CHAP 12

• Categories of financial wealth

  • money
  • bonds
• Money


  All assets that serve as a medium of exchange ‒ paper money, coins, and bank deposits that can be transferred on demand by cheque or electronic means
• Bonds


  All other forms of financial wealth, which includes interest-earning financial assets and ownership shares in firms
• Present value (PV)

  Discounted present value
• Calculating present value


  PV = R1 /(1+i)

  
  

  R1 = amount we receive in 1 year from now

  i = annual interest rate
• A higher market interest rate

  Leads to a lower present value

  
• A 3-year bond promises to repay the face value of $1000 in 3 years and will also pay a 10% coupon payment of $100 at the end of each of the 3 years

  How much is this bond worth now if the market interest rate is 7 percent?

  PV = sum of R/ (1 + i)^T = 262.43
• The present value of any bond that promises one or more future payments is negatively related to the market interest rate
• Equilibrium market price of a bond

  The present value of the income stream that it produces
• An increase in the market interest rate

  Leads to a fall in the price of any given bond
• A decrease in the market interest rate

  Leads to an increase in the price of any given bond
• Cost of investment

  The price of the bond
• Return on the investment


  Sequence of future payments
• A lower bond price


  Implies a higher rate of return on the bond, or a higher bond yield
• Market interest rates and bond yields

  Tend to move together
• An increase in the riskiness of any bond

  Leads to a decline in its expected present value and to a decline in the bond’s price
• It is rare in Canada that government bonds are perceived as risky
• Some bonds issued by some southern European countries have been viewed as high-risk assets
• Demand for money


  The amount of money that everyone (collectively) wants to hold at any time
• Reasons firms and households hold money

  • Transactions demand for money
  • Precautionary demand for money
  • Speculative demand for money
• The demand for money

  Is assumed to be negatively related to the interest rate

  
• The demand for money

  Is assumed to be positively related to real GDP (for any given interest rate)

  
• The demand for money

  Is assumed to be positively related to the price level (for any given interest rate)

  
• An increase in the interest rate

  Increases the opportunity cost of holding money and leads to a reduction in the quantity of money demanded

  
• An increase in real GDP

  Increases the volume of transactions and leads to an increase in the quantity of money demanded
• An increase in the price level

  Increases the dollar value of a given volume of transactions and leads to an increase in the quantity of money demanded
• Money transmission mechanism

  1. Changes in demand/supply of money cause change in equilibrium interest rate

  2. Change in equilibrium interest rate leads to change in desired investment and consumption expenditure

  3. Change in desired aggregate expenditure leads to shift in AD curve and changes in real GDP and price level
• Money is clearly not neutral in the short run
• Long-run money neutrality

  Y* is unaffected by changes in the money supply
• The proposition of long-run money neutrality is debatable
• Hysteresis is the possibility that the short-run path of GDP may have an influence on Y
• A change in the money supply

  Can affect investment and technological change
• In a long period of unemployment

  Workers can lose human capital, which can affect Y* and its growth rate
• 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
• The debate between Keynesians and Monetarists is over
• Empirical research suggests that money demand is relatively insensitive to changes in the interest rate
• The MD curve is quite steep and, as a result, changes in the money supply cause relatively large changes in interest rates
• There is no consensus on whether the ID curve is steep or flat
• • The present value of a bond is the most someone would be willing to pay now to own the bond’s future stream of payments