Time Value of Money

Time Value of Money- is a dollar today worth more than a dollar tomorrow?
   -yes
Why?
  -opportunity cost & inflation
   -this is the reason for charging and paying interest

How to calculate 
- Let :
     V= future value of money
     P=present value of money
     r= real interest rates (nominal rate- inflation rate)
  **********expressed as a decimal************
     n= years
     k= number of times interest is credited per year

The Simple Interest formula

v= (1+r)^n *P

Compound Interest Formula

v= (1+ r ) ^nk * P
          ---
           k



EXAMPLE PROBLEM

Assume that inflation is expected to be 3% and that the nominal interest rate on simple interest saving is 1%.

Step 1: Calculate the real interest rate

 r%= i% - π%
r%= 1%- 3%= -2% or -.02


Step 2: Use the simple interest formula to calculate the future value of 1$1.
v= (1+ r)^n *P
v=(1+(-.02))^1 *1
v= (0.98) * 1
v= $0.98

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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 earnings assets instead of borrowed liabilities.
2. What happens to the quantity demanded increases. There is no incentive to convert cash into interest earning assets.

The Demand for Money
- money = downward slope
What causes money to shift?
1. Δ in price level
2. Δ in income

3. Δ in taxation that affects investment


********money supply is always vertical*********

Increase in Money Supply

Increase money supply-->  decrease interest rate-->increase investments--> increase AD


Decrease in Money Supply
Decrease money supply-->increase interest rates-->decrease investment-->decrease AD


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Financial Sector

Financial Assets VS. Financial liabilities


Financial Assets:
- stocks and bonds
-provide an expected future benefits
- it is what you OWN

VS.


Financial Liabilities
- it is simply what you OWE



Interest rate- it is the cost of borrowing money




Stocks VS. Bonds


Stocks:
- financial assets that convey ownership in a company (part owner)

VS.


Bonds:
- a promise to pay a certain amount of money plus interest in the future


What do banks do?

- a bank is a financial intermediary
   +uses liquid assets (bank deposits)to fiance the investments of borrowers
   +process is known as Fractional Reserve Banking\

(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 bank 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 legal claim
    +the uses of funds by financial intermediaries


*Liabilities (amounts owed)
  +the legal claims against a bank
  + the sources of funds for financial intermediaries