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Chapter 28

ECON 102 Chapter 28: Study Notes (Self Draw Graphs)

Department
Economics
Course Code
ECON 102
Professor
Robert Gateman
Chapter
28

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Chapter 28: Money, Interest Rates, and
Economic Activity
Understanding Bonds
-At any moment, households have a stock of nancial wealth that
they hold in several forms
(Money in bank, bills in wallet, treasury bills and bonds, equity…)
-Financial wealth:
oMoney
All assets that serve as a medium of exchange
(paper, coins, deposits)
oBonds
Financial wealth; interest earning assets and claims
on real capital
Present Value and the Interest Rate
-Bonds: a nancial asset that promises to make one or more
specied payments at specied dates in the future
-Present Value (PV): The value now of one or more payments or
receipts made in the future; often referred to as discounted
present value
oDepends on market interest rate
-Higher market interest rate leads to a lower present value
A Single Payment One Year Hence
-
If R1 is the amount we receive one year from now and i is the
annual interest rate, the present value of R1 is:
PV =
R1
1+i
A Sequence of Future Payments
-
In general, any asset that promises to make a sequence of
payments into the future of R1, R2,…, and so on, up to RT has a
present value given by:
PV =
R1
1+i
+
1+i
¿
¿
¿
R2
¿
+ …
1+i
¿
¿
¿
RT
¿
A General Relationship
-Treasury Bills: a bond that makes no coupon payments and
only a single payment at some point in the future
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-Present value of bonds are negatively related to the market
interest rate
**The present value of any bond that promises a future payment or
sequence of future payments is negatively related to the market
interest rate.
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.
E.g. A bond that promises to pay \$100 one year from now. When the
interest rate is 5%, the present value of his bond is 95.24. Suppose
that some sellers o?er to sell the bond at some other price, say, \$98.
If, instead of paying this amount for the bond, a potential buyer lends
\$98 out at 5% interest, he or she would have at the end of one year
more than the \$100 that the bond will produce. Thus, at any price
above the bond’s present value, the lack of demand will cause the
price to fall.
-At any price above the bond’s present value, the lack of demand
will cause the price to fall
-At any price below the bond’s present value, the abundance of
demand will cause the price to rise
**The equilibrium market price of any bond will be the present value of
the income stream that it produces.
Interest Rates, Market Prices, and Bond Yields:
Link between the market interest rate and bond prices:
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.
-Bond Yield: a function of the sequence of payments and the
bond price.
-Market Interest Rate: the rate at which you can borrow or lend
money in the credit market.
-Interest Rate: the rate of return that can be earned by holding
interest-earning assets rather than money
**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.
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Bond Riskiness:
-Some chance that bond issuers will be unable to make some or
all coupon payments and the repayment of principal
-Purchasers of bond reduce the price they are prepared to pay by
an amount that reCect the likelihood of non-repayment
**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.
The Theory of Money Demand
-To hold more bonds is to hold less money
Demand for Money: The total amount of money balances that the
public wants to hold for all purposes
Three Reasons for Holding Money:
1. Households and rms hold money in order to carry out
transactions. (
Transactions demand for money
)
2. Households and rms are uncertain about when some
expenditures will be necessary, and they hold money as a
precaution to avoid the problems associated with a missing
transaction. (
Precautionary demand for money
)
3. Applies more to large businesses and to professional money
managers than to individuals because it involves
speculating
about how interest rates are likely to change in the future.
(
Speculative demand for money
)
The Determinants of Money Demand:
The Interest Rate:
-No matter what benets households or rms receive from
holding money, there is also cost
-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 (
opportunity cost of holding money)
**Other things being equal, the demand for money is assumed to be
negatively related to the interest rate.
Figure 28-1: Money Demand as a Function of the Interest Rate, Real
GDP, and the Price Level
-The quantity of money demanded is assumed to be negatively
related to the interest rate and positively related to real GDP and the
price level
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