exec supplydemandmarkets

7/29/2019 Exec SupplyDemandMarkets

1/24

Supply and Demand Models of

Financial Markets


2/24

Two Markets

Loanable Funds Market

Determines Interest Rate in Capital Markets

Liquidity Market Determines Money Market Rate


3/24


Consider the financial market at itsbroadest and most abstract.

an amalgamation of the bond market and thelending market (banks, etc.)

Map the relationship between the interestrate and the quantity of funds that are lent.

Supply curve represents the behavior of

savers & lenders Demand curve represents the behavior ofborrowers

Could represent the global financial

market or a large national market.


4/24

Supply Curve: Loanable Funds

Why does the supply curve slope up? When real interest rates offered by banks

are high, savers are rewarded with morefuture consumption and are likely to beinduced to save more.

Caveat: If some savers are setting a targetfor their level of wealth at retirement, a

higher interest rate reduces the amountthey need to save.

For this reason, many economists believesaving curve is very inelastic.


5/24

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 thehurdle.

Households borrow to finance housing. The

higher are interest rates, the smaller is thehouse that the householders can buy with a

mortgage payment that they can afford.


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Competitive Market Equilibrium:


(Geometry)S

D

LF

r*

LF*

r


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Example: Investment Boom in

Japan as economy recovers

S

I

LF

r*

LF*

r

r**

I

LF**


8/24

Savings

We divide savingsinto 2 parts:

SGovernment Public Saving/Government Saving

(Budget Surplus)

+ SPrivate Private Saving

(Household + Business Saving)

= S National Saving


9/24

Example: US Government runs a

deficit to finance military spending

S

I

LF

r*

LF*

r

r**

S

LF**


10/24

Example: US Consumers become

thriftier

S

I

LF

r*

LF*

r


11/24

Global Economy

Additional Source of Savings

Loanable Funds Supply = Public Savings +

Net Capital Inflow from Abroad Two Effects

1. Supply Curve Becomes More Elastic

More globalized, more elastic2. Global Financial Markets also a source of

shifts in Supply Curve


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Questions

Compare Investment Boom in a very

globalized economy with one in a less

globalized economy. What happens to

investment & interest rates?


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Money Markets


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Liquid Assets

Two kinds of assets

1. Liquid Assets (Currency, CheckingAccounts, Savings Accounts) that are

useful for transactions which pay zero orbelow market interest rates.

2. Money market assets (Government bills,

commercial paper, jumbo CDs) that paya market rate, i, but which cannot beused for transactions


15/24

Liquidity Demand

Q: Why does the money

demand curve slope

down?

A: The greater is themarket interest rate,

the greater is the

opportunity cost of

holding money.

Q: What shifts the

money demand

curve?

A: An increase in GDPwill increase the need

for money for

transactions shifting

the demand curveout. A reduction in

GDP will shift the

demand curve in.


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Money Supply

Supply of monetary assets governed by

central bank.

1. Prints currency

2. Makes reserves available to banks

3. Governs fraction of deposits that banks

must keep.


17/24

Money Market

i

Money Demand

i*

Money Supply

M


18/24

Equilibrium in the Money Market

If interest rates are too high, excess supply ofmoney:

people will want to buy interest paying assets likebank accounts or treasury bills.

Bond dealers and banks can reduce the interestrates they are willing to offer

If interest rates are too low, excess demand for

money: people will want to sell interest paying assets likebank accounts or treasury bills to get moreliquidity.

Bond dealers and banks must raise interest rates.


19/24

Changes in Money Market Rates

During Business Cycles

Money Demand Shocks: What happens to

interest rates when GDP (either prices or

real GDP rises)?

What happens when GDP falls?


20/24

Operating Targets: Target Interest

Rates

Most big country CBs target interbank interest

rates, the rate at which banks lend reserves to

one another (in HK, this is called what?)

Fed Federal Funds Rate

BoJ Uncollateralized Call Money Rate

ECB Main Refinancing RateBoK Overnight Call Rate

UK Official Bank Rate


21/24

Target Rates Affect Money Market

Rates

Money Market Rates USA

0

1

2

3

4

5

6

7

Sep-97

Mar-98

Sep-98

Mar-99

Sep-99

Mar-00

Sep-00

Mar-01

Sep-01

Mar-02

Sep-02

Mar-03

Sep-03

Mar-04

Sep-04

Mar-05

Sep-05

Mar-06

C.P. Rate Fed Funds T-Bill 3 Mo

CEIC Database


22/24

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?


23/24

Money Market at ZIRP

Money Demand Money Supply

0

1

2 3

i

i**

i*

M


24/24

Learning Outcomes

Students should be able to:

Use the Loanable Funds model to analyze the

effects of external events on savings, investment,

and real interest rates in capital markets and; Compare capital markets in globalized economies

with those in closed economies.

Use the money supply and demand model ofmoney markets to examine the effect of changes

in the economy on money market rates and;

Characterize the effects of changes in monetary

policy

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