Topic 8: Money Demand, Bonds, Interest Rate, Investment and Money Supply - Knowledge Summary and Exam Analysis

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University of Toronto Scarborough
Economics for Management Studies
Iris Au

Knowledge Summary: Topic 8: Part A – Money Demand, Bonds and Interest rate The Cost of Holding Money and the Demand for Money • The opportunity cost of holding money is the interest rate • When interest rate increases, cost of holding money increases => We would like to hold less money and more of other interest-bearing assets => Demand for money decreases (vice versa) • The demand for money (MD) depends on: 1) Income, Y o We hold money as a means to facilitate our daily purchases o Holding all else constant, when Y increases, our purchases of goods and services increases => demand for money increases o There is a positive relationship between Y and MD 2) Interest rate, r o Holding all else constant, when r increase, cost of holding money increases => demand for money decreases o There is a negative relationship between r and MD • In notation form: o MD = Demand for liquidity = L(r, Y) where L is the liquidity function for money The Relationship between Bond Price and Interest Rate • Assumptions: o There are only two assets in the economy: cash and bonds o Money does not give any returns to its holders o Bonds give a return to its holders but it is not as liquid as cash • Based on the assumptions, the choice of holding money is the choice of holding cash or bonds • A bond is a piece of paper with a face value, maturity date, and a promise to pay interest equal to the coupon rate • General formula for pricing bonds: o o The price of the bond = the present value of promised payments (including the payment of the face value of the bond at maturity ) • Relationships between interest rates and bond prices: o If the interest rate (yield) = coupon rate, then bond price = face value o If the interest rate (yield) < coupon rate, then bond price > face value o If the interest rate (yield) > coupon rate, then bond price < face value Note: • The coupon rate is the interest rate stated on the bond • The interest rate (yield) is the current rate of return of holding this bond until maturity. • Holding all else constant, there is an inverse relationship between bond prices and interest rates (yield) • The yield rate tends to go up as the maturity of the bond increases • The yield rate is higher if you invest in markets that are more risky Topic 8: Part B – Interest Rate, Investment, and Money Supply The Relationship between Interest Rate and Investment • When interest rate increases, then investment decreases (vice versa) • This is because as interest rate increases, it means that the cost of borrowing money also increases => investment becomes less attractive o Whenever the benefit > cost, then it is a good idea to undertake investment o Whenever the benefit < cost, then it is a bad idea to undertake investment • There is an inverse relationship between r and I The Relationship between Money supply, Interest Rate, and Investment • We know that demand for money = liquidity function = L(r, Y) • Supply for money = amount of money available (determined by central bank) • Together, the demand and supply for money forms the Money Market • Case 1: The Effect of an Increase in MS o When MS increases, there will be excess supply of money => people try to use “extra” money to buy interest-bearing assets, such as bonds o Demand for bonds increases => bond prices increase => interest rates decrease o r decreases => cost of
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