Chapter 3,What Is Money?,Meaning of Money,What is it?Money (or the “money supply”): anything that is generally accepted in payment for goods or services or in the repayment of debts. A rather broad definition,Meaning of Money,Money (a stock concept) is different from:Wealth: the total collection of pieces of property that serve to store valueIncome: flow of earnings per unit of time (a flow concept),Functions of Money,Medium of Exchange: Eliminates the trouble of finding a double coincidence of needs (reduces transaction costs)Promotes specializationA medium of exchange mustbe easily standardizedbe widely acceptedbe divisiblebe easy to carrynot deteriorate quickly,Functions of Money,Unit of Account: used to measure value in the economyreduces transaction costsStore of Value: used to save purchasing power over time.other assets also serve this function Money is the most liquid of all assets but loses value during inflation,Evolution of the Payments System,Commodity Money: valuable, easily standardized and divisible commodities (e.g. precious metals, cigarettes).Fiat Money: paper money decreed by governments as legal tender.,Evolution of the Payments System,Checks: an instruction to your bank to transfer money from your accountElectronic Payment (e.g. online bill pay).E-Money (electronic money):Debit cardStored-value card (smart card)E-cash,Measuring Money,How do we measure money? Which particular assets can be called “money”?Construct monetary aggregates using the concept of liquidity:M1 (most liquid assets) = currency + travelers checks + demand deposits + other checkable deposits.,Measuring Money,M2 (adds to M1 other assets that are not so liquid) = M1 + small denomination time deposits + savings deposits and money market deposit accounts + money market mutual fund shares.,Table 1 Measures of the Monetary Aggregates,Monetary Aggregates,M1 vs. M2,Does it matter which measure of money is considered?M1 and M2 can move in different directions in the short run (see figure). Conclusion: the choice of monetary aggregate is important for policymakers.,FIGURE 1 Growth Rates of the M1 and M2 Aggregates, 19602008,Sources: Federal Reserve Bulletin, p. A4, Table 1.10, various issues; Citibase databank; www.federalreserve.gov/releases/h6/hist/h6hist1.txt.,How Reliable are the Money Data?,Revisions are issued because:Small depository institutions report infrequentlyAdjustments must be made for seasonal variationWe probably should not pay much attention to short-run movements in the money supply numbers, but should be concerned only with longer-run movements,Table 2 Growth Rate of M2: Initial and Revised Series, 2008 (percent, compounded annual rate),Chapter 4,Understanding Interest Rates,Present Value,A dollar paid to you one year from now is less valuable than a dollar paid to you todayWhy?A dollar deposited today can earn interest and become $1 x (1+i) one year from today.,Discounting the Future,Simple Present Value,Time Line,$100,$100,Year,0,1,PV,100,2,$100,$100,n,100/(1+i),100/(1+i)2,100/(1+i)n,Cannot directly compare payments scheduled in different points in the time line,Four Types of Credit Market Instruments,Simple LoanFixed Payment LoanCoupon BondDiscount Bond,Yield to Maturity,The interest rate that equates the present value of cash flow payments received from a debt instrument with its value today,Simple Loan,Fixed Payment Loan,Coupon Bond,When the coupon bond is priced at its face value, the yield to maturity equals the coupon rateThe price of a coupon bond and the yield to maturity are negatively relatedThe yield to maturity is greater than the coupon rate when the bond price is below its face value,Table 1 Yields to Maturity on a 10%-Coupon-Rate Bond Maturing in Ten Years(Face Value = $1,000),Consol or Perpetuity,A bond with no maturity date that does not repay principal but pays fixed coupon payments forever,For coupon bonds, this equation gives the current yield, an easy to calculate approximation to the yield to maturity,Discount Bond,Rate of Return,Rate of Return and Interest Rates,The return equals the yield to maturity only if the holding period equals the time to maturityA rise in interest rates is associated with a fall in bond prices, resulting in a capital loss if time to maturity is longer than the holding periodThe more distant a bonds maturity, the greater the size of the percentage price change associated with an interest-rate change,Rate of Return and Interest Rates (contd),The more distant a bonds maturity, the lower the rate of return the occurs as a result of an increase in the interest rateEven if a bond has a substantial initial interest rate, its return can be negative if interest rates rise,Table 2 One-Year Returns on Different-Maturity 10%-Coupon-Rate Bonds When Interest Rates Rise from 10% to 20%,Interest-Rate Risk,Prices and returns for long-term bonds are more volatile than those for shorter-term bondsThere is no interest-rate risk for any bond whose time to maturity matches the holding period,