Supply and Demand Models of Financial Markets Chapter 21, 26, 29 30
Three Markets • Loanable Funds Market • Determines Interest Rate in Capital Markets • Liquidity Market • Determines Money Market Rate • Forex Market • Determines Foreign Exchange Rate
What are some major interest rates in financial markets? Be as specific as possible.
Bond Yields and Interest Rate • Bank accounts typically have very simple interest rates. Balancet+1 = (1+i) ∙ Depositt • Short-term bills have equivalent rates called yields. Face Valuet+1 = (1+i) ∙ Pricet • Simple loans could also be written Repaymentt+1 = (1+i) ∙ Principalt
Liquid Assets Two kinds of assets • Liquid Assets (Currency, Checking Accounts, Savings Accounts) that are useful for transactions which pay zero or below market interest rates. • Money market assets (Government bills, commercial paper, jumbo CD’s) that pay a market rate, i, but which cannot be used for transactions
Q: Why does the money demand curve slope down? A: The greater is the market interest rate, the greater is the opportunity cost of holding money. Q: What shifts the money demand curve? A: An increase in GDP will increase the need for money for transactions shifting the demand curve out. A reduction in GDP will shift the demand curve in. Liquidity Demand
Money Supply • Supply of monetary assets governed by central bank. • Prints currency • Makes reserves available to banks • Governs fraction of deposits that banks must keep.
Money Market Money Supply Money Demand i i* M
Equilibrium in the Money Market • If interest rates are too high, excess supply of money: • people will want to buy interest paying assets like bank accounts or treasury bills. • Bond dealers and banks can reduce the interest rates they are willing to offer • If interest rates are too low, excess demand for money: • people will want to sell interest paying assets like bank accounts or treasury bills to get more liquidity. • Bond dealers and banks must raise interest rates.
Money Market: GDP Rises Money Demand Money Supply i i** 2 i* 1 Money Demand’ M
Operating Targets: Target Interest Rates • Most big country CB’s target interbank interest rates, the rate at which banks lend reserves to one another (in HK, this is called what?)
Target Rates Affect Money Market Rates CEIC Database
Money Supply • Government can control the money supply and can shift the curve in or out by decreasing or increasing money supply. • What does the central bank need to do to money supply to increase the interest rate?
Monetary Policy: Money Supply Shrinks Money Demand Money Supply i i** 2 i* 1 Money Supply’ M
Japan and the Liquidity Trap • BBC Story Download • During the 1990’s and this decade Bank of Japan reduced their interest rate ultimately implementing ZIRP – Zero Interest Rate Policy • Interest rate cannot be set at a rate below zero because of the existence of an alternative financial instrument that always pays better than negative rates.
Money Market at ZIRP Money Demand Money Supply i i* 1 2 3 i** 0 M
Nominal and Real Interest Rates • Nominal return represents how much money you will receive after 1 year for giving up 1 dollar of money today • Real return represents how many goods you can buy if you give up the opportunity to buy 1 good today. • Nominal interest rate is money interest rate. Real interest rate is goods interest rate.
Imagine a 1 year loan [T =1]: The lender gives up some goods to make a loan and will buy goods in the future with the repayment. • If the price of goods at time t is Pt, the foregone current goods are • The goods value of the future repayment is
Real Interest Rate • The real interest rate on the loan is defined as the future goods received relative to current goods foregone
Measuring the Real Interest Rate • Two alternatives • Use nominal interest minus consensus inflation forecast • Use the yield on inflation protected securities.
TIPS Bond • The US Treasury offers bonds whose principal and coupon payments increase with the inflation rate. • Investors are paid off in terms of real purchasing power. • Yield is equivalent to a real interest rate. Additional Information from U.S. Treasury
Real & Nominal Interest Rates π5 Year Forecast
Loanable Funds Market • Consider the financial market at its broadest and most abstract. • an amalgamation of the bond market and the lending market (banks, etc.) • Map the relationship between the interest rate and the quantity of funds that are lent. • Supply curve represents the behavior of savers & lenders • Demand curve represents the behavior of borrowers • Could represent the global financial market or a large national market.
Supply Curve: Loanable Funds • Why does the supply curve slope up? • When real interest rates offered by banks are high, savers are rewarded with more future consumption and are likely to be induced to save more. • Caveat: If some savers are setting a target for their level of wealth at retirement, a higher interest rate reduces the amount they need to save. • For this reason, many economists believe saving curve is very inelastic.
Demand Curve: Loanable Funds • Why does the demand curve slope down? • Firms borrow to finance investment projects. If the return on investment falls below the interest rate, the project is not worthwhile. The higher the interest rate, the fewer projects fall below the hurdle. • Households borrow to finance housing. The higher are interest rates, the smaller is the house that the householders can buy with a mortgage payment that they can afford.
Competitive Market Equilibrium:Loanable Funds Market(Geometry) r S I r* LF* LF
Example: Investment Boom in Japan as economy recovers r S I I´ r** r* 1 LF* LF** LF
Savings • We divide savings into 2 parts:
Example: US Government runs a deficit to finance military spending r S S´ I r** r* 1 LF* LF** LF
Example: US Consumers become thriftier r S I r* LF* LF
Example: US Consumers become thriftier r S S’ I 1 r* r** LF** LF* LF
Global Economy • Additional Source of Savings Loanable Funds Supply = S+KA = National Savings + Net Capital Inflow from Abroad (+/-) • Two Effects • Supply Curve Becomes More Elastic More globalized, more elastic • Global Financial Markets also a source of shifts in Supply Curve
Competitive Market Equilibrium:Loanable Funds Market(Global Economy) r S I S+KA r* KA LF* LF
Questions • Compare Investment Boom in a very globalized economy with one in a less globalized economy. What happens to investment & interest rates? • What happens to a a globalized economy when there is an increase in overseas rates (or an increase in the rate premium).
Government Deficits(Globalized Economy)[r Doesn’t Rise by as Much, I doesn’t fall as much] r S’ I S S’+KA 2 S+KA r** r* 1 LF* LF** LF
Investment Boom(Globalized Economy)[r Doesn’t Rise by as Much, I Rises by More] r I S S+KA r** 2 I’ r* 1 LF* LF** LF
Foreign Interest Rate Rises(Global Economy) r I S+KA’ r** S+KA 2 1 r* LF* LF
Savings Glut • Theory put forth by Fed Chairman explaining the U.S. trade deficit. • Washington Post Article Download
Capital Account • Model can be used to derive equilibrium real interest rates and national saving and investment as well as capital inflows (designated KA). • Trade balance is opposite of the capital account. • Trade balances are temporary.
Net Capital Outflows = ‘Goods & Income Outflows • Private Savings = Y + NFI -Tax – C • Public Savings = Tax – G • S = Y+ NFI – C – G • -KA = S – I = NFI + (Y – C – G – I) • -KA = NFI + NX = CA
Ex Ante Rate and the Fisher Effect • Savings and investment decisions must be made before future inflation is known so they must be made on the basis of an ex ante (predicted) real interest rate. • Fisher Hypothesis: Ex ante real interest rate is determined by forces in the financial market. Money interest rate is just the real ex ante rate plus the market’s consensus forecast of inflation.
Great Inflation of the 1970’s Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/