TIME VALUE OF MONEY

-Is a dollar today worth more than a dollar tomorrow?
 *Yes.
-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 - inflation rate).
       n= years.
       k= number of times interest credited per year.

-The simple interest formula:

 *V= (1+r)^n *P

-The compound interest formula:

 *V= (1+ r/k)^nk *P
Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded.
1) What happens to the quantity demanded of money when interest rates increase?
    *Quantity demanded falls because individuals would prefer to have interest earning assets instead of                 borrowing liabilities.
2) What happens to the quantity demanded when interest rates decrease?
     *Quantity demanded increases. There is incentive to convert cash into interest earning assets.
3) What happens if price level increase?
     Money demand shifters
     *Changes in price level.
     *Changes in income.
     *Changes in taxation that affects investment.
   If the FED increases the money supply, a temporary surplus of money will occur at 5% interest. The              surplus will cause the interest rate to fall to 2%.
4) How does this affect AD?
    a)Increase in money supply > decreases interest rates > increases investment > increases AD.
   If the FED decreases the money supply, a temporary shortage of money will occur at 5% interest. The          shortage will cause the interest rate to rise to 10%.
5) How does this affect AD?
    Decrease money supply > increase interest rate > decrease investment > decrease AD.

FINANCIAL SECTORS

Financial assets

-It is stocks and bonds whose benefit to the owner depends upon the issuer of the asset meeting certain          obligation.

Financial liabilities

-It is liabilities incurred by the issuer of a financial assets to stand behind the issued assets.

Interest rates

-Price payed for the use of a financial asset.

Stocks

-Financial asset that convey ownership in a corporation.

Bonds

-A promise to pay a certain amount of money plus interest in the future.

WHAT BANKS DO

A bank is a financial intermediary
-Uses liquid assets (i.e bank deposits) to finance the investments of borrowers.
-Process is known as fractional reserve banking.
 *A system in which depository institutions hold liquid assets less than the amount of deposits can take the        form of :
   1) Currency in banks vaults.
   2) Bank reserves: deposits held at the federal reserve.

BASIC ACCOUNTING REVIEW

T-Account (balance sheet)

-statements of assets and liabilities.

Assets (amounts owned)

-Items to which a bank holds a legal claim.
-The uses of funds by financial intermediaries.

Liabilities (amounts owed)

-The legal claim against a bank.
-The sources of funds for financial intermediaries.

FUNCTIONS OF THE FEDERAL RESERVE (FED)

1) It issues paper currency.
2) It sets reserve requirements and holds reserves of the bank.
3) It lends money to the banks and charges them interest.
4) They are a check clearing service for banks.
5) They act as a personal bank for the government.
6) They supervise member banks.
7) They control the money supply in the economy.