Unit IV: Time Value of Money, Interest Formulas, What Banks Do

Time  Value of Money

       I.            Is a dollar today worth more than a dollar tomorrow? Yes

    II.            Why? Opportunity Cost and inflation. This is the reason for charging and paying interest

Let v= future value of $

      p= present value of $

                     r= real interest rate (nominal rate minus inflation rate) (express as decimal)                                                                                               

                     n= years

                     k= number of times interest is credited per year

Demand for money has an inverse relationship between the nominal interest rate the quantity of money demanded

       I.            What happens to the quantity of money of moneyed when the interest increases? Quantity demanded falls

    II.            What happens to the quantity demand when interest rates decrease? Quantity demanded increases.

Demand Always Downward

Money Demand Shifters

I.                   Changes in the price level

II.                Changes in income

III.             Changes in taxation that affects investment

Increase money supply, decreases interest rates, investment increases, AD increases and shifts right

Decreasing money supply, increases interest rates, investment decreases, AD decreases and shift left

Financial Sector

-Financial assets are what you own

-Financial Liabilities is what you owe

Interest Rate

-the cost of borrowing money

Stocks

-simply conveying ownership in a company

Bonds

-loaning money to the government

Bonds are safe; stocks are not.

What Banks Do

A bank is a financial intermediary

                               i.            Uses liquid assets (i.e. bank deposits) to finance the investment of borrowers

                             ii.            The process is known as Fractional Reserve Banking, a system in which deposits institution hold liquid assets less than the amount of deposits

                          iii.            Can take the form

a.    Currency in bank vaults

b.    Bank reserve deposits held at the Federal reserve

What Bank Do (continued)

T- Account (balance sheet)

Assets- Items to which a bank hold legal claim

Uses of funds by financial intermediates liabilities (amount owned)

Legal claims against sources of fund financial  intermediaries