Belhaven University Money Banking and Financial Markets Discussion

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1. Prompt: Under what conditions will a discount bond have a negative nominal interest rate? Is it possible for a coupon bond or a perpetuity to have a negative nominal interest rate?Requirement: 75-150 words 2. Prompt: How do the shared passages and Scriptures define and interpret usury, debt, and applying/charging interest charges in the business and individual markets? Additionally, how do postmodernism and secular society compare to the same?Requirement: 75-150 wordsReferences:The Economics of Money, Banking, and Financial Markets textPart 2: Financial Markets IntroductionPart 2.4: The Meaning of Interest RatesPart 2.5: The Behavior of Interest RatesDeuteronomy 23:19-20; Leviticus 25:35-38; Leviticus 25:35-37; Deuteronomy 15:7-11; Deuteronomy 15:1-6

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The Economics of Money, Banking, and
Financial Markets
Business School Edition, Fifth Edition
Chapter 4
The Meaning of Interest
Rates
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Preview
• Before we can go on with the study of money, banking,
and financial markets, we must understand exactly what
the phrase interest rates means. In this chapter, we see
that a concept known as the yield to maturity is the most
accurate measure of interest rate.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Learning Objectives
• Calculate the present value of future cash flows and the
yield to maturity on the four types of credit market
instruments.
• Recognize the distinctions among yield to maturity, current
yield, rate of return, and rate of capital gain.
• Interpret the distinction between real and nominal interest
rates.
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Measuring Interest Rates
• Present value: a dollar paid to you one year from now is
less valuable than a dollar paid to you today.
– Why: a dollar deposited today can earn interest and
become $1×(1+i) one year from today.
– To understand the importance of this notion, consider
the value of a $20 million lottery payout today versus a
payment of $1 million per year for each of the next 20
years. Are these two values the same?
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Present Value
Let i = .10
In one year: $100 × (1 + 0.10) = $110
In two years: $110 × (1 + 0.10) = $121
or $100 × (1 + 0.10)2
In three years: $121 × (1 + 0.10) = $133
or $100 × (1 + 0.10)3
In n years
$100 × (1 + i)n
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Simple Present Value (1 of 2)
PV = today’s (present) value
CF = future cash flow (payment)
i = the interest rate
CF
PV =
(1 + i )n
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Simple Present Value (2 of 2)
• Cannot directly compare payments scheduled in different
points in the time line
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Four Types of Credit Market Instruments
• Simple Loan
• Fixed Payment Loan
• Coupon Bond
• Discount Bond
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Yield to Maturity
• Yield to maturity: the interest rate that equates the
present value of cash flow payments received from a debt
instrument with its value today
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Yield to Maturity on a Simple Loan
PV = amount borrowed = $100
CF = cash flow in one year = $110
n = number of years = 1
$110
$100 =
(1 + i )1
(1 + i ) $100 = $110
$110
(1 + i ) =
$100
i = 0.10 = 10%
For simple loans, the simple interest rate equals the
yield to maturity
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Fixed-Payment Loan
The same cash flow payment every period throughout the
life of the loan
LV = loan value
FP = fixed yearly payment
n = number of years until maturity
LV =
FP
FP
FP
FP
+
+
+
.
.
.
+
1 + i (1 + i )2 (1 + i )3
(1 + i )n
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Coupon Bond (1 of 4)
Using the same strategy used for the fixed-payment loan:
P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C
C
C
C
F
P=
+
+
+. . . +
+
2
3
n
1+ i (1+ i ) (1+ i )
(1+ i ) (1+ i )n
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Coupon Bond (2 of 4)
• When the coupon bond is priced at its face value, the yield
to maturity equals the coupon rate.
• The price of a coupon bond and the yield to maturity are
negatively related.
• The yield to maturity is greater than the coupon rate when
the bond price is below its face value.
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Coupon Bond (3 of 4)
Table 1 Yields to Maturity on a 10%-Coupon-Rate Bond
Maturing in Ten Years (Face Value = $1,000)
Price of Bond ($)
Yield to Maturity (%)
1,200
7.13
1,100
8.48
1,000
10.00
900
11.75
800
13.81
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Coupon Bond (4 of 4)
• Consol or perpetuity: a bond with no maturity date that
does not repay principal but pays fixed coupon payments
forever
P = C / ic
Pc = price of the consol
C = yearly interest payment
Ic = yield to maturity of the consol
can rewrite above equation as this: ic = C/Pc
For coupon bonds, this equation gives the current yield, an
easy to calculate approximation to the yield to maturity
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Discount Bond
For any one year discount bond
F − P
i=
P
F = Face value of the discount bond
P = Current price of the discount bond
The yield to maturity equals the increase in price over the
year divided by the initial price.
As with a coupon bond, the yield to maturity is negatively
related to the current bond price.
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The Distinction Between Interest Rates and
Returns (1 of 4)
• Rate of Return:
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
P − Pt
C
RET =
+ t +1
Pt
Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt +1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt +1 − Pt
= rate of capital gain = g
Pt
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The Distinction Between Interest Rates and
Returns (2 of 4)
• The return equals the yield to maturity only if the holding
period equals the time to maturity.
• A 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 period.
• The more distant a bond’s maturity, the greater the size of
the percentage price change associated with an interestrate change.
• Interest rates do not always have to be positive as
evidenced by recent experience in Japan and several
European states.
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The Distinction Between Interest Rates and
Returns (3 of 4)
• The more distant a bond’s maturity, the lower the rate of
return the occurs as a result of an increase in the interest
rate.
• Even if a bond has a substantial initial interest rate, its
return can be negative if interest rates rise.
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The Distinction Between Interest Rates and
Returns (4 of 4)
Table 2 One-Year Returns on Different-Maturity 10%-CouponRate Bonds When Interest Rates Rise from 10% to 20%
(1)
(2)
Years to Maturity
Initial
When Bond Is
Current
Purchased
Yield (%)
(3)
(4)
(5)
Initial
Price
Rate of
Price
Next
Capital Gain
($)
Year* ($)
(%)
(6)
Rate of Return
[col (2) + col (5)]
(%)
30
10
1,000
503
−49.7
−39.7
20
10
1,000
516
−48.4
−38.4
10
10
1,000
597
−40.3
−30.3
5
10
1,000
741
−25.9
−15.9
2
10
1,000
917
−8.3
+1.7
1
10
1,000
1,000
0.0
+10.0
*Calculated with a financial calculator, using Equation 3.
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Maturity and the Volatility of Bond
Returns: Interest-Rate Risk
• Prices and returns for long-term bonds are more volatile
than those for shorter-term bonds.
• There is no interest-rate risk for any bond whose time to
maturity matches the holding period.
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The Distinction Between Real and Nominal
Interest Rates
• Nominal interest rate makes no allowance for inflation.
• Real interest rate is adjusted for changes in price level so
it more accurately reflects the cost of borrowing.
– Ex ante real interest rate is adjusted for expected
changes in the price level
– Ex post real interest rate is adjusted for actual changes
in the price level
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Fisher Equation
i = ir +  e
i = nominal interest rate
ir = real interest rate
 e = expected inflation rate
When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
The real interest rate is a better indicator of the incentives to
borrow and lend.
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Figure 1 Real and Nominal Interest Rates
(Three-Month Treasury Bill), 1953–2017
Sources: Nominal rates from Federal Reserve Bank of St. Louis FRED database:
http://research.stlouisfed.org/fred2/. The real rate is constructed using the procedure outlined in Frederic
S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” Carnegie-Rochester Conference Series
on Public Policy 15 (1981): 151–200. This procedure involves estimating expected inflation as a function
of past interest rates, inflation, and time trends, and then subtracting the expected inflation measure from
the nominal interest rate.
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Copyright
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
The Economics of Money, Banking, and
Financial Markets
Business School Edition, Fifth Edition
Chapter 5
The Behavior of Interest
Rates
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Preview
• In this chapter, we examine how the overall level of
nominal interest rates is determined and which factors
influence their behavior.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
Learning Objectives (1 of 2)
• Identify the factors that affect the demand for assets.
• Draw the demand and supply curves for the bond market
and identify the equilibrium interest rate.
• List and describe the factors that affect the equilibrium
interest rate in the bond market.
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Learning Objectives (2 of 2)
• Describe the connection between the bond market and the
money market through the liquidity preference framework.
• List and describe the factors that affect the money market
and the equilibrium interest rate.
• Identify and illustrate the effects on the interest rate of
changes in money growth over time.
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Determinants of Asset Demand (1 of 2)
• Economic agents hold a variety of different assets. What
are the primary assets you hold?
• An asset is anything that can be owned and has value.
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Determinants of Asset Demand (2 of 2)
• Wealth: the total resources owned by the individual,
including all assets
• Expected Return: the return expected over the next
period on one asset relative to alternative assets
• Risk: the degree of uncertainty associated with the return
on one asset relative to alternative assets
• Liquidity: the ease and speed with which an asset can be
turned into cash relative to alternative assets
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Theory of Portfolio Choice (1 of 2)
Holding all other factors constant:
1. The quantity demanded of an asset is positively
related to wealth
2. The quantity demanded of an asset is positively
related to its expected return relative to alternative
assets
3. The quantity demanded of an asset is negatively
related to the risk of its returns relative to alternative
assets
4. The quantity demanded of an asset is positively
related to its liquidity relative to alternative assets
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Theory of Portfolio Choice (2 of 2)
Summary Table 1
Response of the Quantity of an Asset Demanded to Changes in Wealth,
Expected Returns, Risk, and Liquidity
Variable
Change in Variable
Wealth
↑
Change in Quantity
Demanded
↑
Expected return relative to other assets
↑
↑
Risk relative to other assets
↑
↓
Liquidity relative to other assets
↑
↑
Note: Only increases in the variables are shown. The effects of decreases in the variables on the quantity demanded
would be the opposite of those indicated in the rightmost column.
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Supply and Demand in the Bond Market
• At lower prices (higher interest rates), ceteris paribus, the
quantity demanded of bonds is higher: an inverse
relationship
• At lower prices (higher interest rates), ceteris paribus, the
quantity supplied of bonds is lower: a positive relationship
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Figure 1 Supply and Demand for Bonds
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Market Equilibrium
• Occurs when the amount that people are willing to buy
(demand) equals the amount that people are willing to sell
(supply) at a given price.
• Bd = Bs defines the equilibrium (or market clearing) price
and interest rate.
• When Bd > Bs , there is excess demand, price will rise and
interest rate will fall.
• When Bd < Bs , there is excess supply, price will fall and interest rate will rise. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Changes in Equilibrium Interest Rates • Shifts in the demand for bonds: – Wealth: in an expansion with growing wealth, the demand curve for bonds shifts to the right – Expected Returns: higher expected interest rates in the future lower the expected return for long-term bonds, shifting the demand curve to the left – Expected Inflation: an increase in the expected rate of inflations lowers the expected return for bonds, causing the demand curve to shift to the left – Risk: an increase in the riskiness of bonds causes the demand curve to shift to the left – Liquidity: increased liquidity of bonds results in the demand curve shifting right Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 2 Shift in the Demand Curve for Bonds Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Shifts in the Demand for Bonds Summary Table 2 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Shifts in the Supply of Bonds (1 of 2) • Shifts in the supply for bonds: – Expected profitability of investment opportunities: in an expansion, the supply curve shifts to the right – Expected inflation: an increase in expected inflation shifts the supply curve for bonds to the right – Government budget: increased budget deficits shift the supply curve to the right Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Shifts in the Supply of Bonds (2 of 2) Summary Table 3 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 3 Shift in the Supply Curve for Bonds Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 4 Response to a Change in Expected Inflation Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 5 Expected Inflation and Interest Rates (Three-Month Treasury Bills), 1953–2017 Sources: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/TB3M; https://fred.stlouisfed.org/series/CPIAUCSL.S. Expected inflation calculated using procedures outlined in Frederic S. Mishkin, “The Real Interest Rate: An EmpiricalInvestigation,” Carnegie-Rochester Conference Series on Public Policy 15 (1981): 151–200. These procedures involve estimating expected inflation as a function of past interest rates, inflation, and time trends. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 6 Response to a Business Cycle Expansion Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 7 Business Cycle and Interest Rates (Three-Month Treasury Bills), 1951–2017 Source: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/TB3MS Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Supply and Demand in the Market for Money: The Liquidity Preference Framework (1 of 2) Keynesian model that determines the equilibrium interest rate in terms of the supply of and demand for money. There are two main categories of assets that people use to store their wealth: money and bonds. Total wealth in the economy = Bs + Ms = Bd+ Md Rearranging: Bs − Bd = Ms − Md If the market for money is in equilibrium (Ms = Md ), then the bond market is also in equilibrium (Bs = Bd ). Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 8 Equilibrium in the Market for Money Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Supply and Demand in the Market for Money: The Liquidity Preference Framework (2 of 2) • Demand for money in the liquidity preference framework: – As the interest rate increases: ▪ The opportunity cost of holding money increases… ▪ The relative expected return of money decreases… – …and therefore the quantity demanded of money decreases. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Changes in Equilibrium Interest Rates in the Liquidity Preference Framework (1 of 3) • Shifts in the demand for money: – Income Effect: a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right – Price-Level Effect: a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Changes in Equilibrium Interest Rates in the Liquidity Preference Framework (2 of 3) • Shifts in the supply of money: – Assume that the supply of money is controlled by the central bank. – An increase in the money supply engineered by the Federal Reserve will shift the supply curve for money to the right. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Changes in Equilibrium Interest Rates in the Liquidity Preference Framework (3 of 3) Summary Table 4 Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 9 Response to a Change in Income or the Price Level Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 10 Response to a Change in the Money Supply Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Money and Interest Rates • A one time increase in the money supply will cause prices to rise to a permanently higher level by the end of the year. The interest rate will rise via the increased prices. • Price-level effect remains even after prices have stopped rising. • A rising price level will raise interest rates because people will expect inflation to be higher over the course of the year. When the price level stops rising, expectations of inflation will return to zero. • Expected-inflation effect persists only as long as the price level continues to rise. Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? (1 of 2) • Liquidity preference framework leads to the conclusion that an increase in the money supply will lower interest rates: the liquidity effect. • Income effect finds interest rates rising because increasing the money supply is an expansionary influence on the economy (the demand curve shifts to the right). Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? (2 of 2) • Price-Level effect predicts an increase in the money supply leads to a rise in interest rates in response to the rise in the price level (the demand curve shifts to the right). • Expected-Inflation effect shows an increase in interest rates because an increase in the money supply may lead people to expect a higher price level in the future (the demand curve shifts to the right). Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 11 Response over Time to an Increase in Money Supply Growth Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Figure 12 Money Growth (M2, Annual Rate) and Interest Rates (Three-Month Treasury Bills), 1950–2017 Source: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/M2SL; https://fred.stlouisfed.org/series/TB3MS Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Copyright Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved. Purchase answer to see full attachment Tags: Interest rates Behavior Deuteronomy 1 User generated content is uploaded by users for the purposes of learning and should be used following Studypool's honor code & terms of service.