonds goes up and that cause the interest rate to fall until it comes to the LM curve .

Note - Continue

• If the economy is located in the area to the right of the LM curve, there is excess demand for money . Example , at point B on the diagram.

• Because of this excess demand for money, people want to hold more money than they currently do, so they sell bonds. This put pressure on the price of bonds to fall and as a result the interest rate goes up to an equilibrium point on the LM curve.

ISLM approach to aggregate output and interest rate

• To produce a model that enables us to determine both aggregate output and the interest rate, we need to put both the IS and the LM curves together into the same diagram

• At the intersection point between the IS and the LM curves, point E, we have an equilibrium in both markets ( The Goods market and the Money market ) .So Yad = Y and Ms = Md .

Note • At any other point in the diagram (other than E)

at least one of these equilibrium condition is not satisfied, and the market forces move the economy toward the general equilibrium, Point E

• Example at point A ( on the IS curve ) :This point is on the IS curve, but not on the LM curve thus the goods market is in equilibrium ( Yad = Y ), but the money market is not on equilibrium.

• At point A, the interest rate is above the equilibrium level , so demand for money is less than the supply ( there is excess supply of money)

Note – continue

• Because at point A, there is excess supply of money , people use this excess to buy bonds. This put pressure on prices of bonds to go up and drive interest rate to fall, which in turn , causes investment spending and net export to rise, and finally cause aggregate output to rise, so the economy moves down the IS curve until the interest rate fall to i* and aggregate output rise to Y* too, so the economy will be at equilibrium point E .

Another Example – Point B on LM curve

• This point is on the LM curve, but not on the IS curve. Therefore, at this point, B, the money market is in equilibrium where Md = Ms , but the aggregate output is higher than the equilibrium level ( There is excess aggregate supply ) .

• Because of this excess supply of goods , firms are unable to sell all their output, this put pressure on firms to cut production and lower the output.

Point B continue

• The decline in output means that the demand for money will fall and that lower the interest rate , so the economy moves down along the LM curve until it reaches the equilibrium point E .