Econ Unit 4 Notes

4.1 Financial Assets

Money vs. Wealth

• Money is anything that can be used to purchase goods and services

• Wealth is an accumulation of saving through the purchases of assets (w/ money) that occurs overtime

Financial Assets

• Income generating claims

  • Where the owner can expect income in return

    • demand deposits > checking account for consumer/firm

    • loan > owner of loan (bank) expects income (in the form of interest) from borrower

    • bond > expects interests

    • homes, land, cars, stocks

    • anything that can be sold for income

  • All have different levels for liquidity

• Liquidity

  • Refers to the ease of buying something else with the asset

    • demand deposits/cash

    • saving accounts > liquid but with liquid

    • bonds > can be converted to cash but may be limits

    • homes, cars, land > there is an expectation that time and terms will slow the liquidation process

• How assets hold value

  • it is expected that assets’ value will grow relative to the growth of the aggregate economy and that assets supply and demand in the markets

Banks as the Intermediary

• Getting a loan is less time consuming option

• Loan is asset for bank

  • they expect income

• Loan is a liability to borrower

  • an obligation to pay

Rate of Return

• Investors are attracted to assets with highest rates of return (that earn most interest)

Opportunity Cost of Holding Money

• Holding onto money prevents one from earning interest on an asset

Bonds

• Most commonly issued by the government, but also by companies

  • uses cash to pay for projects and then issues interest

• A bond has a term > the number of years, the bonds earn interest

  • after the term, the bond holder can exchange it or its purchase value and interest

• Bonds play a key role in monetary policy

• The price of previously issued bonds and the interests rate of bonds have an inverse relationship

  • when the interest rate goes up, price of a previous issued bond goes down

  • why? because newly issued bonds are more attractive to investors because it has a higher rate of return

• When interest role goes down, previous bond goes up

  • newly issued bonds less attractive

4.2 Real vs Nominal Interest

Nominal Interest Rates: the price of the money market graph

• The rates advertised by financial institution

• Not adjusted for inflation

Real Interest Rates: the price of loanable funds market graph

• The real rate of return on financial assets or paid back on loans

• Adjusted for inflation

Fisher Effect

• Real rate of return

• Nominal Interest Rate = Real Interest Rate + Inflation

• Real Interest Rate = Nominal Interest Rate - Inflation

Review

• Opportunity cost of holding cash is the interest you could be earning on a financial asset

  • when we invest in a financial asset, we should take into account the real rate of return (including inflation)

Expected vs Unexpected

• Expected Inflation: the real rate of return on the financial asset falls

  • ex: if I want a 5% real rate of return and inflation is 2%, I should invest in assets with a 7% return

    • if inflation is higher than 2% then the real rate of return will be less than 5%

    • real value of assets fall

Unexpected vs Unanticipated Inflation:

• Lenders, borrowers, savers are making decisions based on expected or anticipated inflation

• If actual inflation is less than or greater than expected inflation, RIR changes

  • lender/borrower can benefit depending on actual inflation

Higher Unanticipated Inflation

• Borrowers are better off

  • pay back loan with dollars of less value

• Lenders are worse off

  • are paid back with dollars with less value

    • RIR is lower then expected

Lower Unanticipated Inflation

• Borrowers are worse off

• Lenders benefit

4.3 Definitions, Measurements and Functions of Money

Money is…

• An asset that is accepted as a means of payment

• US dollar is fiat money

  • not based on anything physical > we all agree it has value

• Real value of money is in what it can purchase

3 Functions of Money

• Unit of Account

  • idea that people accept money in a means to set prices

• Store of Value

  • holds purchasing power over time

  • inflation hurts the ability for money to store value over time

  • ex: sock drawer/backyard

• Medium of Exchange

  • used to exchange goods and services

  • barter economies

    • takes time and energy to exchange goods

  • in money economies, the economy is able to grow faster cause exchange isn’t difficult

Money Supply

• M0 > Monetary Base

  • Currency + Circulation/Bank Reserves

• M1 > Currency, Demand Deposit, and Saving Accounts

  • larger than M0

• M2 > M1 + Certificates of Deposit + Money Market Funds

• M3 > M1+M2 + Longer CD’s + Larger Liquid Assets

• Money Supply = M0 + M1, the most liquid money