Assumptions

Chapter 4. Financial Markets

I. Motivating Question

How Is the Interest Rate Determined in the Short Run?

The interest rate is determined by equilibrium in the money market, i.e., by the condition that money supply equals money demand. Since the text abstracts from all assets other than bonds and money, equilibrium in the money market is equivalent to equilibrium in the bond market. In this chapter, nominal income is taken as given, so there is no need to consider simultaneous equilibrium of goods and financial markets.

II. Why the Answer Matters

Investment is a function of the interest rate (as will be discussed in Chapter 5), so output is affected by the interest rate. In addition, the determination of the interest rate is intimately connected with monetary policy. This chapter takes nominal GDP, which affects money demand, as given, so the financial markets can be considered in isolation from the goods market. Chapter 5 will address the joint determination of output and the interest rate in the short run.

III. Key Tools, Concepts, and Assumptions

Tools and Concepts

i. The chapter defines stock and flow variables and distinguishes wealth (a stock) from income (a

flow).

ii. The chapter introduces monetary policy and describes open market operations.

iii. The chapter makes use of balance sheets for the central bank and private banks.

iv. The chapter introduces various terms and concepts associated with the banking system. These include currency, checkable deposits, reserves, the reserve ratio, central bank money (high powered money, the monetary base), the federal funds market and the federal funds rate, and the money multiplier.

Assumptions

i. This chapter assumes that nominal GDP is given. More precisely, the chapter maintains the fixed-price level assumption from Chapter 3 and adds the assumption that real income is given. Chapter 5 considers the joint determination of the interest rate and real income.

ii. For clarity, the chapter assumes that money and bonds are the only assets available and that money does not pay interest. Money is divided into currency and checkable deposits in the section of the chapter that describes the banking system. The assumption that money does not pay interest is maintained throughout the book. Later chapters introduce other financial assets—stocks and bonds of different maturities—and physical capital.

Date: 2015-02-16; view: 944