Assignment of Money & capital MarketSubmitted to: Mam. Syeda FizzaSubmitted by: Syed Ali Kamran L1f09mbam1165 UNIVERSITY OF CENTRAL PUNJAB LAHORE
Monetary Policy:The regulatory policy which is formulated to control the money supply prevailing in the market.A monetary policy can be “Contractsionary” limit money supply or it can be “Expansionary”increasing the money supply, depending upon the situations.Monetary Policy ToolsMonetary baseMonetary policy can be implemented by changing the size of the monetary base.This directly changes the total amount of money circulating in the economy. A central bank canuse open market operations to change the monetary base. The central bank wouldbuy/sell bonds in exchange for hard currency. When the central bank disburses/collects this hardcurrency payment, it alters the amount of currency in the economy, thus altering the monetarybase.Reserve requirementsThe monetary authority exerts regulatory control over banks. Monetary policy can beimplemented by changing the proportion of total assets that banks must hold in reserve with thecentral bank. Banks only maintain a small portion of their assets as cash available for immediatewithdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing theproportion of total assets to be held as liquid cash, the State Bank changes the availability ofloanable funds. This acts as a change in the money supply. Central banks typically do not changethe reserve requirements often because it creates very volatile changes in the money supply dueto the lending multiplier.Discount window lendingMany central banks or finance ministries have the authority to lend funds to financial institutionswithin their country. By calling in existing loans or extending new loans, the monetary authoritycan directly change the size of the money supply.Interest ratesThe contraction of the monetary supply can be achieved indirectly by increasing the nominalinterest rates. Monetary authorities in different nations have differing levels of control ofeconomy-wide interest rates. In the Pakistan, the State Bank can set the discount rate, as well asachieve the desired Federal funds rate by open market operations. This rate has significant effecton other market interest rates, but there is no perfect relationship. or both In the Pakistan openmarket operations are a relatively small part of the total volume in the bond market. One cannot
set independent targets to monetary base and the interest rate because they are both modified bya single tool — open market operations; one must choose which one to control.By raising the interest rate(s) under its control, a monetary authority can contract the moneysupply, because higher interest rates encourage savings and discourage borrowing. Both of theseeffects reduce the size of the money supply.Goals of Monetary Policy1) Price Stability Unanticipated inflation leads to lender losses. Nominal contracts attempt to account for inflation. Effort successful if monetary policy able to maintain steady rate of inflation.2) High Employment The movement of workers between jobs is referred to as frictional unemployment. All unemployment beyond frictional unemployment is classified as unintended unemployment. Reduction in this area is the target of macroeconomic policy.3) Economic Growth Economic growth is enhanced by investment in technological advances in production. Encouragement of savings supplies funds that can be drawn upon for investment.4) Interest Rate Stability Volatile interest and exchange rates generate costs to lenders and borrowers. Unexpected changes that cause damage, making policy formulation difficult.5) Financial Market Stability6) Foreign Exchange Market Stability
Money market:A security market where short term, more liquid and less riskier securities are traded is called themoney market.Goods market Equilibrium:We combine aggregate supply with the aggregate demand curve by drawing them both on thesame set of axis. AD= As Y=C+I--------------1 Y=C+S-------------2 C+I= C+S I=SMoney Market Equilibrium:When the money demand by consumers and firms equals the money supply with the State Bankhas allowed the banking system to make available. Md = MsWe consider Ms, as an exogenous factor not influenced from the external factors.Money demand has three motives: 1) Transactionary motive. (Md t) 2) Precautionary motive. (Md p) 3) Speculative motive. (Md s) i) Md t= f(y) Md t= K1(y) ii) Md p= f(y) Md p= K2(y)
iii) Md s = f(i) Md s = -mi Put Ms = M0 Md = Md t + Md p + Md s K1y+K2y-mi---------------------- 1 K1y+K2y-mi=Mo i= Ky-mo /mISLM Curve:A diagram used to determine what values of interest rate and total income together produceequilibrium in money market , “supply of money equals to money demanded” and equilibrium ingoods market is “planned expenditure equals to real GDP.The IS/LM model is a macroeconomic tool that demonstrates the relationship between interestrates and real output in the goods and services market and the money market. The intersection ofthe IS and LM curves is the "General Equilibrium" where there is simultaneous equilibrium in allthe markets of the economy. IS/LM stands for Investment Saving / Liquidity preference Moneysupply.
ThFormulationThe model is presented as a graph of two intersecting lines in the first quadrant.The horizontal axis represents national income or real gross domestic product and islabeled Y. The vertical axis represents the nominal interest rate, i.The point where these schedules intersect represents a short-run equilibrium in the real andmonetary sectors (though not necessarily in other sectors, such as labor markets): both productmarkets and money markets are in equilibrium. This equilibrium yields a unique combination ofinterest rates and real GDP. Asset Money Market
IS ScheduleThe IS schedule is drawn as a downward-sloping curve with interest rates as a functionof GDP (Y). The initials IS stand for "Investment and Saving equilibrium" but since 1937 havebeen used to represent the locus of all equilibriums where total spending (consumer spending +planned private investment + government purchases + net exports) equals an economys totaloutput (equivalent to real income, Y, or GDP). To keep the link with the historical meaning,the IS curve can represent the equilibriums where total private investment equals total saving,where the latter equals consumer saving plus government saving (the budgetsurplus) plus foreign saving (the trade surplus). Either way, in equilibrium, all spending isdesired or planned; there is no unplanned inventory accumulation (i.e., no general glut of goodsand services). The level of real GDP (Y) is determined along this line for each interest rate.Thus the IS schedule is a locus of points of equilibrium in the "real" (non-financial) economy.Given expectations about returns on fixed investment, every level of interest rate (i) will generatea certain level of planned fixed investment and other interest-sensitive spending: lower interestrates encourage higher fixed investment and the like. Income is at the equilibrium level for agiven interest rate when the saving that consumers choose to do, out of this income equalsinvestment (or, more generally, when "leakages" from the circular flow equal "injections"). Ahigher level of income is needed to generate a higher level of saving (or leakages) at a giveninterest rate. Alternatively, the multiplier effect of an increase in fixed investment raises realGDP. Both ways explain the downward slope of the IS schedule. In sum, this line represents theline of causation from falling interest rates to rising planned fixed investment (etc.) to risingnational income and output.LM ScheduleThe LM schedule (curve) shows the combinations of interest rates and levels of real income forwhich the money market is in equilibrium. It is an upward-sloping curve representing the role offinance and money. The initials LM stand for "Liquidity preference and Money supplyequilibrium". As such, the LM function is the equilibrium point between the liquiditypreference or Demand for Money function and the money supply function (as determinedby banks and central banks).The liquidity preference function is simply the willingness to hold cash balances insteadof securities. For this function, the interest rate (on the vertical axis) is plotted against thequantity of cash balances (or liquidity, on the horizontal). The liquidity preference function isdownward sloping. Two basic elements determine the quantity of cash balances demanded(liquidity preference) - and therefore the position and slope of the function:
1) Transactions demand for money: this includes both a) the willingness to hold cash for everyday transactions as well as b) as a precautionary measure - in case of emergencies. Transactions demand is positively related to real GDP (represented by Y, and also referred to as income). This is simply explained - as GDP increases, so does spending and therefore transactions. As GDP is considered exogenous to the liquidity preference function, changes in GDP shift the curve. For example, an increase in GDP will, ceteris paribus (all else equal), move the entire liquidity preference function rightward in response to the GDP increase. 2) Speculative demand for money: this is the willingness to hold cash as an asset for speculative purposes. Speculative demand is inversely related to the interest rate. As the interest rate rises, the opportunity cost of holding cash increases - the incentive will be to move into securities.The money supply function for this situation is plotted on the same graph as the liquiditypreference function. The money supply is determined by the central bank decisions andwillingness of commercial banks to loan money. Though the money supply is related indirectlyto interest rates in the very short run, the money supply in effect is perfectly inelastic withrespect to nominal interest rates (assuming the central bank chooses to control the money supplyrather than focusing directly on the interest rate). Thus the money supply function is representedas a vertical line - it is a constant, independent of the interest rate, GDP, and other factors.Mathematically, the LM curve is defined by the equation M / P = L(r,Y), where the supply ofmoney is represented as the real amount M/P (as opposed to the nominal amount M), with Prepresenting the price level, and L being the real demand for money, which is some function ofthe interest rate and the level Y of real income. The LM curve shows the combinations of interestrates and levels of real income for which money supply equals money demand -- that is, forwhich the money market is in equilibrium.For a given level of income, the intersection point between the liquidity preference and moneysupply functions implies a single point on the LM curve: specifically, the point giving the levelof the interest rate which equilibrates the money market at the given level of income. Recallingthat for the LM curve, the interest rate is plotted against real GDP (whereas the liquiditypreference and money supply functions plot interest rates against the quantity of cash balances),an increase in GDP shifts the liquidity preference function rightward and hence raises the interestrate. Thus the LM function is positively sloped.
ShiftsOne hypothesis is that a governments deficit spending ("fiscal policy") has an effect similar tothat of a lower saving rate or increased private fixed investment, increasing the amountof aggregate demand for national income at each individual interest rate. An increased deficit bythe national government shifts the IS curve to the right. This raises the equilibrium interest rate(from i1 to i2) and national income (from Y1 to Y2), as shown in the graph above.From the point of view of quantity theory of money, fiscal actions that leave the money supplyunchanged can only shift aggregate demand if they receive support from the monetary sector. Inthis case, the velocity or demand of money determines aggregate demand. If the velocity ofmoney remains unchanged at the initial level of output, so does aggregate demand. Essentially,the monetary sector is the source of any shift that occurs. From the monetarist perspective,money velocity is stable, but, from a Keynesian point of view, an increase in aggregate demandcan increase the velocity of money and lead to higher output.The graph indicates one of the major criticisms of deficit spending as a way to stimulate theeconomy: rising interest rates lead to crowding out – i.e., discouragement – of private fixedinvestment, which in turn may hurt long-term growth of the supply side (potential output).Keynesians respond that deficit spending may actually "crowd in" (encourage) private fixedinvestment via the accelerator effect, which helps long-term growth. Further, if governmentdeficits are spent on productive public investment (e.g., infrastructure or public health) thatdirectly and eventually raises potential output, although not necessarily as much as the lostprivate investment might have. Whether a stimulus crowds out or in depends on the shape of theLM curve. A shift in the IS curve along a relatively flat LM curve can increase outputsubstantially with little change in the interest rate. On the other hand, an upward shift in the IS
curve along a vertical LM curve will lead to higher interest rates, but no change in output (Thiscase represents the Treasury View).The IS/LM model also allows for the role of monetary policy. If the money supply is increased,that shifts the LM curve to the right, lowering interest rates and raising equilibrium nationalincome.Usually the model is used to study the short run when prices are fixed or sticky andno inflation is taken into consideration. To include these and other crucial issues, several furtherdiagrams are needed or the equations behind the curves need to be modified.Relationship of Money market and ISLM Curve:Three important facts of quantity of money demanded are: 1) Money demanded has a time trend, the result of slow changes in banking sector structure and technology. 2) Money demanded is proportional to total income, which by the circular flow principal is the same as total spending and the same as GDP. 3) Money demanded is inversely related to the nominal interest rates go up, demand for money goes down.Liquidity TrapThe term liquidity trap is used in Keynesian economics to refer to a situation where the demandfor money becomes infinitely elastic, i.e. where the demand curve is horizontal, so that furtherinjections of money into the economy will not serve to further lower interest rates. Under thenarrow version of Keynesian theory in which this arises, it is specified that monetarypolicy affects the economy only through its effect on interest rates. Therefore, if the economyenters a liquidity trap area—and further increases in the money stock will fail to further lowerinterest rates—monetary policy will be unable to stimulate the economy.However, the concept came back to prominence in misconception in the 1990s when theJapanese economy fell into a period of prolong destagflation despite the presence of near-zerointerest rates. While the liquidity trap as formulated by Keynes refers to the existence of anhorizontal demand curve for money at some positive level of interest rates, the liquidity trapinvoked in the 1990s referred merely to the presence of zero interest rates (ZIRP), the assertionbeing that since interest rates could not fall below zero, monetary policy would prove to beimpotent in those conditions, just as it was asserted to be in a proper exposition of a liquiditytrap.
While this 1990s invocation of the term "liquidity trap" was not in conformity with that assertedby Keynes, both treatments have in common first the assertion that monetary policy affects theeconomy only via interest rates and second the subsequent conclusion that monetary policy isimpotent with respect to being able to stimulate the economy under those conditions.Much the same furor has emerged in the Pakistan and Europe in 2008–2009, as short-term policyrates for the various central banks have moved close to zero.Note that the neoclassical economists assertion was the fact that even under an occurrence of aliquidity trap; expansive monetary policy could still stimulate the economy via the direct effectsof increased money stocks on aggregate demand. This was essentially the hope of both the Bankof Japan in the 1990s, when it embarked upon quantitative easing and of the central banks of thePakistan and Europe in 2008–2009, with their foray into quantitative easing. All these policyinitiatives are attempts to stimulate the economy through methods other than the mere reductionof short-term interest rates.