Week_8_-_Money__Interest_Rate

Week_8_-_Money__Interest_Rate - 1 ECMA06 Money &...

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1 Money and Interest Rate Outline What money means in economics? The cost of holding money and the demand for money. The relationship between bond prices and interest rates. The inverse relationship between interest rate and investment – a revisit. The relationship between money supply, interest rate, investment. How does the central bank affect the money supply?
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2 What “Money” Means in Economics? Money is the most liquid asset 1 and it can be used to hold our wealth. Obviously, we can hold our wealth in other less liquid assets such as real estate, cars and etc. In economics , the phrase “we have a lot of money” means we have chosen to hold a larger portion of our wealth in the form of liquid asset. For everyone else , the phrase “we have a lot of money” means we are wealthy. 1 An asset is said to be very liquid if it can easily converted into goods and services (i.e., easy to buy stuffs).
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3 The Cost of Holding Money and the Demand for Money The Cost of Holding Money The opportunity cost of holding money is the interest rate. Why? To some extent, the choice to hold money is a choice among different assets. When we decide to hold our wealth in the form of money, we give up the opportunity to hold our wealth in other form of assets. The value of money DOES NOT “grow” and give us any interest. (Think about what happens if you put a $100 bill under your pillow tonight and then take it out a year later, it is the same $100) However, other assets such as bonds give us a return such as interest. Therefore, the opportunity cost of holding money is the interest rate (the rate of return we could have earned if we hold our wealth in the form of bonds and etc.). Question: What happens to the cost of holding money when interest rate rises?
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4 Answer: The Demand for Money The demand for money (MD) depends on: 1) Income, Y We hold money to facilitate our daily purchases. Holding all else constant, when Y , our purchases of goods and services demand for money . There is a positive relationship between Y and MD.
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5 2) Interest rate, r Holding all else constant, when r , cost of holding money demand for money . There is a negative relationship between r and MD. In notation form: MD = demand for liquidity = L(r, Y) Note: In economics, we also call the demand for money as a demand for liquidity because money is the most liquid asset in the economy. If we want to hold more money, this means we want to hold more liquid assets.
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6 The Relationship between Bond Prices and Interest Rates Assumptions: 1) There are only two assets in the economy: cash and bonds. 2)
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Week_8_-_Money__Interest_Rate - 1 ECMA06 Money &...

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