ECON1102 Lecture Notes - Lecture 7: Nominal Interest Rate, Commodity Money, Money Supply
18 May 2018
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6 – Financial Assets, Money and Private Banks
Financial system
• What happens to private saving? (S = Y – T – C)
Currency, bank deposits, stocks/shares/equities, bonds, other assets
Lenders (saver) → Financial system (intermediation) → Borrower (investor)
Asset prices and yields
• The yield o a fiaial asset is iversely related to the assets prie
• Return = [Pricet+1 + Payoff] / Pricet
Other things equal, an increase in price today implies a decreased return
Bonds: legally enforceable promise to re-pay a debt
• Government bonds and corporate bonds
• Term of bond (maturity) – length of time before bond must be repaid
• Principal – amount that needs to be repaid at maturity
• Coupon payment – regular dollar payment of interest on the bond
• Coupon rate = (Coupon payment) / Principal
• Bond prices and interest rates
Bonds do not have to be held until maturity, but can be bought and sold (traded)
on the bond market
Bond prices and interest rates are inversely related – interest rate = PV
General formulas
• N-period bond: PV = C1 / (1 + i) + C2 / (1 + i)2 + … + CN / (1 + i)N
• Perpetuity (no maturity date): PV = C / i
Functional definition of money
• Medium of exchange – good or asset whose primary purpose is to purchase goods
Increases efficiency of trade
Why not trade directly for goods (i.e. Barter)?
(a) Double coincidence of wants
(b) With medium of exchange, each person sell their goods for medium of
exchange and uses medium of exchange to buy goods they want
Monetary economies
(a) Commodity money: money has some intrinsic value, or convertible to
commodity on demand
(b) Fiat money: oey has o itrisi value, delared legal teder y
government; not convertible into other commodity on demand
• Unit of account – good that is used to compare the value of all other goods and
services
Standard to use medium of exchange as the unit of account
(a) Exception: Haitian dollar – used to indicate prices but not physical form
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2
• Store of value – good or asset that serves as a means of holding (or transferring)
wealth over time
Transfer purchasing power from today into some future period
Disadvantage: low (or zero) nominal return compared to other assets
Advantages: money as medium of exchange is perfectly liquid
(a) Nominal price of money is fixed, so no possibility of capital loss (or gain)
• Many goods and assets can serve as a store of value (e.g. land, bonds, stocks) but do
not possess the medium of exchange or unit of account functions of money
Measuring money
• In modern economies, money provided by:
Government (currency – notes and coin)
Banking system (deposits – accounting)
• Definitions of money measures
Currency = notes and coin on issue (less what is held by RBA and banks)
M1 = currency + current deposits at banks
M3 = M1 + all other bank deposits of non-bank private sector
Broad money = M3 + borrowings from private sector by non-bank depository
corporations (less what these non-banks hold with banks)
Demand for money
• Focus on transactions demand for money (M)
• Demand to hold a certain level or stock of money
MD = P x L (Y, i)
(a) L (.) is some unspecified function
• Factors likely to influence the quantity of money demanded for making transactions:
Value of transactions (i.e. volume x price)
(a) Real GDP (Y) as a proxy for volume of transactions
i. Other things equal, an increase in Y will increase demand for money (M)
(b) Aggregate price level (P)
i. Other things equal, an increase in P will increase demand for M
(Opportunity) cost of holding money
(a) Money that is held to make transactions pays zero or low interest rate
(b) Nominal interest rate you could have earned by holding a bond
i. Nominal interest rate (i) – increase in i will reduce demand for M
Transactions technology
(a) Effects on composition of M
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Document Summary
6 financial assets, money and private banks. Financial system: what happens to private saving? (s = y t c) Currency, bank deposits, stocks/shares/equities, bonds, other assets. Lenders (saver) financial system (intermediation) borrower (investor) Asset prices and yields: the yield o(cid:374) a fi(cid:374)a(cid:374)(cid:272)ial asset is i(cid:374)versely related to the asset(cid:859)s pri(cid:272)e, return = [pricet+1 + payoff] / pricet. Other things equal, an increase in price today implies a decreased return. Bonds do not have to be held until maturity, but can be bought and sold (traded) on the bond market. Bond prices and interest rates are inversely related interest rate = pv. General formulas: n-period bond: pv = c1 / (1 + i) + c2 / (1 + i)2 + + cn / (1 + i)n, perpetuity (no maturity date): pv = c / i. Functional definition of money: medium of exchange good or asset whose primary purpose is to purchase goods.
