unit 4: financial assets

financial sector

network of institutions that link borrowers and lenders. includes banks, mutual funds, pension funds, and other financial intermediaries.

assets

anything tangible and intangible that has value.

interest rate

the amount a lender charges borrowers for borrowing money; the “price” of a loan

interest-bearing assets

assets that earn interests over time (i.e. bonds)

personal finance

the way individuals and families budget, save, and spend

investment

business spending on tools and machinery (note: a low interest rate will increase investment)

liquidity

the ease with which an asset can be converted to a medium of exchange. in general, the higher the liquidity, the lower the rate of return.

bonds (aka securities)

loans, or IOUs, that represent debt that the government, businesses, or individual must repay to the lender. (note: a bond holder has no ownership of the company, and is paid interest)

stocks (aka equities)

represent ownership of a corporation and the stockholder is often entitled to a portion of the profit paid out as dividends.

do the interest rates of bonds change throughout the life of the bond?

no; bonds are issued at a specific interest rate that will not change throughout the life of the bond.

bonds can be sold before they _______.

mature

what type of relationship do bond prices and interest rate have?

inverse

real interest rates

the percentage increase in purchasing power that a borrower pays (adjusted for inflation)

real interest rates equation

real interest rate = nominal interest rate - expected inflation

nominal interest rates

the percentage increase in money that the borrower pays (not adjusted for inflation)

nominal interest rates equation

nominal interest rate = real interest rate + expected inflation

formula to calculate future value

$X (1 + ir)^N

formula to calculate present value

$X / (1 + ir)^N

present value

the current worth of some future amount of money

the barter system

goods & services are traded directly (no money is exchanged)

problems with the barter system

• before the trade could occur, each trader must have something that the other person wants (double coincidence of wants)

• some goods cannot be split

money

anything that is generally accepted as payment for goods & services

wealth

the total collection of assets

income

a flow of earnings per unit of time

commodity money

something that performs the function of money and has intrinsic value (i.e. gold, silver, cigarettes)

flat money

something that serves as money but has no other value or uses (i.e. paper money, coins, digital currency)

the three functions of money

• a medium of exchange

• a unit of account (measure of value)

• a store of value

a medium of exchange

money can easily be used to buy goods and services with no complications of barter system

a unit of account / measure of value

money measures the value of all goods and services; money acts as a measurement of value

a store of value

money allows you to store purchasing power for the future

what backs the money supply?

there is no gold standard. money’s value comes from our belief that it is valuable.

what makes money effective?

• generally accepted

• scarce

• portable & dividable

generally accepted

buyers and sellers have confidence that it is legal tender

scarce

money must not be easily reproduced

portable and dividable

money must be easily transported and divided

purchasing power of money

the amount of goods and services a unit of money can buy

inflation

decreases purchasing power

hyperinflation

increases purchasing power

M1 (highest liquidity)

• currency in circulation

• checkable bank deposits (checking accounts)

• savings deposits (money market accounts)

M2 (near-moneys)

• includes everything in M1

• time deposits (CDs = certificates of deposit)

• money market funds

fractional reserve banking

when banks hold a portion of deposits to cover potential withdrawals and then loan the rest of the money out

the money multiplier

1 / reserve requirement (ratio)

demand deposits

money deposited in a commercial bank in a checking account

required reserves

the percent that banks must hold by law

excess reserves

the amount that the bank can loan out

balance sheet

a record of a banks assets, liabilities, and net worth

asset

something you own

liability

something you owe

transaction demand for money

people hold money for everyday transactions

asset demand for money

people hold money since it is less risky than other assets

what is the opportunity cost of holding money in your pocket or checking account?

the interest you could be earning from other financial assets like stocks, bonds, and real estate.

what is the relationship between the interest rate and the quantity of money demanded?

inverse

when interest rates increase, the quantity of money demanded…

falls; individuals would prefer to have interest-earning assets instead

when interest rates decrease, the quantity of money demanded…

increases; there is no incentive to convert cash into interest-earning assets

money demand shifters

changes in…

• price level

• income

• technology

the supply for money

the u.s. money supply is set by the central bank and is independent from the interest rate

monetary policy

the Fed is a nonpartisan government office that adjusts the money supply to influence the economy

effects of increasing the money supply…

• decreased interest rate

• increased investment

• increased AD

effects of decreasing the money supply…

• increased interest rate

• decreased investment

• decreased AD

money supply shifters

• the reserve requirement (ratios)

• the discount rate

• open market operations

fractional reserve banking

only a small percent of your money is held in reserve. the rest of your money has been loaned out

the reserve requirement

the percent of deposits that banks must hold in reserve (the percent the can NOT loan out)

if there is a recession, the Fed should…

decrease the reserve ratio

• banks hold less money and have more excess reserves

• banks create more money by loaning out excess

• money supply increases, interest rates decrease, AD increases

if there is inflation, the Fed should…

increase the reserve ratio

• banks hold less money and have more excess reserves

• banks create less money

• money supply decreases, interest rates increase, AD decreases

the discount rate

the interest rate that the central bank charges commercial banks

to increase the money supply, the Fed should…

decrease the discount rate

to decrease the money supply, the Fed should…

increase the discount rate