Summary EC 108 Financial Markets Review

Financial markets

The demand for money

● 2 types of money: currency and checkable deposits
○ Checkable deposits are bank deposits on which you can write cheques
● Bonds pay a positive interest rate but can’t be used for transactions
● Money can be used for transactions but pays no interest
● The holding of money and bonds depends on your level of transactions and
the interest rate on bonds
● Demand for money = nominal income x decreasing function of the interest
rate
○ 𝑀𝑑 = $𝑌𝐿(𝑖)
○ An increase in the interest rate decreases
the demand for money because the
opportunity cost of holding money
increases so people put their money into
bonds
○ An increase in nominal income shifts
demand for money to the right

The interest rate

● Equilibrium means that money supply = money demand (the LM relation)
● An increase in nominal income increases the interest rate
● An increase in money supply decreases the interest rate
● Central banks change the money supply by buying and selling bonds (open
market operations)
○ Expansionary - buying bonds and expanding the money supply
○ Contractionary - selling bonds and contracting the money supply
● The balance sheet includes assets and liabilities and must be in equilibrium
○ Assets of the central bank = bonds it holds
○ Liabilities of the central bank = stock of money in the economy
● The higher the price of the bond, the lower the interest rate (negative
relationship)
● The price of the bond = the future price / 1+i