51 econ 350 us financial systems markets and

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Econ 350 U.S. Financial Systems, Markets and Institutions Class 6 In summary, the Fisher effect can be illustrated as follows: Figure 6-9 The Fisher Effect: diagram decrease in decrease in demand for bonds supply of loanable funds increase in increase expected inflation in i increase in increase in supply of bonds demand for loanable funds We can also show the Fisher Effect graphically. Figure 6-10 The Fisher Effect: graphs Bond Market Loanable Funds Market P i LF s 100 B s LF s B d B s 400 50 300 B d LF d LF d B* B LF* LF Here, we assume that the changes in supply and demand offset each other, so that the quantity of bonds and loanable funds remain the same. Without this assumption, the effects on quantity would be indeterminate. The effect on price and interest rates is clear. An increase in expected inflation leads to a decline in the price of bonds and an increase in nominal interest rates. To check your familiarity with the loanable funds model, test yourself by determining the effects of the following events: a. an increase in the government deficit b. a government surplus (an increase in saving). c. a decline in investor confidence due to the corporate accounting scandals. d. an increase in the expected profitability of investment opportunities due to the War on Iraq. e. the 2008 financial crisis 52
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Econ 350 U.S. Financial Systems, Markets and Institutions Class 6 The Keynesian Liquidity Preference Model While we will discuss the ideas of money demand and money supply in more detail in the section on monetary policy, it makes sense to introduce the model now when discussing the determination of interest rates. Money supply For now we assume that the supply of money is fixed by the central bank and is independent of interest rates. The money supply curve is vertical. Money demand Keynes believed that the demand for money depended on three factors. Households hold money due to the transactions motive (for planned purchases), the precautionary motive (for unplanned purchases), and the speculative motive (for investment purposes). The first two depend on the price level and real income, while the latter depends on interest rates. We focus on the speculative demand for money. Assume that households can hold a fixed amount of financial wealth (F) in either money (M) or bonds (B). Money earns no interest but provides liquidity. Bonds represent all those assets that do pay interest but provide less liquidity compared to money. The tradeoff here is between interest income and liquidity. Given our assumptions, then F = M + B and ∆F = ∆M + ∆B where ∆ = change in Households hold a fixed amount of wealth in money and bonds. Any change in financial wealth must come from either a change in money holdings or a change in bond holdings. If F is fixed, then what is ∆F equal to? …………….. ∆F = 0! If ∆F = 0, then 0 = ∆M + ∆B and ∆M = -∆B In order to increase their money holdings, households must decrease their bond holdings.
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