SESSION 8b

Reading
1. This set of slides
2. From the text material
Chapter - 5

The IS-LM frame work:

Linking Goods Market
&
Financial Market

So far..

Real output determined by level of existing

demand

Monetary factors (money supply, interest rates, etc.)

played no role in output determination

Introducing

Role of monetary variables in real economy

The asset or financial market

Link between the real economy and the asset market

Financial market

Goods market

Aggregate demand
and supply of all
final goods and
services

The link :
Interest
rate

Demand and supply of

financial assets like
money, bonds etc.

Changes in interest rates range India (%)

Items

19701

19801

19901

19989

2003

Bank rate

5-6

10

Call money rate

(Mumbai average)

6.38

7.12

11.49

7.83

4.5

Commercial Banks
deposit rate (1-3 years
range)

6
6.5

7.5
8.5

9 - 10

9 - 11

3- 8

Commercial Banks
lending rate range

7
8.5

16.5

16.5

12.14

5
17.5

Treasury Bill rate

8.75

4.75

Central Government
securities (avg 5 yrs)
yield

7.03

11.41

11.86

4.79

 Bank rate
= rate at which the Central Bank lends to commercial banks
Call rate
= rate at which commercial banks lend to other commercial
banks
Real interest rate
= nominal interest rate inflation rate

Yield = the return an investor will receive by holding a

bond to maturity

Outline Financial market

Demand for money, bonds
The money market: interaction between interest rate and
output
Instruments of monetary policy
Goods market:
Investments and interest rates
Real economy: interaction between interest rates and
output
General equilibrium in a closed economy
Effects of monetary policy
Effects of fiscal policy

THE FINANCIAL MARKET

Financial asset
1.
2.

Interest yielding asset:

Bond
Non-interest yielding asset:
Money

Bonds

It is a promise made by the borrower to pay the lender a

stream of returns over a specified period in exchange for
payments now.
Traded also in secondary market.
If price of bonds fall, holder suffers capital loss.
Price fluctuation is caused by interest rate fluctuation.
The
bond

Rs.B

Lende
r

Borrowe
r

Rs.R1 in 1st
yr +
Rs.
R2 in
2nd yr +
Rs. R3 in 3rd

Price of the bond (PB)

= Present value of the income stream from the bond (PVB)
Because
If PB > PVB then no buyer will buy the bond
If PB < PVB then no seller will sell the bond.
PVB = [R1/ (1+r)]

[R2/ (1+r)2]

+ [(R3 + B) / (1+r)3]

Where r = current market interest rate

Given the stream of return,
if current market interest r falls, PV of the income
stream rises.
this bond becomes more attractive relative to other
assets
demand for the bond rises
bond price rises

Risk associated with bonds:

Two kinds of risk associated with bonds.
1.

Default risk:
The possibility that the borrower may fail to repay on
maturity

2.

Risk of capital loss:

The possibility of fall in the market price after purchase of
the bond

To keep the analysis simple we assume that bond

purchasers do not consider these risks before
buying the bond.