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LEC 2: MONEY AND INTEREST RATE - Coggle Diagram
LEC 2: MONEY AND INTEREST RATE
MONEY
Functions
Unit of Account
Used to measure value in the economy
Reduces transaction costs
Store of Value
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
Medium of Exchange
Eliminates the trouble of finding a double coincidence of wants (reduces transaction costs)
Promotes specialization
Evolution of payment system
E-Money
Debit card
Stored-value card (smart card)
E-cash
Commodity Money
valuable, easily standardized, and divisible commodities (e.g. precious metals, cigarettes
heavy and uneasy to transport from one place to another
Electronic Payment
e.g. online bill pay)
Fiat Money
paper money decreed by governments as legal tender
features
no longer backed by a physical commodity
value depends on market demand and supply
Checks
an instruction to your bank to transfer money from your account
Money Aggregate
M1(most liquid assets)
currency + traveler’s checks + demand deposits + other checkable deposits
M2(adds to M1 other assets that are not so liquid)
M1 + small denomination time deposits + savings deposits and money market deposit accounts + money market mutual fund shares
Interest Rates
Simple present value
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
Cannot directly compare payments scheduled in different points in the timeline
Types of credit market instruments
Yield to Maturity on a Simple Loan
Yield to Maturity
the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today
simple loans, the simple interest rate equniiiials theyield to maturity
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
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.
Discount Bond
Return Rate
Real vs Nominal interest rate
Nominal interest rate
makes no allowance for inflation
Real interest rate
is adjusted for changes in price level so it more accurately reflects the cost of borrowing.
Ex ante real interest rate
expected changes
Ex post real interest rate
actual changes
