CH 28 - Money, Interest Rates & Economic Activity

CH 28 - Money, Interest Rates & Economic Activity -...

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CHAPTER 28 28.1 UNDERSTANDING BONDS PRESENT VALUE + INTEREST RATE: Present Value (PV) = the value now of one or more payments or receipts made in the future o Single Payment = R 1 [1 + i] o Sequence of Future Payments = R 1 + R 2 + …. + R T [1 + i] [1 + i] 2 [1 + i] T PRESENT VALUE + MARKET PRICE: The PV of any bond that promises to pay some sequence of payments in the future is negatively related to the market interest rate. A bond’s PV determines its market price = a negative relationship between the market The PV of a bond is the most someone would be willing to pay now to own the bond’s future stream of payments The equilibrium market price of any bond will be the PV of the income stream that it produces INTEREST RATES, MARKET PRICES + BOND YEILDS: Two relationships that link between the market interest rate + bond prices: o The PV of a bond is negatively related to the market interest rate o A bond’s equilibrium market price will be equal to its PV Key Relationship = an increase in the market interest rate leads to a fall in the price of any given bond. A decrease in the market interest rate leads to an increase in the price of any given bond An increase in the market interest rate will reduce bond prices and increase bond yields. A reduction in the market interest rate will increase bond prices and reduce bond yields. Therefore, market interest rates + bond yields move together BOND RISKINESS: The yield on a bond is the rate of return the bondholder receives, having bought the bond at its purchase price and then receiving the stream of future payments, the bond offers o For a given stream of future payment, a lower purchase price implies a higher bond yield An increase in the perceived riskiness of bonds will lead to a reduction in bond prices and thus an increase in bond yields. o These changes are associated with investors’ adjustment of their portfolios out of bonds and toward money An increase in the riskiness of any bond leads to a decline in its expected PV and thus to a decline in the bond’s price. The lower bond price implies a higher bond yield 28.2 THE DEMAND FOR MONEY Demand for Money = the total amount of money balances that the public wishes to hold
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for all purposes No matter why money is held, the cost of doing so is the interest hat could have been
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This note was uploaded on 04/18/2008 for the course ECON 295 taught by Professor Ragan during the Spring '08 term at McGill.

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CH 28 - Money, Interest Rates & Economic Activity -...

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