Chapter 12 - Money, Interest Rates, and Economic Activity Flashcards
What’s the difference between money and bonds?
Money = medium of exchange (cash, deposits)
Bonds = interest-earning financial assets that promise future payments
What is Present Value (PV) and how is it calculated?
PV is the value today of future payments → Formula: PV = R1 / (1 + i)
where R1 is the amount we receive one year from now and i is the annual interest rate
What are multiple payments and what is their corresponding formula?
Multiple payments are when bonds promise to make yearly “coupon payments” and then return the face value of the bond at the end of the loan’s term → Formula: PV = R1/(1+i) + R2/(1+i)^2 + … RT/(1+i)^T
The first term is the value today for receiving the coupon amount a year from now
The second term is the value today of receiving the second coupon payment two years from now
T is the value today of the repayment (face value + coupon)
How does interest rate affect the present value of bonds?
Higher interest rate = lower present value
What happens to bond prices when interest rates rise?
Bond prices fall, and yields increase
What is bond yield?
The rate of return if a bond is held to maturity; yield rises when bond prices fall
What factors influence a bond’s price and yield?
Coupon rate, maturity, perceived risk, and market interest rates
What are the 3 motives for holding money?
Transactions
Precautionary (saving for emergencies)
Speculative (predict that interest rates will go up, so you save money to avoid bigger losses)
How is money demand related to interest rate?
Negatively — higher interest rates increase the opportunity cost of holding money
How is money demand related to real GDP and the price level?
Positively — as GDP and price level rise, money demand increases
What is the formula for money demand?
MD = MD(i, Y, P)
What does the money demand curve look like?
Downward sloping (i on vertical axis, quantity of money on horizontal)
What is monetary equilibrium?
Where money supply = money demand at interest rate i₀
What happens when i > i₀ in monetary equilibrium?
Excess money supply → people buy bonds → bond prices rise → interest rate falls
What happens when i < i₀ in monetary equilibrium?
Excess money demand → people sell bonds → bond prices fall → interest rate rises
What is the liquidity preference theory of interest?
Interest rates adjust as people shift between holding money and bonds in the short run
What is the monetary transmission mechanism?
MS changes → interest rate changes
i changes → investment/consumption changes
AE & AD curves shift → real GDP and prices change
How does an increase in MS affect interest rate and AD?
↓ interest rate → ↑ investment → AD shifts right → ↑ real GDP
What happens in an open economy when MS increases?
↓ interest rate → CAD depreciates → ↑ NX → ↑ AD
What is money neutrality in the long run?
MS affects price level, but not real GDP or other real variables
What is the hysteresis effect?
Short-run changes in GDP from monetary policy can affect long-run potential output (Y*)
What shapes the effectiveness of monetary policy?
Steep MD curve → larger i change
Flat investment demand (ID) → more responsive spending
→ Together = stronger policy impact
How do Keynesians view monetary policy?
Not very effective — investment is not sensitive to interest rate changes
How do Monetarists view monetary policy?
Very effective — money supply changes cause big shifts in interest and investment
