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    Money: - What Is Money? - 3 Distinguishing Features of Money

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    abissembay
    This document defines money and describes its key features as a medium of exchange, unit of account, and store of value. It discusses different forms of money like commodity, fiat, and electronic money. It also explains how interest rates are determined in financial markets using models like the loanable funds and liquidity preference frameworks which analyze the supply and demand of bonds and money. Factors that shift the supply and demand curves for bonds and money are outlined. The term structure of interest rates and theories to explain it like the expectations hypothesis are also summarized.

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    Money: - What Is Money? - 3 Distinguishing Features of Money

    Uploaded by

    abissembay
    26 views46 pages
    This document defines money and describes its key features as a medium of exchange, unit of account, and store of value. It discusses different forms of money like commodity, fiat, and electronic money. It also explains how interest rates are determined in financial markets using models like the loanable funds and liquidity preference frameworks which analyze the supply and demand of bonds and money. Factors that shift the supply and demand curves for bonds and money are outlined. The term structure of interest rates and theories to explain it like the expectations hypothesis are also summarized.

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    Money

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    This document defines money and describes its key features as a medium of exchange, unit of account, and store of value. It discusses different forms of money like commodity, fiat, and electronic money. It also explains how interest rates are determined in financial markets using models like the loanable funds and liquidity preference frameworks which analyze the supply and demand of bonds and money. Factors that shift the supply and demand curves for bonds and money are outlined. The term structure of interest rates and theories to explain it like the expectations hypothesis are also summarized.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    26 views46 pages

    Money: - What Is Money? - 3 Distinguishing Features of Money

    Uploaded by

    abissembay
    This document defines money and describes its key features as a medium of exchange, unit of account, and store of value. It discusses different forms of money like commodity, fiat, and electronic money. It also explains how interest rates are determined in financial markets using models like the loanable funds and liquidity preference frameworks which analyze the supply and demand of bonds and money. Factors that shift the supply and demand curves for bonds and money are outlined. The term structure of interest rates and theories to explain it like the expectations hypothesis are also summarized.

    Copyright:

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    Download as ppt, pdf, or txt
    of 46

    MONEY

    What is Money? 3 Distinguishing Features of Money:


    .Medium Of exchange .Unit of Account .Store of Value

    Medium of Exchange
    Facilitates efficient economic transactions Advantage over Barter Economy:
    Double Coincidence of Wants Not Necessary Promotes Specialization & Division of Labor

    Unit of Account
    Measure of Value in the Economy Common Yardstick to Value Different Goods and Services

    Store of Value
    Enables agents to shift consumption across time, i.e., save now, consume later. Other financial & Non-financial assets may also have this property. Money is distinguished by its Liquidity. Money is unattractive as a store of value in an inflationary environment.

    Forms of Money
    Commodity Money: Money that is inherently valuable, e.g., Gold & Silver Paper Money: Initially paper money used to be convertible into an equivalent amount in precious metals. More recently, no such convertibility : fiat money. Checkable Deposits: Convenient, Safe & Useful for Large Transactions Electronic Money: Debit Cards, Wire Transfers (FedWire, Clearing House Interbank Payments System)
    Efficient Concerns about Safety & Security

    How Do We Measure Money?


    Different Measures of Money Depending Upon What is Included and What is Not. Usual Criterion for Qualifying as Money: Acceptability as Medium of Exchange

    M1
    Also known as Narrow Money Includes
    Currency Travelers Checks Demand Deposits Other Checkable Deposits

    M2
    Also known as Broad Money Includes
    M1 Small Denomination Time Deposits Savings & Money Market Deposits Non-Institutional Shares in Money Market Mutual Funds Overnight Repos Overnight Eurodollar Deposits

    M3
    Includes
    M2 Large Denomination Time Deposits Institutional Shares in Money Market Mutual Funds Term Repos Term Eurodollar Deposits

    L
    Includes
    M3 Short Term Treasury Securities Commercial Paper Savings Bonds Bankers Acceptances

    DETERMINATION OF INTEREST RATES


    How are Interest Rates determined by the Market ? 2 Analytical Frameworks:
    Loanable Funds Framework Liquidity Preference Framework

    Loanable Funds Framework


    Supply & Demand for Bonds Supply of Bonds is Equivalent to Demand for Loanable Funds. Similarly, Demand for Bonds is equivalent to Supply of Loanable Funds Therefore, Demand-Supply Analysis for Bonds is equivalent to Demand-Supply Analysis for Loans

    Demand for Bonds


    As Bond Prices Increase, Demand for Bonds Declines But Higher Bond Prices Imply Lower Interest Rates Therefore, as Interest Rates Increase, Demand for Bonds Increases

    Given the equivalence between Bonds Market Analysis and Loans Market Analysis, these figures can be represented as
    The equilibrium interest rate is determined at the level at which Demand equals Supply

    Changes in Equilibrium Interest Rates


    Distinction between movement Along a Curve and Shifts in a Curve: Change in quantity caused by a change in price, or interest rate: Movement along the curve Change in quantity caused by a change in any other factor: Shift in the curve

    Example of a Shift in the Demand Curve


    People Want to buy more bonds At every price (interest rate) level, more bonds are demanded than before

    Shifts in demand for bonds occur due to changes in


    Wealth
    When Aggregate Wealth in the Economy Increases, people have more money to invest in Financial Assets Demand for Bonds Increases, i.e., Bond Demand Curve Shifts to the Right

    Shifts in demand for bonds occur due to changes in


    Expected Returns on Bonds Relative to Other Assets
    When interest rate increases relative to other asset returns, people invest more in bonds Demand for Bonds Increases, i.e., Bond Demand Curve Shifts to the Right

    Shifts in demand for bonds occur due to changes in


    .Risk of Bonds Relative to Other Assets
    When Bond Riskiness increases, people move investments away from bonds into other assets Demand for Bonds Decreases, i.e., Bond Demand Curve Shifts to the Left

    Shifts in demand for bonds occur due to changes in


    .Liquidity of Bonds Relative to Other Assets
    When Bond Liquidity increases, people invest more in bonds Demand for Bonds Increases, i.e., Bond Demand Curve Shifts to the Right

    Shifts in the supply of bonds occur due to


    Expected Profitability Opportunities of Investment
    When expected profitability of investment opportunities increases, firms want to make bigger investments. To finance these increased investments, more bonds are issued. Therefore, the supply curve for bonds shifts to the right.

    Shifts in the supply of bonds occur due to


    Expected Inflation
    When inflation is expected to be high, the real rate of interest is expected to be low. Therefore, firms want to borrow more. This shifts the bond supply curve to the right.

    Shifts in the supply of bonds occur due to


    Government Activities
    Increased government activities imply increased government spending which has to be financed by issuing more Treasury debt. Thus the bond supply curve shifts to the right.

    Changes in Equilibrium Interest Rates


    Changes inflation: in expected
    Bond Demand Curve shifts to the Left Bond Supply Curve shifts to the Right Interest Rate Increases Fisher Effect

    Changes in Equilibrium Interest Rates


    Business Cycle Expansions
    Bond Demand Curve shifts to the Right Bond Supply Curve shifts to the Right Quantity of Bonds Increases Interest Rate may Increase or Decrease Empirical evidence indicates that interest rate increases

    Liquidity Preference Framework


    Alternative Method for determining Interest Rates Closely related to (alternative representation of) the Loanable Funds framework

    Basic Assumption: All individuals hold their wealth either as interest earning assets (bonds) or as non-interest earning cash. Bonds are desirable because of the interest they earn Cash is desirable because of the liquidity.

    Therefore, allocation between bonds and money represent a trade-off between interest income and liquidity demands.

    Demand Curve for Money


    If interest rates are high, more wealth will be held in bonds If interest rates are low, more wealth will be held as liquid money, because the opportunity cost, i.e., the income foregone, is low.

    Supply Curve for Money


    Supply of Money is Unilaterally fixed by the Central Bank. For USA, it is the Federal Reserve System.
    At equilibrium, money demand = money supply

    Shifts in Demand for Money


    Income effect: Increase in income increases the amount of money individuals want to hold. Therefore, an increase in GNP/Income shifts the money demand curve to the right. Price Level Effect: Increases in price levels reduce the real value of money. Therefore, more money is held by individuals, thus shifting the money demand curve to the right.

    Shifts in Supply of Money


    Supply of money is controlled by the Federal Government through the Central Bank. Money Supply is thus an important tool used by the Fed in trying to control the economy.

    Changes in Equilibrium Interest Rates


    Changes in Income
    Money demand curve moves to the right Money supply curve remains at previous level Interest rate increases

    Changes in Equilibrium Interest Rates


    Changes in price level
    Money demand curve moves to the right Money supply curve remains at previous level Interest rate increases

    Changes in Equilibrium Interest Rates


    Changes Supply in Money

    Money demand curve remains at previous level Money Supply curve shifts to the right Interest rate decreases.

    Impact of changes in Money Supply on Interest Rates has been a topic of controversy. In addition to the direct liquidity effect above, other effects have also been hypothesized. Income Effect: Increase in money supply increases demand for money and thus shifts the demand curve to the right, thereby increasing interest rates. Price-level Effect Expected Inflation Effect These 3 effects work against the liquidity effect on the direction of interest rate movements. In reality, the final outcome depends upon which effect is stronger and which one comes into play earlier.

    TERM STRUCTURE OF INTEREST RATES


    Bonds which are otherwise identical but have different maturities have different yields-tomaturity (YTM). Yield Curve: Curve depicting YTM of par bonds as a function of their maturities.

    Term Structure: Curve depicting the yields on Zero-Coupon Bonds as a function of their maturities. Yield Curves and Term Structures take on a variety of shapes: upward sloping, downward sloping, flat, humped, inverted humped, etc. Most often, however, the Yield Curve is upward sloping.

    What explains the shape of the Yield Curve?


    Expectations Hypothesis Preferred Habitat Hypothesis Liquidity Preference Hypothesis.

    Expectations Hypothesis
    The interest rate on a long term bond equals the average of short-term interest rates that people expect to occur over the life of the long-term bond. Example: The interest rate on a 5 year bond will equal the average of interest rates on the 5 successive 1 year bonds starting today.

    Expectations Hypothesis
    Upward sloping Yield Curve denotes the markets expectation that short-term interest rates will rise in the future Downward sloping Yield Curve denotes the markets expectation that short-term interest rates will decline in the future Flat Yield Curve denotes the markets expectation that short-term interest rates will remain stable in the future.

    Expectations Hypothesis
    Simple theory that explains the empirically observed phenomenon of interest rates of different maturities moving together over time. However, it is difficult to explain the fact that the Term Structure is upward sloping most of the time. This would seem to indicate that short term interest rates should be rising most of the time. However, in an efficient market, they should be as likely to move up as down. This is a serious weakness of the Expectations Hypothesis.

    Preferred Habitat Hypothesis


    The market for bonds of each maturity is largely separate and segmented from the markets for bonds of all other maturities. The equilibrium interest rate in each maturity bond market is established by demand and supply in that market alone, with absolutely no across-market effects.

    Preferred Habitat Hypothesis


    Not a very satisfactory theory. Does not explain the smooth nature of observed Yield Curves Does not explain the comovements of several interest rates.

    Liquidity Preference Hypothesis


    The interest rate for a long term bond equals the average of short-term interest rates expected to occur over the life of the long-term bond plus a term premium that depends upon demand and supply for bonds of that term.

    Liquidity Preference Hypothesis


    Emphasis on liquidity: Investors prefer to hold more liquid, i.e., shorter term bonds. Therefore, they need a higher return, or a term premium, on longer term bonds. Satisfactory explanation for the normally observed upward sloping nature of the term structure.

    Liquidity Preference Hypothesis


    A sharply upward sloping Yield Curve denotes the markets expectation that short-term interest rates will rise in the future A flat or downward sloping Yield Curve denotes the markets expectation that short-term interest rates will decline in the future A moderately upward sloping Yield Curve denotes the markets expectation that short-term interest rates will remain stable in the future.

    Synthesis of the previous two theories.

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