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Chapter 28

ECON 102 Chapter Notes - Chapter 28: Economic Equilibrium, Liquidity Preference, Money Supply


Department
Economics
Course Code
ECON 102
Professor
Robert Gateman
Chapter
28

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ECON 102: Principles of Macroeconomics
Chapter 28
28.1 Understanding Bonds
Present Value and the Interest Rate:
Bond: financial asses that promises to make one or more specified payments at specified
future dates
Present value (PV): the value now of one or more payments or receipts made in the future
o Often referred to as discounted present value
o Depends on the interest rate (interest rate is used to discount the value of future
payments)
A Single Payment One Year Hence:
o
o The higher the interest rate, the lower the present value of the bond
A Sequence of Future Payments:
Coupon payments: promised payments each year of a bond, on top of the face value of the
bond
Higher interest rates imply that any future payments are discounted at a higher rate and thus
have a lower present value
A General Relationship:
Treasury bills: short-term government bond (does not make coupon payments)
o Also longer-term government bond, corporate bonds that make regular coupon
payments
A bond's present value is negatively related to the market interest rate
Present Value and Market Price:
Present value of a bond established the price at which a bond will be exchanged in the
market
o Present value of a bond is the most someone is willing to pay for a bond on the
market
o At any price below the bond's present value, the demand will push the price to rise
At present value, the bond is at the equilibrium market price
Interest Rates, Market Prices, and Bond Yields:
The present value of a bond is negatively related to the market interest rate
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
Bond yield: function of the sequence of payments and the bond price

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ECON 102: Principles of Macroeconomics
o Market interest rate: rate at which you can borrow or lend money in the credit market
Rise in the market interest rate leads to a decline in the present value of any bond
o As bond prices fall, its yield or rate of return rises
o Market interest rates and bond yields tend to move in the sand direction
Bond Riskiness:
Yields on specific bonds can rise or fall even when there is no change in the market interest
rate
o Occurs when there is a change in the perceived riskiness of the bond
If the purchasers think that the borrowers are unlikely to fulfill the payments
o Lower expected present value leads fewer buyers to be interests in purchasing the
bond
Equilibrium price declines, the yield rises (high risk investment)
28.2 The Demand for Money
Demand for money: total amount of money balances that the public wants to hold for all
purposes
People must decide what portion of money they wish to hold in bonds and money
Three Reasons for Holding Money:
Households and firms hold money in order to carry out transactions (transaction demand
for money)
o Money on hand, or in the bank that is easily accessible
Household and firms hold money if they are uncertain about when some expenditures are
necessary
o Hold money as a precaution to avoid problems associated with missing a transaction
o This is also called precautionary demand for money
Large businesses and professional money managers speculate about how interest rates in
the future
o This is called speculative demand for money
o Purchasing bonds, GICs, shares certificates, etc.
The Determinants of Money Demand:
Interest rates, the level of GDP and the price level all affect the amount of money in
demand
The Interest Rate:
The cost of holding money is the income that could be earned from interest-earning bonds
o This is called the opportunity cost of holding money
o An increase in interest rates leads firms/households to reduce the desired money
holdings
o Reduction in interest rates will increase the holding of money (negatively related)
Real GDP:
The amount of transactions that firms/households want to make is positively related to the
level of income and production in the economy (the level of real GDP)
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