L2 - The Money Market (Financial Markets) Flashcards
What are the major functions of money?
- Medium of exchange: mitigating the double coinicidence of wants
- Unit of account: representing the real value of any economic items (e.g. prices and debts)
- Store of value: holding wealth and transferring the purchasing power into the future
What are the money aggregates in an economy?
- M0 or the monetary base: This is the narrowest aggregate and includes the amount of liquid cash in circulation in the form of currency notes, coins, cash or bank reserves, etc. These are highly liquid equivalents.
- M1: Also known as narrow money, it includes M0 aggregates and demand deposits held by individuals and businesses in commercial banks.
- M2: M2 contains M1 aggregates, marketable securities, saving deposits, time deposits, and less liquid bank deposits.
- M3: Known as broad money, this includes M2 aggregates and money market funds such as commercial papers, mutual funds, institutional money market funds, etc.
- M4: This is the final measure constituting M3 aggregates and less liquid funds held outside commercial banks.
What is the double coincidence of wants?
The Double Coincidence of Wants is an economic concept in barter systems where two individuals each possess something the other wants, enabling a mutually beneficial exchange without the need for a medium of exchange like money. This concept highlights one of the limitations of barter economies and why the use of money mitigates against it, as money acts as a universal medium of exchange, making transactions easier and more efficient.
What is a bond?
A bond is a financial instrument that represents a loan made by an investor to a borrower, typically a corporation or government. When an investor buys a bond, they are essentially lending money to the issuer in exchange for periodic interest payments and the return of the bond’s face value at maturity. Bonds are used by organizations to raise capital and are considered a form of debt security.
Why is the bond value negatively related to interest rate?
Fixed Interest Payments
Bond values are negatively related to interest rates because bonds typically offer fixed interest payments. When market interest rates rise, newly issued bonds provide higher coupon payments to attract investors. However, existing bonds still offer the same fixed interest payments as when they were issued, making them less attractive in comparison.
Why is the bond value negatively related to interest rate?
Opportunity Cost
Opportunity cost is related to the negative relationship between bond values and interest rates because as market interest rates increase, the opportunity cost of holding older bonds with lower fixed coupon rates rises. Investors have the option to invest in new bonds with higher coupon rates, which can provide them with more income, making existing bonds less desirable.
Why is the bond value negatively related to interest rate?
Bond Prices and Yield
Bond prices and yields have an inverse relationship. When market interest rates rise, the fixed coupon payments of existing bonds become less attractive compared to higher rates available on new bonds. To make existing bonds more competitive, their prices must decrease, resulting in a higher yield for the existing bonds to attract investors in a rising interest rate environment.
Why is the bond value negatively related to interest rate?
Bond Market Dynamics
Bond market dynamics impact bond values and interest rates because when bond prices fall due to rising interest rates, investors may demand higher yields on those bonds to compensate for the increased risk of holding bonds with lower prices. This demand for higher yields further drives down the prices of existing bonds in response to changing market conditions.
What is the one-period pricing formula?
What is the concept behind the on period pricing formula?
What is the definition of Money Demand?
In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments.
Draw the money demand curve
What causes the mondey demand curve to shift its location?
- If there is an increase in Price Level or if there is a shift in Income the money demand curve will shift to the right
- If there is an increase in Price Level you are going to want to hold a higher cash balance to account for that higher price level
- If there is an increase income people are more likely to spend more, which will in turn lead to higher cash balance being held
Who determines the money supply is this economic model?
The Central Bank
What happens if we have an interest rate that is above the equilibrium interest rate?
You get a surplus of money, you will see that the Money Demand is less than Money Supply, so there will be a surplus of money in the market and the only way that the market will come back into Equilibrium is if the interest rate is lowered. The same thing (vive versa) can be said if there was an interest rate that is below the equilibrium interest rate (There is a shortage of money rather than a surplus)
How does an increase in the Money Supply affect the interest rate?
The equilibrium interest rates decreases (The opposite happens vice versa)
What happens when Money Demand increases (i.e. Price Level or Disposable Income increasing)?
The equilibrium interest rate increases
What Open Market Operations?
What is the money multiplier?
The money multiplier is a concept in banking and economics that represents the potential increase in the money supply through the fractional reserve banking system. It is the inverse of the reserve requirement ratio and indicates how much new money can be created by the banking system through the process of lending.
What are the zero lower bound and liquidity trap?
