Money’s Economic Function/Creation, Interest Rates/Bond Prices, Time Value of Money
What is Money?
Anything that’s commonly used to buy & sell goods/services. Money is referred to as currency if it is the dominant circulating medium of exchange.
3 Important Economic Functions (or Characteristics) of Money
- Is it a good medium of exchange? Can you use it as a method of payment for products?
- Is it a store of value? Can you store it & use it later?
- Bitcoin is not a valid store of value since its worth is extremely volatile over time. This is why it’s not considered money.
- Is it a unit of account? Does it work as an objective measure of cost/value?
2 Alternatives to Money
- Not exchanging products: Everything that is needed by an individual is made by themselves.
- Problem: Doesn’t realize the benefits of specialization.
- Bartering: When products are exchanged for each other rather than for an intermediate good (money).
- Problem: It’s not always the case that a person will always have the product that another person desires.
- Problem: It’s difficult to price things, and keep track of the relative value of all the goods. This wastes time.
What are Commodity Monies?
Something that is used as money that has value other than its use as money. Dollar bills can’t be used in anything other than its use of money, but cattle can.
What are Fiat Monies?
A government declares that something is money & the citizens use it as money. Basically, it’s money because the government says so. For example, the Canadian government has defined the Canadian dollar as legal tender (courts will enforce the settlement of any debt repaid with dollars). However, the dollar is valuable only because people believe it is valuable.
What Do We Use as Money?
Currency, checking/saving account deposits, & certificates of deposits (like saving accounts, except with penalties for withdrawals). Credit cards are a lot like checks themselves – a means of transferring money. Normally stocks & bonds are not included because they must be changed into something (money) that can be used to buy products.
Definitions of the Money Supply
- Monetary Base (MB) - The monetary base is currency in circulation plus any deposits at the Federal Reserve, which has complete control over this quantity.
- M(1) - The sum of currency in circulation, plus checking account deposits, demand deposits, and negotiable order of withdrawal (NOW) accounts. The most liquid type of money supply.
- M(2) - The sum of currency in M(1) plus savings accounts, money market mutual funds, small denomination (less than $100k) time deposits and certificates of deposit (CDs). Slightly less liquid than M(1).
What are Certificates of Deposits (CDs)?
A Certificate of Deposit (CD) is a savings certificate that states the value of the certificate and when it can be traded in for money. An investor purchases a CD with an interest rate for a fixed amount of time. At the end of that time, the investor can withdraw the initial deposit and interest earned on the CD. If the CD is less than $100,000, it is called a small CD or a small-time deposit. If it is greater than $100,000, it is called a large or jumbo CD. If the CD is withdrawn early, meaning before the end of the agreement, then the owner will have to pay a penalty. The Federal Reserve includes small-time deposits in M2.
What is an Individual Retirement Account (IRA)?
An Individual Retirement Account (IRA) is a savings account that accrues interest and generally cannot be withdrawn until the owner of the account is of retirement age. If the owner withdraws the money early, he or she is heavily taxed and must pay a penalty. For this reason, money market accounts held in IRA’s are not included in M2.
Banking & The Creation of Money
How Do Banks ‘Create’ Money?
Banks use funds they accumulate from depositors to make loans. However, they can’t use all their funds due to laws surrounding reserves (currency in a bank vault or deposits a bank keeps with the Federal Reserve). Banks must follow required reserve ratios which dictate the percentage of funds that must be kept on reserve. The extra currency in a bank’s vaults are called excess reserves.
Notice how the sum of bank reserves in Bank A & Bank B is equal to $1,000.
What is the Upper Limit of how much money banks can ‘create’?
By using the Simple Money Multiplier formula:
Markets for Money
Demand for Money
The demand for money instead describes the amount of our assets and wealth we are willing and able to hold in the form of currency at different costs, or prices. Since we use money to purchase products, it’s important to have currency equal to or greater than the value of our purchases.
The demand for money is linked closely to 2 factors:
- Real GDP - When real GDP rises, people are purchasing more & need more money to make those purchases.
- Price Level - When price levels rise, purchases are more expensive & people need more money to make those purchases.
The demand for money is also affected by:
- Convenience: If it’s inconvenient or costly to liquidate our assets/wealth, we’ll hold more currency. If it’s easy, we’ll hold less. The state of our financial technology affects the demand for money by determining how convenient it is to change our wealth into money.
- Interest Rates: Our demand for currency is affected by opportunity costs. By holding currency, we lose interest, from potential savings, bonds, mutual funds, etc. As interest rate increases, the opportunity cost increases. Thus, interest is the price of holding money.
Supply of Money
Supply of money is ultimately determined by monetary policy makers at the Federal Reserve. This means that the supply of money is a vertical line located at the quantity of money in circulation.
Equilibrium in the money market is reached when the supply of money & demand of money intersects at a certain interest rate.
Interest Rates & Bonds
What are Interest Rates?
We refer simply to “interest rates” incredibly generally, as they all do move in the same direction. However, there are hundreds of interest rates for different things in an economy. The highest rates are normally those that are the riskiest for the lender, the longest term, or the least collateral.
What is a Bond?
A bond is a piece of paper issued when a corporation or government borrows money. When a bond is first issued, it promises to repay the amount borrowed in a certain number of years, its maturity date. It also promises to pay a specific amount of interest each year. Bonds can be sold before they mature and are bought & sold in the market.
Relationship Between Bonds & Interest Rates
There is an inverse relationship between bond prices and interest rates. As interest rates rise, the prices of existing bonds fall. As current interest rates fall, the prices of existing bonds rise.
The inverse relationship is true for existing bonds because they become more attractive as interest rates fall & less attractive as interest rates rise. If rates fall, your bond is now paying a higher interest rate than most other bonds & is very attractive to buyers. If rates rise, your bond is no longer as attractive & price falls.
The Time Value of Money
Money today is more valuable than money tomorrow because it can be invested.
What is Present Value of Money?
Today’s value, in dollars, of a payment or multiple payments made in the future.
How to calculate present value of a future payment?
The present value of a future payment is how much one would have to have now to be equal to the future payment. The comparison assumes that you could earn interest on the present value between now & the time of the future payment.
Present Value = (Future Value) / (1 + the interest rate)t
Calculating Present Value of Bonds
What is the Future Value of Money?
Evaluating payments or multiple payments at a specific time in the future.
Future Value = (Present Value)(1 + the interest rate)t
*t is the number of years.
Relationship Between Future & Present Value
The present value of a future payment is always going to be less than number of dollars to be paid in the future.