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Chapter 28

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ECON 110
Ian James Cromb

Chapter 28: Money, Interest Rates, and Economic Activity Understanding Bonds Present Value and the Interest Rate  Present value (PV) is the value now of one or more payments to be made in the future o Depends on the current interest rate to determine the present value A Single Payment One Year Hence  R is the amount we receive one year from now, i is the annual interest rate 1 o Present Value = R 1 (1+i) A Sequence of Payments  Present Value =  R 1 first payment, R 2 Second payment, R = Tinal payment + FV of bond  i = is the annual interest rate  The exponent is the period (1=payment in first period, 2 = second, etc.) Present Value and the Market Price  The PV of a bond is the most someone is willing to pay now to own the bond’s future stream of payments  equilibrium market price is PV of the income stream it produces o Wouldn’t pay more than the PV because you could just put the money in another area and get the same return without paying more Interest Rates, Market Prices, and Bond Yields  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 in an increase in the price of any given bond  Remember: The cost of the investment is the price of the bond, the return on the investment is the sequence of future payments o If your ROI on the bond is 8%, your yield on the bond is 8% per year  As the price of the bond drops due to increasing market rates, your yield increases o Investment costs less but you have the same rate of return Bond Riskiness  An increase in the riskiness of any bond leads to a decline in its expected present value o Leads to a decline in the bond’s price implying a higher bond yield The Demand for Money  This is the total amount of money that the public wants to hold for all purposes  Assumption: Only two types of assets (money and bonds) – if households and firms are dividing their given stock and you know the demand for one, you also know the other Three Reasons for Holding Money 1. Transactions demand for money – households and firms hold money in order to carry out transactions  want it to be readily available 2. Precautionary demand for money – Firms and households are uncertain about when some expenditures will be necessary and they hold money as a precaution to avoid the problems associated with missing a transaction 3. Speculative demand for money – Involves firms speculating about how interest rates are likely to change in the future  don’t want to lose money from bond’s value dropping The Determinants of Money Demand The Interest Rate  The cost of holding income is the money that could have been earned if it were instead in the form of interest-earning bonds o An increase in the interest rate leads firms and households to reduce their desired money holdings  reduction in interest rates leads to increased money holdings Real GDP  The amount of transactions that firms and households make is positively related to the level of income and production in the economy – i.e. The level of real GDP  An increase in the real GDP increases the volume of transactions in the economy and is assumed to cause an increase in desired money holdings The Price Level  An increase in the price level leads to an increase in the dollar value of transactions even if there is no change in the real value of transactions o As P rises, households and firms will need to hold more money in order to carry out the same real value of transactions  increase in desired money holdings Monetary Equilibrium and National Income Monetary Equilibrium  Side Note: If MS curve is vertical, it is assumed to be independent of the interest rate o MS shifts to the right if the BoC increases reserves or if commercial banks decide to lend out a larger fraction of their reserves  opposite = shift left  MD curve is downward sloping indicating that households/firms decide to hold more money and fewer bonds when the interest rate falls  Monetary Equilibrium occurs when the demand for money = the supply of money  If there is excess supply of money, the interest rate falls bringing it to equilibrium  If there is excess demand for money, the interest rate rises bringing it to equilibrium The Monetary Transmission Mechanism  This is the channels by which a change in the demand for or supply of money leads to a shift of the AD curve  three stag
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