Chapter 27 Flashcards
for simplicity, what two forms of financial assets do we assume exist?
- money (earns no interest)
* bonds (earn interest)
def. present value
the value now of one or more payments or receipts made in the future
Consider an asset that pays $X in one year’s time. If the interest rate is i% per year, the PV of the asset is
PV = $X/(1+i)
the PV is _______ related to the interested rate
negatively
generally describe a competitive market for bonds
- buyers should be prepared to pay no more than the bond’s PV
- sellers should be prepared to accept no less than the bond’s PV
what should the equilibrium market price of a bond (or another financial asset) be?
the PV of the stream of income generated by the bond.
3 conclusions about bond pricing
- The PV of a bond is negatively related to the market interest rate.
- The market price for a bond should equal its PV.
Since a bond’s yield is inversely related to its price, we conclude that:
3. Market interest rates and bond yields tend to move together.
def. bond yield
a function of the sequence of payments and the bond price
def. market interest rate
the rate at which you can borrow or lend
money in the credit market.
A rise in the market interest rate will lead to a ______ in the present
value of any bond and thus to a ______ in its equilibrium price. As
the bond price _____ its yield or rate or return rises
decline, decline, falls
An increase in the riskiness of any bond leads to a _______ in its expected PV, and thus to a _______ in the bond’s price.
decline, decline
high risk leads to ______ yield
high
the amount of money that everyone wishes to hold is __________
the demand for money
what is the opportunity cost of holding money?
the interest that could have been earned if the money had been used to purchase bonds
what are the three reasons for holding money?
• the transactions motive
• the precautionary motive
• the speculative motive: if interest rates are expected to rise in the future, bond prices will be expected to fall, bondholders experience a decline in the value of their bond holdings.
==> expectation of higher interest rates in the future will lead to the
holding of more money now.
What three variables are the determinants of money demanded?
- real GDP (+): The amount of transactions that individuals want to make is positively related to the level of income and production in the economy – that is to the level of GDP.
- the price level (+): If prices are higher, households and firms will need to hold more money in order to carry out the same real value of transactions.
- the interest rate (-): is the opportunity cost of holding money
a fall in the interest rate reduces the opportunity cost of holding money because ___________
the rate of return
on bonds declines.
movements along the money demand curve imply _________
the substitution of assets
between money and bonds
describe the money demand curve
This money demand (MD)
curve is sometimes called the liquidity preference function.
Changes in Y or P cause
the MD curve to shift.
Changes in the interest rate cause movements along the MD curve
T or F: The decision to hold money is the same as the decision not to hold bonds
true
monetary equilibrium occurs where?
when the quantity
of money demanded equals the quantity of money supplied:
==> equilibrium interest rate
describe the monetary transmission mechanism
connects changes in MD and/or MS with aggregate demand
Three stages:
1. ΔMD or ΔMS => Δ in equilibrium interest rate
2. Δi => Δ in desired investment expenditure
3. ΔI^D => Δ in AD
a increase in the money supply _______ the equilibrium interest rate
reduces
an increase the demand for money ________ the equilibrium interest rate
increases
Describe the process of changes in the equilibrium interest rate
Stage 1. Shifts in the MS or MD curves cause the equilibrium interest rate to change
Stage 2. Changes in the equilibrium interest rate lead to changes in desired investment
Stage 3. Changes in desired investment lead to a shift in the AE function, and thus a shift in the AD curve.
in a/an _____ economy with mobile financial capital, there is an extra channel to the transmission mechanism.
Why?
open
As interest rates change, financial capital flows between countries, putting pressure on the exchange rate.
As the exchange rate changes, net exports change, adding to the effect on aggregate demand
what is a third reason for the negative slope of the AD curve (in addition to • ΔP leads to Δwealth and • ΔP leads to ΔNX)
—the effect of interest rates.
A rise in P leads to:
• an increase in money demand
• higher interest rate
==> this reduces desired investment
T or F: a shift in the AD curve will lead to different effects in the short run than in the long run
true
money neutrality
the idea that changes in the money supply do not have real effects on the economy
**because in the long run, output eventually returns
what does money neutrality look like?
• MD shifts up as P and Y adjust to new long-run
equilibrium
• interest rate returns to
its initial level
Why is the proposition of long-run money neutrality is debatable?
Hysteresis: the growth rate of Y* may be affected by the short run path of real GDP.
Why?
• A change in the money supply, through its effect on the interest rate, can affect investment and technological change.
• In a long period of unemployment workers can lose human capital, this can affect Y* and its growth rate.
What are other propositions regarding the neutrality of money?
- Altering the number of zeros on the monetary unit, and on everything else stated in those units, will have no economic consequences.
- Altering the nature of the monetary unit will have no real economic effects
- These propositions emphasize the nominal nature of money
The short-run effect of a change in the money supply depends on what?
the extent of the shift of the AD curve
what was the debate in the 1950s and 1960s regarding the effectiveness of monetary policy about generally?
• centred around the slopes of the MD and I
D curves
• Keynesians versus Monetarists
Keynesians argued that monetary policy was not very effective:
• MD curve was relatively flat
• ID curve was relatively steep
Monetarists argued that monetary policy was very effective:
• MD curve was relatively steep
• ID curve was relatively flat
Much empirical support for the idea that the money demand curve
is not flat. What does this mean?
=> changes in money supply do lead to changes in the equilibrium interest rate
=> monetary policy can be effective
