ECON 1113 1st Edition Lecture 17 Outline of Last Lecture I. Case Study: Double Digit Inflation and the Recession of 1982II. How the Federal Reserve System (the Fed) Controls the Money Supply (MS)A. Institutional BackgroundB. Three Tools of Monetary Policy (changes in MS to influence macroeconomic conditions)Outline of Current Lecture I. The Government Bond MarketA. Bond Prices and Interest YieldsB. How It WorksC. Why Are There So Many Different Interest Rates?II. Money Demand (MD) or Liquidity PreferenceA. Motives for Holding (Demanding) MoneyB. Money Demand, Money Supply, and Interest Rate DeterminationCurrent LectureI. The Government Bond MarketA. An auction market with government bonds being auctioned to the highest bidder1. Government bonds (IOUs): written evidences of government debtB. 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 versa2. 90 Day Treasury Bills (bonds)LotsMaturity Value-- MarketPrice= Discount x4 =AnnualIncome/MarketPrice=PercentageYieldA $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%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 repaida. Very short termsi. Overnight loans (~12 hours)- Federal Funds Market: commercial banks loan reserves to other commercial banks to be repaid the next business dayii. Lower interest ratesb. Very long termsi. 30 year US Treasury bondsii. Higher interest rates2. Yield Curvea. Diagram has maturity term on the x-axis and interest yield on the y-axisb. As the maturity terms increases, interest yield increases as well3. Default Risk: the chance or probability that a lender may not be repaid (the borrower may “default” on his repayment obligation)a. Low default riski. US government bonds (zero default risk)ii. Lower interest ratesb. High default riski. Junk bonds/debts (IOUs) issued by companies with financial problemsii. Greek government bondsiii. Higher interest rates4. 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. Examplei. $100 interest as tax free bond as opposed to $100 interest from taxable bondii. Interest rates on tax free municipal bonds are lower than the rates on identical taxable bondsII. Money Demand (MD) and Liquidity Preference (Keynesian Terminology)A. Consider two types of assets1. Money which does not pay interest2. Interest-bearing assets (like bonds)B. Motives for holding or demanding money balances1. Transactions Motive: money balances held (demanded) to carry out daily transactionsa. Medium of exchange: characteristics of money2. Precautionary Motive: money balances held (demanded) as a precaution against circumstances requiring cash on hand3. Speculative Motive: money balances held (demanded) in case there are favorable changes in asset pricesa. Refers to money held in case of financial “good deals”b. Case Study: 1933i. Stocks could be purchased for ten cents due to the lowest worst stock circumstances in historyii. Fear that the opportunity had passed to invest because the“stern goddess of opportunity” passed up those without liquid