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ECO102H1 (54)
Chapter 28

ECO100Y1 Chapter 28 Notes

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Robert Gazzale

ECO100Y1 Textbook Notes Chapter 28 28.1 Understanding Bonds  To simplify, financial wealth is grouped into two categories: o Money  All assets that serve as a medium of exchange (i.e. paper money, coins and deposits on which cheques can be drawn). o Bonds  Includes interest-earning financial assets and claims on real capital (equity).  Bond: a financial asset that promises to make one or more specified payments at specified 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 PV. o The interest rate is used to discount the value of the future payments into their PV.  Where R i1 the amount to be received one year from now.  The higher the interest rate, the more the future payment is discounted and thus is worth less at the present time.  For a sequence of payments for T years,  The present value of any bond that promises a future payment or sequence of future payments is negatively related to the market interest rate.  The PV of a bond is the most someone would be willing to pay now to own the bond’s future stream of payments. o If the market price of any asset is greater than the PV of its income stream, no one will want to buy it, and the resulting excess supply will push down the market price. o If the market price is below its PV, there will be a rush to buy it, and the resulting excess demand will push up the market price.  The equilibrium market price of any bond will be the PV of the income stream that it produces.  Key relationship: o An increase in the market interest rate leads to a fall in the price of any given bond. o A decrease in the market interest rate leads to an increase in the price of any given bond.  For a given sequence of future payments, a lower bond price implies a higher rate of return on the bond, or a higher bond yield.  The bond yield is a function of the sequence of payments and the bond price.  The market interest rate is the rate at which you can borrow or lend money in the credit market.  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.  “The” interest rate refers to the rate of return that can be earned by holding interest-earning assets rather than money.  An increase in the riskiness of any bond leads to ta decline in its expected PV 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  Demand for money: the total amount of money balances that the public wants to hold for all purposes. o Public must either choose bonds or money.  Three reasons for holding money: o Transactions demand for money  Households and firms hold money in order to carry out transactions.  The money held helps pay for purchases or routine expenses for firms. o Precautionary demand for money  Firms and households hold money due to their uncertainty about when some expenditures will be necessary.  The money is held as a precaution to avoid problems associated with missing a transaction.  The invention of the ATM has made this reason less important (easier to obtain cash when needed by simply going to an ATM). o Speculative demand for 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.  The expectation of increases in future interest rates will lead to the holding of more money (and fewer bonds) now as financial managers adjust their portfolios in order to preserve their values.  An increase in interest rates declines the value of current bond holdings.  Other things being equal, the demand for money is assumed to be negatively related to the interest rate. o This is a movement along the M cuDve, which graphs the relationship between interest rates and the quantity of money demanded.  An increase in real GDP increases the volume of transactions in the economy and is assumed to cause an increase in desired money holdings. o A shift to the right of the D curve.  An increase in the price level is assumed to cause an increase in desired money holdings. o Also a shift of the right of the D curve. o More money will be needed to carry out the same real value of transactions. o An assumption is made that if real GDP and interest rates are constant, the demand for money is proportional to the price level.  Since the demand for money reflects firms’ and households’ preference to hold wealth in the form of a liquid asset (money) rather than a less liquid asset (bonds), economists often refer to the money demand function as a liquidity preference function.  Central assumptions: o An increase in the interest rate increases the opportunity cost of holding money and leads to a reduction in the quantity of money demanded. o An increase in real GDP increase the volume of transactions and leads
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