Chapter 13

Money and
Financial
Markets

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 Introduction to Financial Markets

• Financial Markets are organized exchanges where

securities and financial instruments are bought and
sold.
– Financial markets provide direct finance when borrows issues
securities directly to savers.
– More commonly, Financial Intermediaries make loans to
borrowers and obtain funds from savers, often by accepting
deposits.
• Financial intermediaries spread risk and collect information
efficiently.

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 Figure 13-1 The Role of Financial
Intermediaries and Financial
Markets

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 Money vs. Capital Market
Instruments

• Money Market Instruments are assets that have short

maturities, usually less than one year, small fluctuations
in price and minimal risk of default.
– Examples: CDs, commercial paper, U.S. T-bills
• Capital Market Instruments are assets that have
relatively long maturities, can experience large
fluctuations in price, and often expose investor to more
risk of default.
– Examples: Corporate stocks and bonds, U.S. T-notes and bonds,
mortgages

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 Table 13-1 The Main Financial
Intermediaries and Instruments in
2007 (1 of 2)

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 Table 13-1 The Main Financial
Intermediaries and Instruments in
2007 (2 of 2)

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 Table 13-1 The Main Financial
Intermediaries and Instruments in
2007

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 Definitions of Money

• M1 is the U.S. definition of the money supply that includes only

currency (CU), transactions accounts or deposits (D), and traveler’s
checks.
– Algebraically: M1 = CU + D
• M2 is the U.S. definition of the money supply that includes M1; savings
deposits, including money market deposit accounts; small time
deposits; and money market mutual funds.
• High-powered Money (H) is the sum of currency hold outside
depository institutions and the reserves (RES) held inside them.
– Algebraically: H = CU + RES
– H is also sometimes referred to as the Monetary Base.

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 Table 13-2 Components of the M1 and
M2 Measures of the Money Supply,
Sept. 2007 ($ billions)

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 Process of Money Creation

• Suppose there is a $100 deposit of gold coins.

– Assume the Reserve Ratio (e) is 10%, so the bank
keeps 10% of all deposits as reserves. Therefore, the
bank can loan out the remaining $90 of gold coins.
– Assuming the public holds no currency, the new $90
loan will be spent and then redeposited by the new
holder of the $90
– The bank keeps $9 to meet the 10% reserve
requirement and then can make another loan of $81.
– This process repeats and repeats… and ultimately the
original deposit of $100 leads to the creation of $1000
units of money, all in the form of bank deposits!
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 Money Multiplier Equations

• The money creation process can be represented

algebraically to show how the amount of high-powered
money affects the total value of deposits when there are no
currency holdings: H
D
e
• When the public holds a fraction of its deposits as currency
(where c = CU/D), the money multiplier equation becomes:

M1 
1  c  H
(e  c )
– Note: The coefficient of H is called the Money Multiplier

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 Three Fed Tools for Changing MS

• Open Market Operations are purchases and sales of

government securities made by the Federal Reserve in order to
change H.
– An open market purchase (sale) of bonds would increase (decrease) the
money supply.
• The Discount Rate is the interest rate the Federal Reserve
charges depository institutions when they borrow reserves.
– An increase (decrease) in the discount rate would tend to decrease
(increase) the money supply.
• Required Reserves are the reserves that Federal Reserve
regulations require depository institutions to hold.
– An increase (decrease) in the required reserve ratio would tend to
decrease (increase) the money supply.

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 Difficulties in Controlling MS

• The Federal Reserve cannot control the money

supply precisely for several reasons:
– Multiple definitions of money.
– The public chooses the amount of currency it holds.
– Funds shifting between accounts subject to reserve
requirements (like deposits) and those that are not
(like money market mutual funds) will change the
average reserve ratio.
• A Money-Multiplier Shock is any event that
causes the money multiplier to change.
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 Table 13-3 A Simplified Version of
the Fed’s Balance Sheet (all
values in $ billions)

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 Theories on the Demand for
Money

• In the early 1950s, William J. Baumol and James

Tobin demonstrated that the transactions demand
for money depends on the interest rate.
• James Tobin also showed that people demand
money as a store of value as part of an effort to
diversify their portfolios of financial assets.
• Milton Friedman had a similar approach to Tobin’s
portfolio theory suggesting that money demand
depends on both income and wealth.
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 Figure 13-2 Alternative Allocations of
an Individual’s Monthly Paycheck
Between Cash and Savings Deposits

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 International Perspective:
Cash Fades Out as Plastic Takes
Over

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 Financial Regulation and the
IS Curve

• Until 1986, federal regulations put ceilings on the interest

rate that could be on many types of deposits.
– If nonregulated i, then funds from regulated accounts would be
shifted out of commercial banks and thrift institutions (this process
was called Disintermediation)
 The supply of funds available for mortgages
 Spending in the housing market became depressed
– Financial deregulation removed this interest rate gap, and thus,
spending does not fall as much when i
• The effect of financial regulation on the IS curve is to make
the IS curve steeper since now an increase in interest rates
does not lead to as large a fall in spending.
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 Financial Regulation and the
LM Curve

• Before deregulation, we can assume that the interest rate

paid on M1 was rm = 0.
• If r  people will switch out of M1 into interest-bearing
financial assets.
• But after financial deregulation, if r  rm since banks
and thrift institutions are now allowed to pay interest on
their deposits.
 There is a smaller switch out of M1 into other higher
interest-bearing financial assets.
• Result: The LM curve is steeper after financial
deregulation.
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 Figure 13-3 The Effect of Financial
Deregulation in the Commodity
and Money Markets

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 Figure 13-4 The Effect of a Lower
Money Supply on Interest Rates
and Output

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 Fed Target Policies

• The Federal Reserve has a choice of policy

targets in its conduct of monetary policy:
– Target the money supply
– Target the interest rate
– Target inflation
• The unpredictability of MD and the resulting
volatility of interest rates has caused the
Fed to target interest rates at this time.
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 Figure 13-5 Effects on Real Output of Policies that
Either Stabilize the Interest Rate or Stabilize the
Real Money Supply when Either Commodity
Demand or Money Demand Is Unstable

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 Chapter Equations

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 Chapter Equations

General Form Numerical Example

eD  H 0.11,000   100 (13.1)

General Form Numerical Example

H 100
D 1,000  (13.2)
e 0.1

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 Chapter Equations

General Form Numerical Example

eD  cD  H 0.1D  0.15D  100
or
e  c D  H 0.25D  100 (13.3)

H 100
D D  400 (13.4)
ec 0.25

M  D  cD  1  c  D (13.5)

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 Chapter Equations

M  1  c  D
1  c H

1.15 100 
 460 (13.6)
ec 0.25

M s  money multiplier  H (13.7)

rC
cost  bT  (13.8)
2
or
Y rC
b 
C 2
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 Chapter Equations

2bY
C (13.9)
r

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