Topic 3; Financial Markets (2017)

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Universidad Universidad Pompeu Fabra (UPF)
Grado International Business Economics - 1º curso
Asignatura Introduction to macroeconomics
Año del apunte 2017
Páginas 7
Fecha de subida 06/08/2017
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TOPIC 3 FINANCIAL MARKETS Barter Economy= you exchange one good/service for another; no money Necessary → double coincidence of needs When two people meet each person has what the other one needs and wants what the other one has.
Monetary Economy= exists a medium of exchange generally accepted, something easy to count, easy to transport and easy to store.
Functions of Money Medium of exchange Unit of account → money as a numeraire, is the reference to set prices of goods and services. Allows relative prices between any pair of goods or services.
Store of value, a way to keep resources to the present to the future. It has high liquidity, it can always be use.
Types of Money: Commodity money: has intrinsic value; value even if it isn't used as money: gold and other metals, leather, cigarettes Fiat money: doesn't have intrinsic value, if you have a bill, it's very valuable for me, but you go to another "Galaxy", it doesn't have any value there. Trust is essential for fiat money. Is established as money by a government decree.
Quantity of Money: currency and deposit accounts. Currency is coins and bills, and that's money. Lots of times we don't pay with cash, you pay with credit cards. If we pay w/ a credit card, we are paying with a loan from the bank, and if it’s a debit card, we pay w/ the money in our accounts.
THE DEMAND FOR MONEY Given your financial wealth, we assume choice of two assets Money which you can use for transactions, and pays no interest Types of money: -Currency: coins and bills -Deposit Accounts: bank deposits on which you can write cheques Bonds, pay a positive nominal interest rate, I, but they cannot be used for transactions, basically we save money that cannot use until the time is finished. Here we also have stock market values, bonds issued by governments, bonds issued by firms….
HOW DO YOU SPLIT YOUR WEALTH BETWEEN THESE TWO ASSETS? The proportions depend on the level of transaction and the interest rate of bonds (or alternative assets).
If the interest rate is low, we'll keep our money, because they won't give many return, because the reason to hold part of your wealth in bonds is that they pay interest rate.
Income is what you earn from working plus what we receive from interest from any assets and/or dividends we have. It's something we receive so it's a flow.
Saving is the after-tax income that we don't expend. It's also a flow. We may have also savings from previous periods, and that's a stock, it's a synonym for wealth.
Financial wealth (or simply wealth) is the value of all our financial assets minus all our financial liabilities. It's a stock variable. Financial assets that can be used directly to buy goods and services are called money → currency + deposit accounts Investment - purchase of new capital goods, from machines to plants to office buildings Financial investment - purchase of shares or other financial assets Money Maker Funds: banks pull together the funds of many people and use them to buy bonds.
Demand for money Increases in proportion to nominal income, $Y (level of transactions). Depends negatively on the interest rate, L(i) (return to alternative option for wealth – bonds) → The higher the interest rate, the more efficient the bonds will be.
DETERMINING THE INTEREST RATE Assume a fix supply, and the supply of money is in this point, currency (there are no deposit account).
We have a central bank, that is the only one supplying the money, is the one that controls the amount of money in the economy.
Relation between demand, income and interest rate ; is the demand for money; the amount that people want to hold. $Y denotes nominal income. SO, this equation reads: the demand for money M^d is equal to nominal income $Y, times a function of the interest rate I, with the function denoted by L(i). So, the demand of money increases to a proportion to nominal income, and it depends negatively on the interest rate, as we see for the — under the function L(i) Equilibrium condition in financial markets: ; Money Supply=Money Demand This equilibrium relation is called the LM relation. The central bank controls completely the supply of money, so this is an amount given. So the central bank decides the amount of money, and that determines the equilibrium. The equilibrium value of money is set by the central bank, and the interaction of that supply and the demand function determines the equilibrium point of the market.
What would happen if the income in the economy raises (GDP)? Then, for the same amount of supply of money, the interest rate is going to go up. Moreover, if the supply of money changes, then the interest rate is lower.
The demand for money M^d, drawn for a level of nominal income $Y, is downward slopping: a higher interest rate implies a lower demand for money.
How do central banks change / introduce the new quantity of money in the economy? Open market operations   This are called "Open-market operations", and take place in the ‘open market’ for bonds If the central bank buys government bonds (public) or private bonds (from firms), this operation is called an expansionary open market operation because the central bank increases (expands) the supply of money. They put liquidity in the market → expansionary monetary policy  If the central bank sells bonds, this operation is called a contractionary open market operation because the central bank decreases (contracts) the supply of money. They want to get money back → contractory monetary policy This is a balance, so an operation must be made in both sides of the balance sheet.
When the price of a bond goes up, it means that the firm is borrowing at a low interest rate. If the price of a bond goes down, it means that the firm is borrowing at a high interest rate.
Relation between Bond Prices and Bond Yields (i) A bond has a "face value" → it's a piece of paper that says "you buy this at price P and you'll get the face value in x years". People want to get a return if they are in the bond market, s the lowest the value the buyer pays, the higher will be their return.
We'll talk about nominal interest rate, because we are looking for the nominal value of the return.
So, the lowest is the interest rate of those bonds, the higher the prices of the bonds will be. So if the bond price increases (because you sell the bond for a higher price in a secondary market), the return goes down.
If we are given the interest rate, we can figure out the price of the bond using the same formula.
The interest rate is determined by supply of money = demand for money. When the central bank sells bonds, they are putting more bonds in the market → it supplies more bonds for the same demand, so prices go down and the interest rate will go up (Contractionary Open Market Operations). On the other hand, if the central banks buys bonds and pays them by creating money, there are less bonds for the same demand, so the price of bonds goes up and the interest rate decreases (Expansionary Opne Market Operation). Their target is essentialy the interest rate, and their instrument is the supply of money. Thinking of the central bank as choosing the interest rate is useful because that is what modern central banks do. CB think about the interest rate they want to achieve, and then adjust the money supply to get their interest rate target.
WE INTODUCE THE PRIVATE BANKS! We consider the possibility of having deposit accounts, not only money and bonds. Why is this so important? For consumers it doesn't change things very much, but for the economy it makes a big different, because banks will be creating money and we'll see that. The enconomy that the central bank puts in the economy was until now the total money and marked the equilibrium, but now his money can be multiplied by the privae banks.
Banks – special type of financial intermediaries because their liabilities are money • • Banks receive funds from people and firms. The liabilities of the banks are equal to the value of these deposit accounts, which are money.
Banks must keep as reserves some of the funds they receive. Reserves = cash + account at central bank → most of the reserves are actually accounts at the central bank Banks hold reserves for three reasons: 1.
2.
3.
On any given day, some depositors withdraw cash from their deposit accounts, while others deposit cash into their accounts. Outflows and inflows may be different → they need R On any given day, people with accounts at the bank write checks to people with accounts at other banks, and people with accounts at other banks write checks to people with accounts at the bank. Amounts may be different → need R Banks are subject to reserve requirements established by central banks. Since 2012, the reserve ratio for the Euro zone is 1%. → R/D ≥ 0.01 With the deposits banks will give loans to consumes, privates or buy bonds, to privates or the government. Banks have their reserves in accounts at the central banks. They are assets. The central banks have a liability, which are the reserves of the different private banks.
Loans represent on average 70% of bank’s non-reserve assets. Bonds represent around 30%. For understanding the supply of money, the distinction between loans and bonds is irrelevant, so we will assume only bonds. → READ THE FOCUS: Bank runs, deposit insurance and wholesale funding Now we'll b talking about the supply of money and high power money.
The demand for central bank money is equal to: demand for currency by people CU + demand for reserves by banks R The supply of central bank money is under the direct control of the central bank H The equilibrium interest rate is such that: demand central bank money=supply central bank money H= Money is what we use for exchange, and high power money is the money that the central banks control.
Demand for Money When people can hold both currency and deposit accounts, the demand for money involves two decisions.
1. People must decide how much money to hold.
2. They must decide how much of this money to hold in currency and how much to hold in deposit accounts. This accounts do not have an interest rate.
• Overall money demand Assume fix proportion of currency: • Demand for currency • Demand for deposit accounts The Demand for Reserves The larger the amount of deposit accounts, the larger the amount of reserves the banks must hold, for both precautionary and regulatory reasons.
Reserve ratio ≡ θ bank reserves per € of deposits Relation between reserves (R) and deposits (D): R   D  The demand for reserves by banks is given by: The Demand for Central Bank Money is equal to the sum of the demand for currency and the demand for reserves.
   The Determination of the Interest Rate In equilibrium, supply of central bank money (H) equal to the demand for central bank money (Hd).
 H= • If people hold only currency c=1;  • If people hold only deposit accounts c=0;    TWO ALTERNATIVE WAYS OF LOOKING AT THE EQUILIBRIUM think of equilibrium in terms of supply and demand of bank reserves: The interbank market: banks keep those reserves, a lot of them, and they move huge amounts of money, and an extra amount of reserves makes them loose a lot of money. There's a marker between private banks, where banks lend or borrow between them, in 24h. CB can buy bonds from banks (increase H through open market operations), influence the supply of reserves, and push interbank interest rate down. (For the Eurozoe is called EONIA (Euro overnight index average)) EURIBOR (Euro Interbank Offered Rate) – average interest rate at which a large panel of European banks lend to each other. There are different maturities, ranging from one week to one year. No collateral is needed. One year maturity as reference for mortgages in Spain.
The interest in interbank market is usually 0.2% (20 basis points) higher than the Marginal Lending Facility (interest rate of the central bank. banks go to central banks to ask for a loan, and that's the interest that they pay) of the corresponding Central Bank, because the CB requires collateral (when the private banks go to ask for a loan, they had to bring a collateral of high quality, it's like a type of "BONO" to assure the payment). Interbank markets are private banks. Central Banks do not belong to the interbank.
The first symptom of the financial crisis was the lack of liquidity. The banks stopped trusting eachother, and they couldn't get loans. The Central Bank replaced the traditional liqidity system then.
The Eurosystem offers credit institutions two standing facilities (most recent values set on March 16 2016): Marginal lending facility, to obtain overnight liquidity from the ECB, against the presentation of sufficient eligible assets. Marginal lending facility Rate= 0.25% — Deposit facility, to make overnight deposits with the CB. Deposit facility Rate= -0.40% The Eurosystem’s regular open market operations consist of: Main Refinancing Operations (MRO)     One-week liquidity-providing operations Serve to steer short-term interest rates Signal the monetary policy stance in the Euro area Rate= 0.00% Longer-term refinancing operations (LTRO)   Three-month liquidity-providing operations Provide longer-term refinancing to the financial sector LTRO with a three year maturity  Launched in December 2011 Targeted longer-term refinancing operations (TLTRO)    Launched in 2014 to provide long-term refinancing operations in euro with a four-year maturity.
The purpose was to support bank lending to the real economy The amount that banks can borrow is linked to their loans to non-financial corporations and households (targeted) Quantitative easing    Expands purchases to include bonds issued by euro area central governments, agencies and European institutions (adds to the private sector asset backed securities and covered bonds purchase program) Combined monthly asset purchases to amount to €60 billion Started in March 2015 and intended to be carried out until at least September 2016. It was extended until at least March 2017 and increased to €80 billion.
   On December 8 2016 it was extended to December 2017 and down to €60 billion starting April 2017.
Designed to fulfill price stability mandate of ECB and achieving inflation rates close to 2% over the medium term.
Only bonds with investment grade BBB- or better ************* Overall supply of money = Overall demand for money  H ; → Overall supply of money (  ) = money multiplier (  * high power money (H) UNDERSTANDING THE MONEY MULTIPLIER        People hold only deposits, c=0 multiplier=1/θ Let θ=0.1 multiplier = 1/0.1= 10 To simplify assume only two commercial banks, A and B The central bank buys €100 bonds in an open market operation The central bank creates €100 to pay the seller - Charles If no banks, the increase in money supply is €100 With banks, this is the beginning of the story **** Follow the power point → since the bank cannot be at 100% reserves because it will lose money, the bank will try to make credit w/ the 90% of Charles money, or will make a bond or something → bank keeps the 10% of the reserve ratio, an lends 90% of Charle's Money → So, since the bank lends money, in this economy we have the 1000 the Charles had olus the 90$ that the bank lends → ¡Creation of money! Then, since nobody uses money, "Anne" (the person that the money is lended to) goes to the bank to put money in her account, and this bank is going to keep the minimum amount of reserves and give a loan of the 90% of Anne's money. → ¡Creation of money! Charle's 100, Anne's 90, Jane's 81 → Jane will go to the bank to put that money into the bank, the bank will save 10% for the deposit and loan the 90% of the money.
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