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Chapter 28

# ECON 295 Chapter 28: Chapter 28 notes.docx

Department
Economics
Course Code
ECON 295
Professor
Kenneth Ragan
Chapter
28

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Chapter 28
Money, Interest Rates, and Economic activity
I) Understanding Bonds
Economists often simplify the analysis of financial assets by considering only two types of
assets—non-interest-bearing “money” and interest-bearing “bonds”.
A) Present Value and the Interest Rate
A bond is a financial asset that promises to make one or more specified payments at specified
dates in the future.
Present value (
PV
): The value now of one or more payments or receipts made in the
future.
PV =R1
1+i++RT
(1+i)T
RT
being a payment in the future (coupon or face value).
A GENERAL RELATIONSHIP
There are many types of bonds. Some make no coupon payments and only a single payment
(the “face value”) at some point in the future.
Example: Treasury bills.
Other bonds make regular coupon payments as well as a final payment of the bond’s face
value.
Example: Long-term government or corporate bonds.
The present value of any bond that promises a future payment or sequence of future
payments is negatively related to the market interest rate.
B) Present Value and Market Price
The present value of a bond is the most someone would be willing to pay now to own the
bond’s future stream of payments.
At any price below the bond’s present value, excess demand will cause the price to rise.
At any price above the bond’s present value, excess supply will cause the price to fall.
The equilibrium market price of any bond will be the present value of the income stream
that it produces.

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C)Interest Rates, Market Prices, and Bond Yields
1. The present value of a bond is negatively related to the market interest rate.
2. A bond’s equilibrium market price will be equal to its present value.
An increase in the market interest rate leads to a fall in the price of any given bond.
A decrease in the market interest rate leads to an increase in the price of any given
bond.
The bond yield is a function of the sequence of future payments and the bond price.
The market interest rate is the rate at which you can borrow or lend money in the credit market.
An increase in the market interest rate will reduce bond prices and increase bond yields.
A reduction in the market interest rate will increase bond prices and reduce bond yields.
Therefore, market interest rates and bond yields tend to move together.
D)Bond Riskiness
An increase in the riskiness of any bond leads to a decline in its expected present value
and thus to a decline in the bond’s price.
The lower bond price implies a higher bond yield.

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II) The Demand for Money
Demand for money: The total amount of money balances that the public wants to hold for all
purposes.
In other words, we want to know how households and firs want to divide their financial assets
between money and bonds.
A) Three Reasons for Holding Money
1. Household and firms hold money in order to carry out transactions  transactions
demand for money
2. Uncertainty about when some expenditures will be necessary  precautionary demand
for money
3. Speculative demand
B) The Determinants of Money Demand
a) The Interest Rate
The cost of holding money is the income that could have been earned if that wealth were
instead held in the form of interest-earning bonds.
This is the opportunity cost of holding money.
Other things being equal. The demand for money is assumed to be negatively related to
the interest rate.
Changes in interest rates lead to movements along the
MD
curve.
Changes in real GDP and the price level cause the
MD
curve to shift.
b) Real GDP
An increase in real GDP increases the volume of transactions in the economy and is
assumed to cause an increase in desired money holdings.
Increase in real GDP  rightward shift of
MD
c) The Price Level
An increase in the price level is assumed to cause an increase in desired money
holdings.
Increase in price level  rightward shift of
MD
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