💳Principles of Finance Unit 3 – Economic Foundations: Money & Interest Rates

What's Money All About?

• Money serves as a medium of exchange, unit of account, and store of value enabling efficient transactions and economic activity
• Fiat money is legal tender backed by the government's authority (U.S. dollar) while commodity money has intrinsic value (gold coins)
• Money supply measures the total amount of money circulating in an economy categorized as M1, M2, M3, and M4 based on liquidity
  • M1 includes currency, demand deposits, and other highly liquid assets
  • M2 adds savings deposits, money market funds, and small time deposits to M1
• Velocity of money measures how quickly money changes hands calculated as $\frac{\text{Nominal GDP}}{\text{Money Supply}}$
• Inflation erodes the purchasing power of money over time as prices rise
• Deflation occurs when the general price level falls leading to increased purchasing power of money but potential economic slowdowns
• Hyperinflation is extremely rapid inflation often caused by excessive money printing (Venezuela, Zimbabwe) severely damaging the economy

How Interest Rates Work

• Interest rates represent the cost of borrowing money or the return on lending/saving money typically expressed as an annual percentage
• Simple interest is calculated on the principal amount only using the formula $I = P \times r \times t$ where $I$ is interest, $P$ is principal, $r$ is interest rate, and $t$ is time
• Compound interest is calculated on the principal and accumulated interest leading to exponential growth over time
  • The compound interest formula is $A = P(1 + \frac{r}{n})^{nt}$ where $A$ is the final amount, $P$ is principal, $r$ is annual interest rate, $n$ is the number of compounding periods per year, and $t$ is the number of years
• Higher interest rates incentivize saving and discourage borrowing while lower rates encourage borrowing and spending
• Real interest rates adjust for inflation to measure the true cost of borrowing or return on lending calculated as $\text{real interest rate} = \text{nominal interest rate} - \text{inflation rate}$
• The risk-free rate is the theoretical interest rate on an investment with zero risk often benchmarked to government bond yields
• Risk premiums compensate lenders for taking on additional credit risk, liquidity risk, or other uncertainties

Supply and Demand of Money

• The money market illustrates the supply and demand for money determining the equilibrium interest rate
• Money supply is controlled by the central bank and typically visualized as a vertical line as it does not depend on interest rates in the short run
  • Expansionary monetary policy increases the money supply shifting the curve to the right and lowering interest rates
  • Contractionary monetary policy decreases the money supply shifting the curve to the left and raising interest rates
• Money demand represents the public's desire to hold cash and liquid assets influenced by interest rates, income levels, and payment conventions
  • Money demand curve slopes downward as higher interest rates increase the opportunity cost of holding cash
• Equilibrium interest rate occurs at the intersection of money supply and demand curves
• Shifts in money supply or demand lead to changes in the equilibrium interest rate and impact economic variables like investment, consumption, and GDP
• The liquidity preference theory asserts that money demand arises from three motives: transactions, precautionary, and speculative purposes
• Quantity theory of money states that the money supply has a direct and proportional effect on the price level expressed as $MV = PQ$ where $M$ is money supply, $V$ is velocity of money, $P$ is price level, and $Q$ is real GDP

Central Banks and Monetary Policy

• Central banks are responsible for conducting monetary policy to achieve price stability, maximum employment, and stable economic growth
  • The Federal Reserve is the central bank of the United States consisting of the Board of Governors, 12 regional Federal Reserve Banks, and the Federal Open Market Committee (FOMC)
  • The European Central Bank (ECB) oversees monetary policy for the Eurozone
• Open market operations involve buying and selling government securities to control the money supply and influence interest rates
  • Buying securities injects money into the economy, increasing the money supply and lowering interest rates
  • Selling securities removes money from the economy, decreasing the money supply and raising interest rates
• The discount rate is the interest rate charged by the central bank on loans to commercial banks influencing their borrowing costs and lending rates
• Reserve requirements set the minimum amount of customer deposits banks must hold in reserve impacting their lending capacity
• Forward guidance communicates the central bank's future policy intentions to shape market expectations and enhance policy effectiveness
• Quantitative easing involves large-scale asset purchases to increase the money supply and stimulate the economy when interest rates are near zero
• The Taylor Rule is a monetary policy guideline that suggests how central banks should adjust interest rates in response to changes in inflation and economic output

Types of Interest Rates

• Nominal interest rates are quoted rates not adjusted for inflation representing the actual borrowing cost or lending return
• Real interest rates adjust nominal rates for inflation to capture the true purchasing power of money
• The federal funds rate is the overnight lending rate between banks influencing short-term interest rates across the economy
• The prime rate is the interest rate banks charge their most creditworthy customers serving as a benchmark for consumer and business loans
• LIBOR (London Interbank Offered Rate) is a global reference rate at which major banks lend to one another in the international interbank market
• Treasury yields represent the interest rates on U.S. government debt securities spanning maturities from 4 weeks to 30 years
  • The yield curve plots Treasury yields across different maturities
  • A normal yield curve slopes upward indicating higher yields for longer maturities
  • An inverted yield curve slopes downward often signaling economic uncertainty or a potential recession
• Mortgage rates are interest rates charged on home loans typically based on the lender's cost of funds, credit risk, and loan terms
• Credit card interest rates are charged on outstanding balances and vary based on the cardholder's creditworthiness and card features

Time Value of Money Basics

• The time value of money (TVM) is the concept that money available now is worth more than an identical sum in the future due to its earning potential
• Present value (PV) is the current value of a future sum discounted at a specific interest rate calculated as $PV = \frac{FV}{(1+r)^n}$ where $FV$ is future value, $r$ is the discount rate, and $n$ is the number of periods
• Future value (FV) is the value of a present sum at a future date assuming a specific interest rate calculated as $FV = PV(1+r)^n$
• Net present value (NPV) is the difference between the present value of cash inflows and outflows used to evaluate the profitability of investments
  • A positive NPV indicates a profitable investment while a negative NPV suggests an unprofitable one
• The discount rate is the interest rate used to calculate present values reflecting the opportunity cost and risk of an investment
• Annuities are series of equal payments made at fixed intervals (monthly rent)
  • The present value of an annuity is calculated using the formula $PV = PMT \times \frac{1 - (1+r)^{-n}}{r}$ where $PMT$ is the periodic payment, $r$ is the discount rate, and $n$ is the number of periods
• Perpetuities are annuities that continue indefinitely with the present value calculated as $PV = \frac{PMT}{r}$

Interest Rates and the Economy

• Interest rates significantly influence economic activity by affecting borrowing, spending, and investment decisions
• Higher interest rates discourage borrowing and spending, slowing economic growth and curbing inflation
  • Businesses may postpone investments and consumers may save more and spend less
  • Mortgage rates rise, cooling the housing market
• Lower interest rates encourage borrowing and spending, stimulating economic growth and potentially fueling inflation
  • Businesses may expand and invest in new projects while consumers increase spending
  • Lower mortgage rates boost housing demand and construction activity
• The IS-LM model illustrates the relationship between interest rates and economic output in the short run
  • The IS (Investment-Saving) curve represents the goods market equilibrium
  • The LM (Liquidity Preference-Money Supply) curve represents the money market equilibrium
  • The intersection of the IS and LM curves determines the equilibrium interest rate and output level
• The Fisher effect states that nominal interest rates rise with expected inflation to maintain the real interest rate
• The international Fisher effect suggests that differences in nominal interest rates between countries reflect differences in expected inflation rates
• Yield curve inversions, where short-term rates exceed long-term rates, often precede economic recessions as they signal market expectations of future economic weakness and potential interest rate cuts

Real-World Applications

• Mortgage rates directly impact housing affordability and the real estate market
  • Lower rates make homes more affordable, increasing demand and prices
  • Higher rates reduce affordability, slowing home sales and price growth
• Bond prices and interest rates have an inverse relationship
  • When interest rates rise, bond prices fall as newer bonds offer higher yields
  • When interest rates fall, bond prices rise as existing bonds become more attractive
• Savings account and certificate of deposit (CD) rates are influenced by the general level of interest rates
  • Higher rates benefit savers with increased returns on their deposits
  • Lower rates reduce the incentive to save and may encourage investing in riskier assets
• Businesses consider interest rates when making capital budgeting decisions and evaluating investment opportunities using NPV and IRR (internal rate of return) analysis
• Governments and municipalities factor in interest rates when issuing bonds to finance public projects and infrastructure
• Central banks monitor interest rates and economic indicators to formulate appropriate monetary policy responses
  • The Federal Reserve's dual mandate seeks to achieve maximum employment and price stability
  • The ECB's primary objective is to maintain price stability in the Eurozone
• Interest rate changes can impact currency exchange rates through the interest rate parity theory and capital flows
  • Higher interest rates attract foreign capital, appreciating the domestic currency
  • Lower interest rates lead to capital outflows, depreciating the domestic currency