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Chapter 28

Economics 102: Chapter 28

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ECON 102
Robert Gateman

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 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) ECON 102: Principles of Macroeconomics o Positive relationship between real GDP and desired money holdings The Price Level:  Increase in the price level leads to an increase in the dollar value of transactions o Even if there is no change in the real value of transactions o As the price level rises, households/firms will need more money to make the same number of real value transactions o An increase in the price level is assumed to cause an increase in desired money holdings Money Demand: Summing Up  Liquidity preference: whether firms/households want to hold money (liquid) or bonds (less- liquid)  o The amount of money firms/households want to hold at any given times depends on the variables o Interest rates negatively effect desired money holding o Real GDP positively effects desired money holding o The price level positively effects desired money holding 28.3 Monetary Equilibrium National Income Monetary Equilibrium:  o Increases if the central bank increases reserves in the banking system or if the commercial banks decide to lend out a larger fraction of those reserves o Decreases if the central bank decreases reserves in the banking system or if commercial banks decide to reduce lending   Monetary equilibrium: situation in which the demand for money equals the supply of money o The interest rates adjust to bring about the equilibrium o An excess supply of bonds will force the price of bonds down (increased interest rates)  The interest rate will rise enough that there will be no excess supply  Liquidity preference theory of interest: a demand to hold money is a demand for more liquid assets Monetary Transmission Mechanism:  The channels by which a change in demand for or supply of money l
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