4.1 & 4.2 Financial Assets and Real/Nominal Interest Rates

Focus on financial assets and the distinction between nominal and real interest rates.
Aim: Understand money flow in the financial system and the nuances of borrowing costs.

Definition: The financial system connects savers with borrowers.
Savers: Individuals or institutions with surplus cash.
Borrowers: Businesses, governments, and individuals seeking funds for various projects (e.g., factories, highways, homes).
Financial Intermediaries: Institutions, like banks, that facilitate connections between savers and borrowers.
Functionality:
- Money deposited in banks is lent out, creating benefits for savers (interest earnings), borrowers (funding for projects), and banks (profit from the interest spread).

Asset: Anything of value that provides future benefits (e.g., factories, bonds).
Liability: An obligation to pay money in the future (e.g., loans, mortgages).
Perspective: An item can be an asset for one party and a liability for another (Example: A car loan is a liability for the borrower and an asset for the bank).

Real Assets (Physical Assets): Tangible items (e.g., factories, machinery, real estate).
Financial Assets:
- Definition: Contractual claims on something of value.
- Four main types to know for AP Macro:
  - Cash and Bank Deposits: Highly liquid.
  - Bonds: Securities representing a loan made by an investor to a borrower. Bonds are interest-bearing assets.
  - Promise to pay fixed interest and return principal.
  - Liquid and can be resold.
  - Stocks: Represent ownership in a company.
  - Entitlement to a portion of profit and potential appreciation in value.
  - Derivatives: Contracts whose value is derived from an underlying asset (e.g., stocks, bonds, commodities). Used for hedging risk, speculation, and leverage.

Company Example: "Fields Follies" raises money via an initial public offering (IPO).
- Sells 100 shares at $100 each, raising $10,000.
- Shareholder Jacob buys 1 share for $100; after one year, receives $9.99 in dividends and sells the share for $120.
- Total return = Increase in value + Dividends = $20 + $9.99 = $29.99.

Definition: The ease of converting an asset into cash without losing value.
Cash: Perfectly liquid.
Bank Deposits: Nearly as liquid as cash; can withdraw immediately.
Stocks and Bonds: Relatively liquid, often sold quickly, but price may fluctuate.
Physical Assets: Typically illiquid (e.g., selling a house may take months).

More liquid assets may offer lower returns (e.g., cash, checking accounts).
Less liquid assets may provide higher returns (e.g., savings accounts, stocks).
Opportunity Cost of Holding Cash: Example of $100 kept in wallet (0% interest) versus savings account (5% interest), resulting in a $5 opportunity cost if cash is held.

Definition: The opportunity cost of holding wealth as cash.
Role of Banks: Pay interest to savers to compensate for allowing banks to use their funds.
Bonds Explored:
- Features of Bonds:
1. Face Value: Amount paid back at maturity (e.g., $1,000 bond).
2. Maturity: Duration until repayment (e.g., 10 years).
3. Coupon Payments: Payments made at a specified interest rate (e.g., 5% coupon on a $1,000 bond = $50 per year).
Total Return on Bonds: Includes coupon payments and principal repayment.

Concept: When interest rates rise, bond prices fall; when interest rates fall, bond prices rise.
Example: Selling an old bond when new bonds offer higher returns leads to a decrease in the bond's market price to attract buyers.

Nominal Interest Rate: Advertised rate (e.g., 5%, 10%), the rate written into loan agreements.
Real Interest Rate: Adjusted for inflation, the rate that affects purchasing power.
Importance: Inflation erodes the real value of money.
Example: If nominal is 5% and inflation is 5%, purchasing power remains unchanged.
Calculation: Real Interest Rate = Nominal Rate - Inflation Rate.

Banks set nominal rates based on desired real interest and projected inflation.
Example: If a bank wants a 5% real rate and expects 3% inflation the required nominal rate would be 8%.

Principle: When expected inflation increases, nominal interest rates adjust correspondingly, leaving the real interest rate unchanged.
Nominal Interest = Real Interest + Inflation.
Impact of Inflation Surprises: Unexpected inflation benefits borrowers and hurts lenders, while disinflation benefits lenders.

Definition: Nominal interest rates cannot fall below zero.
Concept: Negative rates mean lenders would effectively pay borrowers, which is impractical.
Real interest rates can be negative if inflation exceeds the nominal rate.

Financial system channels savings into investments through financial assets: stocks (ownership) offer dividends, bonds (loans) include principal and interest.
Bond prices inversely correlate with interest rates due to opportunity costs.
Importance of distinguishing nominal and real interest rates, capturing the Fisher Equation, and understanding the implications of expected vs. unexpected inflation.
These principles relate to broader topics like monetary policy, which will be explored further in the course.