Lecture Notes on Economy and Financial Sector

Financial Sector and Real Economy

• The real economy involves the production and exchange of goods and services.
• The financial sector involves the creation and exchange of financial assets.
• Financial assets include money, stocks, and bonds.
• A functioning financial sector is crucial for organizing and coordinating an economy.

Links Between the Economy and Financial Sector

• Interest rates serve as the primary link between the real economy and the financial sector.

Demand for Money and Interest Rates

• There is an inverse relationship between the quantity demanded for money and interest rates.
• When interest rates increase, the quantity demanded for money decreases, and vice versa.
• The quantity of money in the system is typically fixed.

Types of Money Supply

• Fixed Supply of Money: The amount of currency in the system is fixed. Increasing the supply of money leads to a decrease in interest rates.
• Loanable Funds: This refers to the money available for lending, which varies with interest rates.
• The loanable Funds can shift due to money migrating from other countries based on relative interest rates.
• Increased loanable funds put downward pressure on interest rates; decreased loanable funds increase interest rates.

Interest Rate as Rent for Money

• Interest rate is essentially the rent for money, similar to renting any other asset like an apartment or a car.
• The percentage paid by the borrower for the money is the interest rate.
• This percentage grants the borrower the right to use the money as agreed.
• Borrowing money is analogous to leasing an asset for a specified period.

Businesses, Consumers, and Demand for Money

• Businesses are primary borrowers, using funds for projects, employee payments, and expansion.
• Lower interest rates encourage businesses to borrow and invest, effectively turning borrowing into investment.
• Consumers also borrow money when interest rates are low, mainly for residential housing and personal expenses (e.g., buying refrigerators or cars).
• Increased demand for money, driven by lower interest rates, comes from both businesses and consumers, contributing to increased aggregate expenditure.

Impact of Interest Rates on Aggregate Expenditure

• Decreasing interest rates leads to increased investment expenditure.
• Increase investment expenditure increases overall aggregate expenditure.
• Graphically, this results in a shift of the aggregate demand curve to the right.
• This shift can help an economy move from a recessionary gap towards full employment.
• Financial markets, by influencing interest rates, can stimulate the economy similarly to government fiscal policies.

Financial Assets

• Stocks: Represent ownership in a company.
• Bonds: Represent lending money to an entity.
• Derivatives: Financial instruments like options and futures.
• Loans and Receivables: Loans are assets for banks; receivables are receipts of future payments (e.g., Intel selling chips to HP with payment due later).
• Certificate of Deposit (CD): A bank deposit with a special contract where the money is lent to the bank for a fixed period.
• Bank Deposit: Money deposited in a bank account.
• Cash or Cash Equivalent: Actual currency in circulation or assets easily convertible to cash.

Bonds in Detail

• Types of bonds: Municipal bonds, corporate bonds, and treasury bonds.
• Municipal Bonds: Issued by state, county, and city governments.
• Corporate Bonds: Issued by businesses.
• Treasury Bonds: Issued by the U.S. federal government.
• Treasury Bills (T-bills): Maturity less than one year.
• Treasury Notes (T-notes): Maturity between one and ten years.
• Treasury Inflation-Protected Securities (TIPS): Protect against inflation.
• Treasury Bonds: Maturity greater than ten years.
• Bonds can be given as birthday gifts, ensuring funds for college.

Bond Prices and Interest Rates

• Bond prices have an inverse relationship with interest rates.
• Face value is the amount written on the bond certificate; bond price is what it can be sold for in the market.
• If a person buys a bond for $1,000$ with a $50$ annual interest (5% interest rate) for three years, they receive $50$ each year and $1,000$ at the end of the term.
• If interest rates change, the bond's market price fluctuates.
• Formula for bond price: $PP = \frac{Annual \, Interest}{Current \, Interest \, Rate}$
• Inverse relationship: Bond prices drop when interest rates increase and rise when interest rates decrease.

Examples Demonstrating Bond Price and Interest Rate Relationship

• Scenario 1: Interest rate rises to 10%. Bond price = 50 / 0.10 = $500. The bond's value decreases.
• Scenario 2: Interest rate drops to 1%. Bond price = 50 / 0.01 = $5,000. The bond's value increases significantly.
• Professionals specialize in bond trading, profiting from predicting interest rate movements.

Rationale Behind the Inverse Relationship

• Consider two identical office buildings: Building A is leased for $100,000 per month for ten years; Building B is vacant.
• If the rental market in San Francisco increases, Building B can be leased at a higher rate, making it more valuable than Building A.
• If the rental market decreases, Building A's fixed lease makes it more valuable than Building B.
• The building's value has an inverse relationship with the rental market.
• Analogy to bonds: The bond's value changes based on prevailing interest rates – the “rent” for money.
• As interest rates go up, the price of the bond goes down, reflecting the inverse relationship.