Supply and Demand Models of Financial Markets

Two Markets

• Loanable Funds Market– Determines Interest Rate in Capital Markets

• Liquidity Market– Determines Money Market Rate

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)

S

D

LF

r*

LF*

r

Example: Investment Boom in Japan as economy recovers

S

I

LF

r*

LF*

r

r**

I´

LF**

Savings

• We divide savings into 2 parts:

SGovernment Public Saving/Government Saving

(Budget Surplus)

+ SPrivate Private Saving

(Household + Business Saving)

= S National Saving

Example: US Government runs a deficit to finance military spending

S

I

LF

r*

LF*

r

r**

S´

LF**

Example: US Consumers become thriftier

S

I

LF

r*

LF*

r

Global Economy

• Additional Source of Savings

Loanable Funds Supply = Public Savings +

Net Capital Inflow from Abroad

• Two Effects1. Supply Curve Becomes More Elastic

More globalized, more elastic

2. Global Financial Markets also a source of shifts in Supply Curve

Questions

• Compare Investment Boom in a very globalized economy with one in a less globalized economy. What happens to investment & interest rates?

Money Markets

Liquid Assets

Two kinds of assets1. Liquid Assets (Currency, Checking

Accounts, Savings Accounts) that are useful for transactions which pay zero or below market interest rates.

2. Money market assets (Government bills, commercial paper, jumbo CD’s) that pay a market rate, i, but which cannot be used for transactions

Liquidity Demand

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.

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.

Money Market

i

Money Demand

i*

Money Supply

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.

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?

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?)

Fed Federal Funds Rate

BoJ Uncollateralized Call Money Rate

ECB Main Refinancing Rate

BoK Overnight Call Rate

UK Official Bank Rate

Target Rates Affect Money Market Rates

Money Market Rates USA

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Sep

-97

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-99

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

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?

Money Market at ZIRP

Money Demand

Money Supply

0

11

22 33

i

i**

i*

M

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 of money markets to examine the effect of changes in the economy on money market rates and;

• Characterize the effects of changes in monetary policy