March 19 Flashcards
if firms need to borrow, what can they issue?
bonds
money versus bonds
MONEY = no interest
BONDS
a) savings account
b) bonds
what do people look at when deciding whether to buy a bond versus store money in savings account?
the market interest rate
if the market interest rate fosters a profit higher than the bond yield, you’ll be willing to pay less for the bond
(the higher the market interest rate, the more you’ll earn by storing money in savings account)
is the yield of a bond clear?
yes
the sequence of future payments is set - you know what it will be
present value (PV)
the value NOW of ONE or MORE payments or receipts made in the future
asset that pays $X in one year’s time. if interest rate in i% per year, the PV of the asset is…
PV = $X / (1 + i)
PV = R1 / (1 + i) + R2 / (1 + i)^2 + … + RT / (1 + i)^T
what happens to PV of bonds if the market interest rate increasees?
it decreases!
(because in the PV equation, we’re dividing X by a larger number)
with no risk, what should be PV of the bond be?
its price
no risk, then PV = price
what do you need to calculate the yield of a bond?
the PV and the price
and if there’s no risk at all, you should be getting the interest rate
Price = $X / (1 + yield)
what’s the PV and interest rate when there’s no risk?
PV = price of the bond
yield = interest rate
(with risk, the PV doesn’t equal the price and the interest rate doesn’t equal the yield)
with a higher interest rate, what happens to the PRICE OF BONDS and what happens to the BOND YIELDS?
price of bonds DECREASE
which means the bond yields INCREASE
(because for the same sequence of payments you are paying less)
how can the central bank affect bond yields?
indirectly, through changing the market interest rate
higher market interest rate = decrease in price of bonds = higher bond yields
market interest rates and bond yields tend to move…
together
if a bond is seen as higher risk, then there’s a decline in…
its PV
and thus a decline in its price
high risk = high yield
are Canadian gov bonds seen as risky?
no
in our simplified model, if we know the demand for bonds, we also know…
the demand for money
relationship between demand for money and the interest rate
negative
3 reasons for holding money
- transactions motive
- precautionary motive
- speculative motive
expectation of higher interest rate in the future will lead to the holding of more ________ now
money
(if interest rates are expected to rise in the future, bond prices will be expected to fall, and thus bondholders will experience a decline in the value of their bond holdings)
2 points on buyers and sellers in 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’s the equilibrium market price of a bond?
should be the PV of the stream of income generated by the bond
bond yield is a function of…
- the sequence of payments
- the bond price
market interest rate
the rate at which you can BORROW or LEND MONEY in the credit market
demand for money
the amount of money that everyone wishes to hold
the opportunity cost of holding money
is the INTEREST that COULD HAVE BEEN EARNED if the money had been used to purchase bonds
speculative motive
if interest rates are expected to rise in the future
bond prices will be expected to fall
bondholders will thus experience a decline in the value of their bond holdings
^ expectations of higher interest rates in the future will lead to the holding of more money now
3 variables: the determinants of money demanded
- real GDP (+)
- price level (+)
- interest rate (-)
real GDP as a variable that determines the money demanded
amount of transactions that individuals want to make is POSITIVELY RELATED to the level of income and production in the economy
price level as a variable that determines the money demanded
if prices are higher, households and firms will NEED TO HOLD MORE MONEY in order to carry out the same real value of transactions
interest rate as a variable that determines the money demanded
the OPPORTUNITY COST of holding money
so it’s negatively related to the demand for money
what happens to the opportunity cost of holding money when the interest rate falls?
fall in interest rate REDUCES the opportunity cost of holding money
because the RATE OF RETURN on BONDS DECLINES
movements along the money demanded curve imply what?
substitution of assets between money and bonds
money demand (MD) curve is sometimes called…
the liquidity preference function
money demanded as a function of the interest rate, real GDP and the price level: what causes shifts versus movements of/along the MD curve?
SHIFTS: caused by changes in Y or P
MOVEMENTS: caused by changes in the interest rate
an increase in Y or P leads to what in terms of money demanded?
increase in Y or P leads to INCREASE in money demand
at any given interest rate
money demand equation
MD = MD (i, Y, P)
the decision to hold money is the same as the decision…
the decision NOT TO HOLD BONDS
monetary equilibrium
occurs when the quantity of money DEMANDED equals the quantity of money SUPPLIED
occurs at the equilibrium interest rate
2 forces that act to achieve monetary equilibrium
- EXCESS DEMAND for money causes the interest rate to RISE
- EXCESS SUPPLY of money causes the interest rate to FALL
monetary transmission mechanism
connects change in MONEY DEMANDED and MONEY SUPPLY with AGGREGATE DEMAND
3 stages of the monetary transmission mechanism
- change in money demanded or money supply leads to change in the EQUILIBRIUM INTEREST RATE
- change in the interest rate leads to change in DESIRED INVESTMENT EXPENDITURE
- change in desired investment expenditure leads to change in AGGREGATE DEMAND
increase in the money supply does what to the equilibrium interest rate?
reduces it
increase in the demand for money does what to the equilibrium interest rate?
increases it
step 1: shifts in the money supply or money demand curves cause what to change?
the equilibrium interest rate
(step 1 of the money transmission mechanism)
step 2: changes in the equilibrium interest rate lead to changes in what?
desired investment expenditure
lower interest rates lead to higher desired investment
(step 2 of the money transmission mechanism)
step 3: changes in desired investment lead to shift in…
the AE function, and thus a shift in the AD curve
summary of the money transmission mechanism
- an increase in the supply of money or a decrease in the demand for money
- excess supply of money
- fall in the equilibrium interest rate
- increase in desired investment expenditure
- upward shift of the AE curve
- rightward shift in the AD curve
money transmission mechanism: an OPEN-ECONOMY modification
in an open economy with MOBILE FINANCIAL CAPITAL, there’s an EXTRA CHANNEL to the transmission mechanism
- as interest rates change, FINANCIAL CAPITAL FLOWS BETWEEN COUNTRIES
- this puts pressure on the EXCHANGE RATE
- as the exchange rate changes, NET EXPORTS CHANGE - ADDING to the effect on aggregate demand
summary of the money transmission mechanism in an open economy
- increase in supply of money or decrease in demand for money
- excess supply of money
- fall in equilibrium interest rate
4A. increase in desired investment expenditure
4B. CAPITAL OUTLOW AND CURRENCY DEPRECIATION (because Canadian dollars are sold in exchange for foreign currencies in order to buy foreign bonds)
4C. INCREASE IN NET EXPORTS (because Cad exporters have advantage bc of depreciated Cad dollar)
- upward shift in AE curve
- rightward shift of AD curve
in previous chapters, there were 2 reasons for the negative slope of the AD curve
- change in P leads to change in wealth (increased P = reduced wealth)
- change in P leads to change in NX (increase in P = reduced NX)
but this chapter, we can add a 3rd reason
3rd reason for the negative slope of the AD curve
effect of INTEREST RATES
rise in P leads to:
- increase in money demanded
- higher interest rates
this reduces desired investment
rise in P does what do desired investment, via interest rates?
increase in P leads to increase in money demanded
this increase in money demanded leads to higher interest rates
this REDUCES DESIRED INVESTMENT
(one reason why the AD curve is negatively sloped)
long run neutrality of money
shift in the AD curve will lead to DIFFERENT effects in the SHORT versus LONG run
in the long run, output eventually returns to Y*
MONEY NEUTRALITY is the idea that changes in the money supply don’t have real effects on the economy
is the proposition of long run money neutrality debatable?
yes
hysteresis
hysteresis
the growth rate of Y* may be affected by the short run path of real GDP
why?
- a change in money supply (through its effect on the interest rate) can affect INVESTMENT and TECHNOLOGICAL CHANGE
- in long period of unemployment, workers can LOSE HUMAN CAPITAL, and this can affect Y* and its growth rate
if we want a constant interest rate, what must the central bank constantly do?
adjust the money supply
lower interest rates means lower ______ on all bonds…
lower YIELD on all bonds
relationship between the average annual inflation rate and the annual growth rate of money supply
positive
HEADS UP
didn’t get trhough all the slides - review last ones before final (starting aat the one about “Two more propositions (less controversial…)
