Unit 4 Notes - March 9th, 2016

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.