3-9-16

Time Value of Money, Interest, Money Supply and Demand, Interest, and Stocks and Bonds

Time Value of Money

Is a dollar today worth more than a dollar tomorrow?

Correct Answer: Yes

Why?: Opportunity cost and Inflation, this is the reason for charging and paying interest.

V=Future value of $

P= Present Value of $

R=Real Interest rate (nominal rate-inflation rate) expressed as a decimal

N=Years

K=Number of times interest is credited per year

The Simple Interest Formula

v=(1+r)^n *p

The Compound Interest Formula

v=(1+r/k)^nk *p

Assume that inflation is expected to be 3% and that the nominal interest rate on simple interest savings is 1%. Calculate the future value of $1 after  1 year.

Step 1: Calculate the real interest rate

1%-3%=-2%

Step 2: Use the simple interest formula to calculate the future value of $1.

(1+(-.02))^1*1

v=.98*1

V=$0.98

Assume that inflation is still expected to be 3% but that the nominal interest rate on simple interest savings is 4%. Calculate the future value of $1 after 1 year.

Real Interest Rate

4%-3%=1%

Future Value of $1

(1+.01)^1 *1

v=$1.01

(1+.025/12)^(10*12)*1000

Money Supply Line

Vertical

Money Demanded Line

Downward Slopping

Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded.

1. What happens to the quantity demanded of money when interest rates increase?

Quantity demanded falls because individuals would prefer to have interest earning assets instead of borrowed liabilities.

2. What happens to the quantity demanded when interest rates decrease?

Quantity demanded increases. There is no incentive to convert cash into interest earning assets.

The Demand for Money

What happens if price level increase?

Money Demanded Shifts to the right.

Causes 
1. Change in Price Level

2. Change in Income

3. Changes in Taxation that affects investment

Increasing the Money Supply

Shifts to the RIght (vertical line)

How does it affect AD?

GDP= C, G, Ig, and  Xn.

Increase Money Supply = Decrease in Interest Rate = Investment Increases = AD Increases

Decrease in the Money Supply

Shifts to the Left

Money Supply Decreases = Increase in Interest Rate = Investment Decreases = AD Decreases

Financial Sector

Financial Assets vs Financial Liabilities

Financial Asset- Something that you own

Financial Liabilities- Something you owe

Interest Rate

Interest- The cost of borrowing money

Stocks vs Bonds

Stock- Share of a company that you buy so you're a shareholder

Bond- Lend money to the government and it’s a promise that they will pay you back with interest

What Banks Do

A Bank is a financial intermediary

Uses liquid assets (ie bank deposits) to finance the investments of borrowers

Process is 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:

1. Currency in bank vaults
2. Bank Reserves- deposits held at the Federal Reserve

Ultimate Lenders (Households, Businesses, and Governments) to

Financial Intermediaries (Commercial Banks, S&Ls, Savings Banks, Credit Unions, Insurance Companies, Mutual Funds, Pension Funds, and GOvernments) to

Ultimate Borrowers (Households, Businesses, and Government)

T-Account (Balance Sheet)- Statements of assets and liabilities, owe and own are equal

Assets (amounts owned)- items to which a bank holds legal claim, the uses of funds by financial intermediaries

Liabilities (Amounts owed)- the legal claims against a bank, the sources of funds for financial intermediaries

When the fed buys bonds they increase the money supply, when the fed sells bonds they decrease the money supply.