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Understanding Equilibrium Interest Rates

This document summarizes key concepts related to financial markets and monetary policy. It discusses how central banks use monetary policy tools like open market operations to influence interest rates and achieve equilibrium in money markets. The goal is to determine the equilibrium interest rate in both the short run and long run. Financial assets are divided into money and bonds, with money fulfilling transaction needs and bonds providing investment returns through interest rates. Monetary policy works by adjusting the money supply, which shifts the money demand curve and changes the equilibrium interest rate in the money market.

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94 views9 pages

Understanding Equilibrium Interest Rates

This document summarizes key concepts related to financial markets and monetary policy. It discusses how central banks use monetary policy tools like open market operations to influence interest rates and achieve equilibrium in money markets. The goal is to determine the equilibrium interest rate in both the short run and long run. Financial assets are divided into money and bonds, with money fulfilling transaction needs and bonds providing investment returns through interest rates. Monetary policy works by adjusting the money supply, which shifts the money demand curve and changes the equilibrium interest rate in the money market.

Uploaded by

satyabasha
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Lecture4:FinancialMarkets

Goal:Determineequilibriuminterestrate
Shortrun
Maincyclicalinstrument(CentralBank)
Monetarypolicy(asopposedtofiscal
policy)-- bothare(primarily)aggregate
demandpolicies
FinancialAssets
Money,bonds,stocks,mutualfunds,
derivatives
Reducetotwo:
Money:transaction(liquidity)role.
Bond:investment-- paysaninterestrate:i
Keyquestion:Howmuchofeach?
Tradeoff:transactionservicesvsreturn.
MoneyDemand
Fix(nominal)wealthat:PWealth
M + B =
d
d
PWealth
=> determineonlyoneofthem
M =PYL(i)
d
MoneyDemandDiagram
i
PY > PY
M
d

M
d
M
HighU.S.nominalinterestratesduring late70s-
early80s=>sharpdeclinein M/PY
EquilibriumInterestrate
Simplemodel:
Moneysupplyisconstant(i.e.itdoesntdepend
on interestrateorPorY)
Equilibrium:
M = PYL(i)
Ourinterestistodeterminetheinterestrate,
sowefixPandY.
Equilibrium
i
M
s
M
d
M
d
M
Money
MonetaryPolicy
i
M
s
M
d
M
s
M
Money
OpenMarketOperation
CentralBankbuysbondsintheopenmarket
Asaresult,priceofbondsrises
=> interestratefalls
i =
B
P
B
$100- P
EquilibriuminMratherthan
CentralBankM
M
s
= H
c+(1-c)
M
s
=M
d
=>
H 1 = PYL(i)
c+(1-c)
Examples:a)Y2k;b)Prudence;c)OMOwithmultiplier

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