Chapter 12 - Money, Interest Rates and Economic Activity Flashcards
How do we define bonds in this chapter?
All other forms of financial wealth (that are not money).
Includes interest-earning financial assets and ownership shares (stocks).
Explain the relationship between ‘bonds’ and risk curve.
An increase in the risk of any bond leads to a decline in its expected present value, and thus to a decline in the bond’s price. The lower bond price implies a higher bond yield.
Suppose a 3-year bond promises to repay the face value of $1000 in 3 years and will also pay a 10% coupon payment of $100 at the end of each of the 3 years.
How much is this bond worth now if the market interest rate is 7 percent?
Present Value (PV)
PV = R_1 / (1+i)
General formula with future payments:
PV = R_1 / (1+i) + R_2 / (1+i)^2 + ….+ R_T / (1+i)^T
So, for this question
PV = $100/1.07 + 100/(1.07)^2 + 1100/(1.07)^3 = 1078.73$
How does market interest rate affect a bond’s present value?
The present value of any bond that promises one or more future payments is negatively related to the market interest rate.
Define the present value of a bond.
The present value of a bond is the most someone would be willing to pay now to own the bond’s future stream of payments.
Key relationships to remember:
– An increase in the market interest rate leads to a fall in the price of any given bond.
– A decrease in the market interest rate leads to an increase in the price of any given bond.
How risky can government-issued bonds be? Explain.
It is rare in Canada that government bonds are perceived as risky. However, some bonds issued by European countries have been viewed as high-risk assets. The risk comes from the possibility of the government defaulting on its payments. For example, due to irresponsible fiscal policies, Greece experienced a Debt crisis, which led to Greece defaulting on payments.
Fun googling:
The Greece 10Y Government Bond has a 4.157% yield
The Germany 10Y Government Bond has a 1.976% yield
The Canada 10Y Government Bond has a 2.925% yield
The India 10Y Government Bond has a 7.304% yield
The Egypt 10Y Government Bond has a 19.596% yield
How do we define Money Demand?
The amount of money that everyone (collectively) wants to hold at any time is called the demand for money.
Why is money demanded? Why do firms and households hold money?
1- Transactions demand for money
2- Precautionary demand for money
3- Speculative demand for money
What are the determinants of money demanded? What influences the amount of money demanded and why?
The amount of money demanded is influenced by interest rates, real GDP, and the price level.
- The demand for money is assumed to be negatively related to the interest rate.
- The demand for money is assumed to be positively related to real GDP (for any given interest rate).
- The demand for money is assumed to be positively related to the price level (for any given interest rate)
Why is the AD curve negatively sloped?
1- The change in wealth.
2- The substitution between domestic and foreign goods
3- Interest rates. A rise in the price level raises the money value of
transactions and leads to an increase in the demand for money. This increase in demand raises the equilibrium interest rate, which reduces investment expenditure.
What do we mean by long-run money neutrality?
Y* remains unaffected by any change in the money supply.
What is Hysteresis Effect and why could it happen?
Hysteresis is the possibility that the short-run path of GDP may have an influence on Y*.
One reason is the effect on human capital that comes with a prolonged period of unemployment.
Another reason is the change in money supply.
Discuss both points of view of Keynesian and Monetarist economists. How has it been resolved/who won?
Economists who follow the ideas of John Maynard Keynes, argued that changes in the money supply led to relatively small changes in interest rates, and that investment was relatively insensitive to changes in the interest rate.
These Keynesian economists concluded that monetary policy was not a very effective method of stimulating aggregate demand—they, therefore, emphasized the value of using fiscal policy.
Another group of economists, led by Milton Friedman, argued that changes in the money supply caused sharp changes in interest rates, which, in turn, led to significant changes in investment expenditure.
These Monetarist economists concluded that monetary policy was a very effective tool for stimulating aggregate demand
TLDR: Keynesians argued that monetary policy was not very effective, Monetarists argued that monetary policy was very effective.
The debate between Keynesians and Monetarists is over. Empirical research suggests that money demand is relatively insensitive to changes in the interest rate. Today we incorporate concepts from both in modern economics.
