Time
Value of Money
·
Is a dollar today worth more than a dollar
tomorrow?
o
Yes
·
Why?
o
Opportunity Cost and Inflation. This is
the reason for charging and paying interest.
LET
·
v = Future Value of Money
·
p = Present Value of Money
·
r = Real Interest Rate (Nominal –
Inflation) [Expressed as a Decimal]
·
n = Years
·
k = Number of Times Interest is Credited
Per Year
Simple
Interest Formula
v
= (1 + r)n * p
Compound
Interest Formula
v
= (1 + r / k)nk * p
Demand
for Money
Demand for Money has an inverse
relationship between nominal interest rates and the quantity of money demanded.
·
What happens to the Quantity Demanded of
Money when the Interest Rates increase?
o
Quantity Demand falls because individuals
would prefer to have interest earning assets instead of borrowed liabilities.
·
What happens to the Quantity Demanded of Money
when the Interest Rates decrease?
o
Quantity Demand increases. There is no
incentive to convert cash into interest earning assets.
Money Demand Shifters
·
Changes in Price Level Increases Income
·
Changes in Income
·
Changes in Taxation that affects
investment
Increasing Money Supply
·
How does Money Supply affect AD?
o
Increase in MS -> Decrease in Interest
Rates -> Increase in Investments -> Increase in AD
·
If the FED increases the Money Supply, a
temporary surplus of money will occur at 5% interest.
·
The surplus will cause the interest rate
to fall to 2%
Decreasing Money Supply
o
Decrease in MS -> Increase in Interest
Rates -> Decrease in Investments -> Decrease in AD
·
If the FED decreases Money Supply, a
temporary shortage of money will occur at 5% interest.
·
The shortage will cause the interest rate
to rise to 10%
Financial Sector
Financial Assets: Assets such as stocks and bonds
provide expected future benefits. It benefits the owner based upon the issuer
of the asset meeting certain obligations.
VS
Financial Liabilities: Liabilities incurred by the issuer
of a financial asset to stand behind the issued asset.
Assets
are what you own, Liabilities are what you owe.
Interest Rate: The price paid for the use of a
financial asset.
Stocks Vs Bonds
Stocks: Financial assets that convey
ownership in a company. [You become a shareholder]
Bonds: The promise to pay a certain amount
of money plus interest in the future. [No hold; safer]
What do Banks Do?
A bank is a financial
intermediary.
·
Uses liquid assets (bank deposits) to
finance the investments of borrowers.
·
Process known as Fractional Reserve
Banking: A system in which
depository institutions hold liquid assets less than the amount of deposits.
·
Can take the form of:
o
Currency in bank vaults
o
Bank Reserves: Deposits held at the Federal Reserve.
