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Chapter 28

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ECON 110
Ian James Cromb

Chapter 28 – Money, Interest Rates, and Economic Activity 28.1 – Understanding Bonds  People hold their money in interest-earning assets (bond) and non-interest earning assets (money-mediums of exchange) -> simplification concept Present Value and the Interest Rate  Present Value (PV): value now of one or more payments or receipts made in the future; referred to as discounted present value o Depends on the interest rate  PV = R 1amount received one year from now) / 1 + i (interest) o Accounts for one year at stable interest rate  PV = R / (1 + i) T o Where T = number of years, accounts for compounded interest over multiple years  Treasury Bills: only one payment at some point in future  Present value of bond that promises a future payment or sequence of future payments is negatively related to the market interest rate (when i goes us, PV goes down) Present Value and Market Price  PV of bond is the most someone would be willing to pay now to own the bond’s future payments  At any price above PV lack of demand drops price  Any price below PV, excess demand raises price Interest Rates, Market Prices, and Bond Yields  PV of bond is negative related to market interest rate  Bond’s equilibrium market price = PV o Increase in interest rate leads to fall in price, decrease in interest rate leads to increase in price  Bond Yield is a function of sequence of payments and bond price  Increase in market interest rate will reduce bond prices and increase bond yields Bond Riskiness  Increase in riskiness of a bond leads to a decline in its expected PV and thus decline in bond’s price, which implies a higher bond yield  Premium when bond is above $100, discount when under  Yield curve/term structure of interest rates: relationship between time held and interest rate, higher yields on long-term bonds called term premium 28.2 – The Demand for Money  Demand for Money total amount of money balances the public wishes to hold for all purposes Reasons for Holding Money  Transactions Demand: having money readily available to perform transactions, make purchases, pay expenses  Precautionary Demand: to account for any uncertain upcoming expenditures, has decreased with technology  Speculative Demand: expectation of increases in future interest rates lead to holding of more money now to preserve value The Determinants of Money Demand  The opportunity cost of holding money is the income that could have been earned if money were held in a bond  The demand for money is assumed to be negatively related to the interest rate 1  Movement from i t1 i 0lowered interest) increases money held, decreases bonds  The M Durve shifts to the right to D ’ as a result of an increase in Y or P o Y: as GDP rises, more transactions will occur, so more money needs to be held o P: the value of transactions increases (though volume remains stable) and more money will need to be held for each transaction  When real GDP and i are constant, the demand for money is proportional to the price level Money Demand: Summing Up  Liquidity Preference function is the money demand function as: MD= M DL-, Y+, P+) o Amount of money households want to hold is dependent on three variables, affecting positively or negatively  Assumptions… 1. Increased interest rate increases the opportunity cost of holding money, leading to reduction in quantity of money demanded 2. Increase in real GDP increases volume of transactions 3. Increase in price level increases dollar value of given volume of transactions 28.3 – Monetary Equilibrium and National Income  Examining the short-run model, with the addition of money and interest rates 2  M , the money supply, is vertical, indicating assumed independence of interest rate. Increases (shifts to right) when central S bank increases reserves, or decides to lend out a larger fraction of those reserves  M , the money demand, is downward sloping because firms hold more money when interest falls D  Monetary Equilibrium: when M = MD S  Everyone tries to add to their money balances, selling bonds, which creates an excess supply of bonds, signifying an excess demand for money (M ), 1i )1 The excess supply of bonds causes a fall in market price, so an increase in interest rates. Bonds become more attractive again and people stop selling them off. Moves to E.  At (2 ), bonds are very attractive, so people feel they have an excess supply of money and whish to purchase more bonds, This bids up the price of bonds, and interest rates fall, making bonds less attractive again. Moves to E.  Liquidity preference theory of interest: demand to hold money over bonds is a demand for the more liquid asset The Monetary Transmission Mechanism  Monetary Transmission Mechanism: channels by which a change in the demand for or supply of money leads to a shift of the aggregate demand curve  Increase in supply of money (increased reserves of central bank/increase portions) create an excess supply at the original interest rate. The excess supply leads firms to buy bonds, driving up the price and pushing down interest  Increase in demand for money creates excess demand at original interest rate. Firms try to sell of bonds, increasing supply and pushing down price, which increases interest rates. Increase in demand may be result of increased GDP, price, or riskiness (preference to hold money) 3  I = investment demand  A decrease in interest rate leads to an increase in desired investment  Consumption expenditure (especially when credit is used on big-ticket items) is negatively related to interest rate  Increases in the money supply increased desired investment expenditure by the change in i  An increase in the money supply causes a reduction in the interest rate and an increase in desired investment; causing a rightward shift of the AD curve Increase in the supply / decrease in demand for money Excess supply of money
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