Chapter 28 Money, Interest Rates, and Economic Activity Notes
28.1 Understanding Bonds
x at any moment, households have a stock of financial wealth that they hold in many forms
x by money it’s meant all assets that serve as medium of exchange—paper, money, coins, deposits on which cheques can be drawn
x by bonds it’s meant all other forms of wealth; this includes interest-earning financial assets and claims on real capital (equity)
Present Value and the Interest Rate
x present value (PV) Æ the value now of one or more payments or receipts made in the future; often referred to as discounted PV
x the PV of any bond that promises future payment or sequence of future payments is negatively related to the market interest rate
Present Value and Market Price
x the PV of a bond is the most someone would be willing to pay now to own the bond’s future stream of payments
x if market price (MP) of any asset > PV of its income stream, no one will buy it, and this excess supply will push down the MP
x if MP < PV, there will be a rush to buy it, and this excess demand will push up the MP
x when the bond’s MP = PV, there is no pressure for the price to change
x 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
x there are two relationships that link market interest rates 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.
x 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
x 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 move together
x 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
28.2 The Demand for Money
x demand for money Æ the total amount of money balances that the public wishes to hold for all purposes
x if households and firms are choosing how to divide their given stock of assets between money and bonds, it follows that if
demand for money is known, the demand for bonds is also known
Reasons for Holding Money
x there are three reasons why firms and households hold money:
1. Households and firms hold money in order to carry out transactions. Economists call this transactions demand for money.
2. They are uncertain about when some expenditure will be necessary, and they hold money as a precaution to avoid the
problems associated with missing a transaction. This is referred to as the precautionary demand for money.
3. The 3rd reason for holding money 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. Economists call this the
speculative demand for money.
The Determinants of Money Demand
x other things being equal, the demand for money is assumed to be negatively related to the interest rate
x increase in real GDP increases volume of transactions in economy and therefore leads to increase in desired money holding
x an increase in the price level is assumed to cause an increase in desired money holdings
Money Demand: Summing Up
x the central assumptions are:
1. Increase in interest rate increases opportunity cost of holding money and leads to reduction in quantity of money demanded.
2. An increase in real GDP increases the volume of transactions and leads to increase in the quantity of money demanded.
3. An increase in the price level increases the dollar value of a given volume of transactions and leads to an increase in the
quantity of money demanded.
28.3 Monetary Equilibrium and National Income
x monetary equilibrium Æ a situation in which the demand for money equals the supply of money
x monetary equilibrium occurs when rate of interest is such that the quantity of money demanded = the quantity of money supplied
The Monetary Transmission Mechanism
x monetary transmission mechanism Æ channels by which change in demand for or supply of money leads to shift of AD curve
x it operates in three stages:
1. changes in the demand for money or the supply of money cause a change in the equilibrium interest rate
2. the change in the interest rate leads to a change in desired investment and consumption expenditure
3. the change in desired AE leads to a shift in the AD curve and thus to short-run changes in real GDP and the price level
x an increase in the money supply causes a reduction in the interest rate and an increase in desired investment therefore causing a
rightward shift of the AD curve; a decrease in the money supply causes an increase in the interest rate and a decrease in desired
investment therefore causing a leftward shift of the AD curve