Supply and Demand Models of Financial Markets

Chapter 21, 26, 29 30

Three Markets

• Loanable Funds Market– Determines Interest Rate in Capital Markets

• Liquidity Market– Determines Money Market Rate

• Forex Market– Determines Foreign Exchange Rate

Money Markets

Interest Rates

• What are some major interest rates in financial markets? Be as specific as possible.

Bond Yields and Interest Rate

• Bank accounts typically have very simple interest rates.

Balancet+1 = (1+i) ∙ Depositt

• Short-term bills have equivalent rates called yields.

Face Valuet+1 = (1+i) ∙ Pricet

• Simple loans could also be written

Repaymentt+1 = (1+i) ∙ Principalt

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.

Money Market: GDP Rises

iMoney Demand

i*

Money Supply

M

Money Demand’

i**

1

2

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

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

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?

Monetary Policy: Money Supply Shrinks

iMoney Demand

i*

Money Supply

M

Money

Supply’

i**

1

2

Japan and the Liquidity Trap

• BBC Story Download • During the 1990’s and this decade Bank of

Japan reduced their interest rate ultimately implementing ZIRP – Zero Interest Rate Policy

• Interest rate cannot be set at a rate below zero because of the existence of an alternative financial instrument that always pays better than negative rates.

Money Market at ZIRP

Money Demand

Money Supply

0

11

22 33

i

i**

i*

M

ZIRP: Japan

Jul-1985 Jul-1988 Jul-1991 Jul-1994 Jul-1997 Jul-2000 Jul-2003 Jul-2006

10

9

8

7

6

5

4

3

2

1

0

JP: Call Rate: Uncollaterized: Overnight% pa

Loanable Funds Market

Nominal and Real Interest Rates

• Nominal return represents how much money you will receive after 1 year for giving up 1 dollar of money today

• Real return represents how many goods you can buy if you give up the opportunity to buy 1 good today.

• Nominal interest rate is money interest rate. Real interest rate is goods interest rate.

• Imagine a 1 year loan [T =1]: The lender gives up some goods to make a loan and will buy goods in the future with the repayment.

• If the price of goods at time t is Pt, the foregone

current goods are

• The goods value of the future repayment is

t

t

PrincipalP

1 t+1t

t

Repaymenti

Principal

t+1

t+1

Repayment

P

Real Interest Rate

• The real interest rate on the loan is defined as the future goods received relative to current goods foregone

11

1

11

1

t+1 t+1

t+1 tt

t t+1

t t

tt t t t

t

Repayment RepaymentP Principal

rPrincipal P

P P

ir r i

Measuring the Real Interest Rate

• Two alternatives

1. Use nominal interest minus consensus inflation forecast

2. Use the yield on inflation protected securities.

TIPS Bond

• The US Treasury offers bonds whose principal and coupon payments increase with the inflation rate.

• Investors are paid off in terms of real purchasing power.

• Yield is equivalent to a real interest rate.

Additional Information from U.S. Treasury

Real & Nominal Interest Rates

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

Yield

2003 2004 2005 2006

TIPS 5 year Treasury

π5 Year Forecast

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)

SI

LF

r*

LF*

r

Example: Investment Boom in Japan as economy recovers

S

I

LF

r*

LF*

r

r**

I´

LF**

1

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**

1

Example: US Consumers become thriftier

S

I

LF

r*

LF*

r

Example: US Consumers become thriftier

S

I

LF

r*

LF*

r

LF**

S’

r**

1

Global Economy

• Additional Source of Savings

Loanable Funds Supply = S+KA =

National 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

Competitive Market Equilibrium:Loanable Funds Market

(Global Economy)

SI

LF

r*

LF*

r

S+KA

KA

Questions

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

• What happens to a a globalized economy when there is an increase in overseas rates (or an increase in the rate premium).

Government Deficits(Globalized Economy)

[r Doesn’t Rise by as Much, I doesn’t fall as much]

SI

LF

r*

LF*

r

S+KAr**

LF**

1

2

S’

S’+KA

Investment Boom(Globalized Economy)

[r Doesn’t Rise by as Much, I Rises by More]

SI

LF

r*

LF*

r

S+KA

I’r**

LF**

1

2

Foreign Interest Rate Rises(Global Economy)

I

LF

r*

LF*

r

S+KA1

2

S+KA’

r**

Savings Glut

• Theory put forth by Fed Chairman explaining the U.S. trade deficit.

• Washington Post Article Download

Recent TIPS Bond

Capital Account

• Model can be used to derive equilibrium real interest rates and national saving and investment as well as capital inflows (designated KA).

• Trade balance is opposite of the capital account.

• Trade balances are temporary.

Net Capital Outflows = ‘Goods & Income Outflows

• Private Savings = Y + NFI -Tax – C

• Public Savings = Tax – G

• S = Y+ NFI – C – G

• -KA = S – I = NFI + (Y – C – G – I)

• -KA = NFI + NX = CA

US Current Account

-7.00%

-6.00%

-5.00%

-4.00%

-3.00%

-2.00%

-1.00%

0.00%

1.00%

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

NX NFI CA

Ex Ante Rate and the Fisher Effect• Savings and investment decisions must be

made before future inflation is known so they must be made on the basis of an ex ante (predicted) real interest rate.

• Fisher Hypothesis: Ex ante real interest rate is determined by forces in the financial market. Money interest rate is just the real ex ante rate plus the market’s consensus forecast of inflation.

1EA FORECAST

t t ti r

Great Inflation of the 1970’sUS Inflation Rates & Interest Rates

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00M

ar-5

5

Mar

-58

Mar

-61

Mar

-64

Mar

-67

Mar

-70

Mar

-73

Mar

-76

Mar

-79

Mar

-82

Mar

-85

Mar

-88

Mar

-91

Mar

-94

Mar

-97

Mar

-00

Mar

-03

%

Interest Rates

Inflation

Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/

Exchange Rate Model

Exchange Rates are Volatile

Yen-Dollar Rate

80.00100.00120.00140.00160.00180.00200.00220.00240.00260.00280.00

Jan-

84

Jan-

86

Jan-

88

Jan-

90

Jan-

92

Jan-

94

Jan-

96

Jan-

98

Jan-

00

Jan-

02

Jan-

04

Jan-

06

Yen

per

Do

llar

Why do exchange rates change?

• Relative values of two currency determined by supply and demand by traders of the two currencies.

• People trade currencies to engage in foreign trade and international investment.

• Monetary policy is a prime driver of exchange rates.– And vice versa, Some economies structure

monetary policy around exchange rate.

Forex Market: Supply & Demand

Consider the spot foreign exchange market. • Price of US$: S is the price of US$ in terms of DCU.• Supply of US$: Foreign people who want to acquire

DCU to buy domestic goods or assets.– When US$ becomes expensive, domestic goods

or assets get cheap and foreign investors are attracted to domestic currency.

• Demand for US$: Domestic people who want to acquire US$ for foreign purchases or overseas investment.– When US$ get cheap, US$ goods or assets get

cheap and demand for US$ rises

Equilibrium in Forex MarketSupply Equals Demand

S

Demand

Supply

S*

Increase in Desired Capital Outflows by Domestic Investors/

Desired Purchases of Foreign GoodsS

Supply Demand

S*

Demand '

1

S** 2 Domestic Currency Depreciates

Increase in Desired Capital Inflows by Foreign Investors/

Desired Purchases of Domestic GoodsS Supply

Demand

S*

Supply'

1

S** 2

Domestic Currency Appreciates

US Monetary Policy Causes US$ Interest Rates Go Up

Relative Demand for US$ Goes UpS

Supply Demand

S*

Supply'

Demand '

1

S**2

Domestic Currency Depreciates

Domestic Monetary Policy CausesD.C. Interest Rates Go Up

Relative Demand for US$ Goes DownS Supply

Demand

S*

Supply'

Demand '

1

S**

2

Domestic Currency Appreciates

Monetary Policy & Exchange Rates

• The central impact of the foreign currency intervention is on domestic interest rates.

• Monetary policy that shifts domestic interest rates will also shift exchange rates regardless of whether it occurs through currency intervention, OMO, or some other change in quantity of bank reserves.

• Monetary policy that does not shift interest rates will not shift exchange rates.

Foreign Currency Intervention• Foreign currency purchase:

– Central bank purchases foreign currency– Credit reserve accounts of counterparty commercial bank– More reserves pushes down interest rates

• Increases demand for and reduces supply of US$ in forex market

• Foreign currency sale– Central bank sells foreign currency– Debit reserve accounts of purchasing bank– Less reserves pushes up interest rates– Reduces demand for and increases supply of US$ in

forex market

S

Supply

Demand

S*

Demand '

A

1. Domestic Currency Faces Depreciation Pressure

Excess Demand for Foreign Currency

SSupply

Demand

S*

Demand '

A

B

1. Central Bank does Forex Sale maintaining Exchange Rate Stability

2. Shrinking money supply and higher domestic interest rates

Forex Sale

Supply'

S

Supply Demand

S*

A

1. Domestic Currency Faces Appreciation

Excess Supply of Foreign Currency

S

SupplyDemand

S*

A

Forex Purchase

B

Supply'

Demand '

1. Central Bank does Forex Purchase maintaining Exchange Rate Stability

2. Growing money supply and lower domestic interest rates

Iron Triangle of International Finance

Open to International Capital Flows

Monetary Policy that Controls The Interest Rate

Fixed Exchange Rates

Pick 2 items from this menu

Uncovered Interest Parity

• Bloomberg News Download

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;

Learning Outcomes Pt. 2

• Use the Supply-Demand model of the forex model to explain:– the effect of international trade conditions on

the exchange rate.– the impact of interest rates and other financial

market conditions on exchange rates.– Government policy efforts to stabilize the

exchange rate.

Discussion Question

• In the past 3 years, the US dollar has been weak against a number of currencies including the British pound, Euro, Australian dollar, etc.

– Discuss what types of firms in a country might benefit from a strong currency and what types will benefit from a weak country. What aspects of a firm's balance sheets and income statements can you imagine might be affected?

– Use the exchange rate model/money market model to help understand what would happen to the domestic economy if the government decided to weaken the currency. Which types of firms might benefit and which would lose.