1st Edition ECON 1113 Lecture 17 Outline of Last Lecture I Case Study Double Digit Inflation and the Recession of 1982 II How the Federal Reserve System the Fed Controls the Money Supply MS A Institutional Background B Three Tools of Monetary Policy changes in MS to influence macroeconomic conditions Outline of Current Lecture I The Government Bond Market A Bond Prices and Interest Yields B How It Works C Why Are There So Many Different Interest Rates II Money Demand MD or Liquidity Preference A Motives for Holding Demanding Money B Money Demand Money Supply and Interest Rate Determination Current Lecture I The Government Bond Market A An auction market with government bonds being auctioned to the highest bidder 1 Government bonds IOUs written evidences of government debt B General Relationship there is an inverse relationship between bond prices and interest yields and interest rates in general 1 If bond prices increase it implies that interest rates decrease and vice versa 2 90 Day Treasury Bills bonds Lots Maturit y Value Market Price Discount x 4 Annual Incom e A 10 000 9900 100 x 400 9900 4 B 10 000 9950 50 x 200 9950 2 C 10 000 9975 25 x 100 9975 1 Market Price Percentage Yield These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute a Maturity value amount the bond holder receives when the government has to make repayment of the borrowed money the repayment amount due when the bond matures b In this example 90 days term of the loan 3 months 3 General Relationship interest yields on short term US government bonds like 90 Day Treasury bills and interest rates in general move in the same direction C Why are there so many different interest rates 1 Term to maturity how long until a loan must be repaid a Very short terms i Overnight loans 12 hours Federal Funds Market commercial banks loan reserves to other commercial banks to be repaid the next business day ii Lower interest rates b Very long terms i 30 year US Treasury bonds ii Higher interest rates 2 Yield Curve a Diagram has maturity term on the x axis and interest yield on the y axis b As the maturity terms increases interest yield increases as well 3 Default Risk the chance or probability that a lender may not be repaid the borrower may default on his repayment obligation a Low default risk i US government bonds zero default risk ii Lower interest rates b High default risk i Junk bonds debts IOUs issued by companies with financial problems ii Greek government bonds iii Higher interest rates 4 Tax Treatment some bonds issued by municipalities and state government have no tax charged on those bonds interest payments tax free or municipal bonds a Example i 100 interest as tax free bond as opposed to 100 interest from taxable bond ii Interest rates on tax free municipal bonds are lower than the rates on identical taxable bonds II Money Demand MD and Liquidity Preference Keynesian Terminology A Consider two types of assets 1 Money which does not pay interest 2 Interest bearing assets like bonds B Motives for holding or demanding money balances 1 Transactions Motive money balances held demanded to carry out daily transactions a Medium of exchange characteristics of money 2 Precautionary Motive money balances held demanded as a precaution against circumstances requiring cash on hand 3 Speculative Motive money balances held demanded in case there are favorable changes in asset prices a Refers to money held in case of financial good deals b Case Study 1933 i Stocks could be purchased for ten cents due to the lowest worst stock circumstances in history ii Fear that the opportunity had passed to invest because the stern goddess of opportunity passed up those without liquid capital
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