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ECON 209 (28)
Chapter 28

Economics Chapter 28 Summary.docx

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Economics (Arts)
ECON 209
Mayssun El- Attar Vilalta

Economics Chapter 28 Summary: Money, Interest Rates and Economic Activity 28.1 Understanding Bonds - Bonds: financial wealth including interest earning financial assets and claims on real capital (equity) Present Value and the Interest Rate - Bond: financial asset promising to make one or more specified payments at specified dates in the future - Present value: value now of one or more payments or receipts made in the future; AKA discounted present value—depends on interest rate A single Payment One Year Hence - You subtract the interest rate from the value that is meant to be loaned in order to get back the exact value of the loan a year (etc.) later - Present value x (interest rate) = what you want to get back - What you want to get back/ interest rate= how much you should loan out today (present value) - PV = R1/ (1+i) – where R1 is amount we receive a year from now and “i” is annual interest rate - Higher interest rate = lower present value R1 is A Sequence of Future Payments - If the bank promises to pay back in “coupon” payments meaning they pay you back over a term 2 T of several years then the formula is PV= R1/ (1+i) + R2/(1+i) +…+ RT/ (1+i) A General Relationship - Treasury Bills: making no coupon payments and only a single payment (the “face value”) at some point in the future - b/c bonds make payments in the future, their present value is negatively related to market’s interest rate Present Value and Market Price - The present value of a bond is the most someone would be willing to pay now to own the bonds future stream of payments - Any price above the present value would be pointless to buy since they’ll be losing money— demand for bonds fall - Any price below present value would lead to increased profit thus increasing demand for bonds - The equilibrium market price of any bond will be the present value of the income stream that it produces Interest Rates, Market Prices, and Bond Yields - An increase in market price leads to fall in price of bond. A decrease in market interest rate leads to an increase in the price of bonds - Lower bond price= higher bond yield - Bond yield: a function of the sequence of payments and the bond price market interest rates and bond yields move in the same direction - An increase in market interest rate will reduce bond prices and increase bond yields. A reduction in market interest rate will increase bond prices and reduce bond yields Bond Riskiness - An increase in riskiness of any bond leads to decline in its expected present value and thus a decline in bond’s price. Lower bond price = high bond yield= high risk investment 28.2 The Demand for Money - Demand for money: amount of money that everyone in the economy wants to hold - Includes the demand for bonds Three Reasons for Holding Money 1. To carry out transactions: readily available for upcoming transactions b/c it’s costly and time consuming to have to sell bonds 2. As a precaution to avoid problems associated w/ missing a transaction aka precautionary demand for money—for emergencies or unplanned expense 3. Speculative demand for money: when bond prices fall, bondholders experience decline in value of their bond holdings. The expectation of increases in future interest rates will therefore lead to the holding of more money (and fewer bonds) now as financial managers adjust portfolios to preserve values Understanding Bond Prices and Bond Yields - Issuer: borrower of money; usually the gov’t of Canada - Coupon: the coupon rate—annual rate of interest that bond pays as it matures - Maturity: when the bond matures and face value is repaid to bondholder. All debt obligations are then fulfilled - Price: market price of the bond; present value x interest rate - Yield: rate of return earned by bond holder if bond is bought at the current price and held to maturity earning all regular coupon payments Bond Prices and Yields - Positive relationship between bond price and coupon rate - Positive relationship between bond yield and term to maturity: higher yield on long term bonds reflect term premium meaning higher yield is needed as incentive for all the money tied up w/ bondholder - Positive relationship between bond yield and perceived riskiness of bond issuer: riskier bonds need higher bond yields to incentivize bondholders The Determinants of Money Demand 1.) The Interest Rate - Cost of holding money is the income that could have been earned if wealth were instead held in form of interest earning bonds—opportunity cost of holding money - Demand for money is negatively related w/ interest rate - Decision to hold money is decision NOT to hold bonds 2.) Real GDP - Amount of transactions firms and households make is positively related to level of income and production in economy aka real GDP - Positive relationship between real GDP and desired money holdings - An increase in real GDP increases volume of transactions in the economy and is assumed to cause an increase in desired money holding 3.) The Price Level - An increase in price level is assumed to cause an increase in desired money holdings as they need more money to carry out the same transactions - If real GDP & interest rate are constant, the demand for money is proportional to the price level Money Demand: Summing Up - Liquidity preference function AKA M or mDney demand function = MD (i (-), Y (+) , P (+)) - Says that the amount of money firms and households want to hold is dependent on interest rate, real GDP and price level w/ the pos. and neg. signs dictating pos. or neg. relation - Since whatever is not money demand becomes bond demand, this eq’n is the opposite for bonds - The lower the interest rate = lower opportunity cost for holding money so people choose to hold more; but lower interest rate means bonds are less attractive so people hold fewer bonds 28.3 Monetary Equilibrium and National Income Monetary Equilibrium - Vertical money supply curve indicates it is assumed to be independent of the interest rate - MS increases (shifts right) if central bank increases reserves in the banking system or if commercial banks decide to lend
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