Value of Money

·         Is a dollar today worth more than a dollar tomorrow? - Yes

·         Why? - Opportunity costs & inflation

Let :

• v = future value of $ 
• p = Present value of $
• r = real interest rate (nominal - inflation rate) expressed as decimal
• n = years
• k = # of times interest is credited per year 

Formulas

• Simple Interest Formula - -v = (1 + r)^n x p 
• Compound Interest Formula - - v = (1 + r / k)^nk x p

Money demand has an inverse relationship between nominal interest rates and the quantit of money demanded

·         What happens to the quantity demanded of money when interest rates increases? Quantity demanded falls because individuals would prefer to have interest earning assets instead of borrowed liabilities

·         What happens to quantity demanded when interest rates decrease? Quantity demanded increases, there is no incentive to convert cash into interest earning assets

What happens if price level increases?

• Money demand Shifters that affects investment
• Changes in Price Level
• Changes in Income
• Changes in Taxation

Increasing the Money Supply

- 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%

 

How this affect AD:

Money supply (increase) -> interest rate(decrease) -> Investment (increases) -> Increases AD

Decreasing the Money Supply:

Money supply (decreases) -> interest rate (increase) -> investment (decrease) -> Decrease AD

Financial Sector:

• Financial Assets (Own) vs Financial Liabilities (Owe)
• Financial Assets:-
• Stocks or bonds that provide expected future benefits
• Benefits the owner only if the issuer of the asset met certain obligations
• Financial Liabilities:
• Incurred by the issuer of a financial asset to stand behind/by the issued asset

Interest Rate - price paid for use of a financial asset

Stocks vs Bonds

• Stocks:
• Financial assets that convey ownership in a corporation
• Bonds:
• Promise to pay a certain amount of money plus interest in the future

What Banks do

·         A bank is a financial intermediary - uses liquid assets (i.e. bank deposits) to finance the investment of borrowers

·         Process kown as Fractional Reserve Banking - system which depository institutions hold liquid assets less than the amount of deposits

·         Can take the form of:

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

 

Basic accounting review

·         T- Account (Balance sheet) - statement of assets and liabilities

·         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 if funds for financial intermediaries