LEC 2: MONEY AND INTEREST RATE
MONEY
Functions
Evolution of payment system
Money Aggregate
Unit of Account
Store of Value
Medium of Exchange
Eliminates the trouble of finding a double coincidence of wants (reduces transaction costs)
Promotes specialization
Used to measure value in the economy
Reduces transaction costs
Used to save purchasing power over time
Other assets also serve this function
Money is the most liquid of all assets but loses value during inflation
E-Money
Commodity Money
Electronic Payment
Fiat Money
Checks
valuable, easily standardized, and divisible commodities (e.g. precious metals, cigarettes
heavy and uneasy to transport from one place to another
paper money decreed by governments as legal tender
features
no longer backed by a physical commodity
value depends on market demand and supply
an instruction to your bank to transfer money from your account
e.g. online bill pay)
Debit card
Stored-value card (smart card)
E-cash
M1(most liquid assets)
M2(adds to M1 other assets that are not so liquid)
currency + traveler’s checks + demand deposits + other checkable deposits
M1 + small denomination time deposits + savings deposits and money market deposit accounts + money market mutual fund shares
Interest Rates
Simple present value
Types of credit market instruments
Return Rate
Real vs Nominal interest rate
a dollar paid to you one year from now is less valuable than a dollar paid to you today.
PV = today’s (present) value
CF = future cash flow (payment)
i = the interest rate
PV =CF/(1+i)^n
Yield to Maturity on a Simple Loan
Cannot directly compare payments scheduled in different points in the timeline
Yield to Maturity
simple loans, the simple interest rate equniiiials theyield to maturity
the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today
Fixed-Payment Loan
The same cash flow payment every period throughout the life of the loan
Coupon Bond
Acoupon bond is identified by four pieces of information
Face value
Agencies that issue this bond
Maturity date
The coupon rate
Discount Bond
click to edit
The price of a coupon bond and the yield to maturity are negatively related.
IfYTM=couponrate,bondprice=facevalue,thebondissoldatpar.
IfYTM>couponrate,bondprice<facevalue,thebondissoldatadiscounttoitsfacevalue
IfYTM<couponrate,bondprice>facevalue,thebondissoldatapremiumtoitsfacevalue.
Nominal interest rate
Real interest rate
makes no allowance for inflation
is adjusted for changes in price level so it more accurately reflects the cost of borrowing.
Ex ante real interest rate
Ex post real interest rate
expected changes
actual changes
