Chapter 1

Why Study
Money, Banking,
and Financial
Markets?

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 Preview

• To examine how financial markets such as

bond, stock and foreign exchange markets
work
• To examine how financial institutions such
as banks, investment and insurance
companies work
• To examine the role of money in the
economy

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 Learning Objectives

• Recognize the importance of financial

markets in the economy.
• Describe how financial intermediation and
financial innovation affect banking and the
economy.
• Identify the basic links among monetary
policy, the business cycle, and economic
variables.
• Explain the importance of exchange rates in
a global economy.

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 Why Study Financial Markets?

• Financial markets are markets in which

funds are transferred from people and firms
who have an excess of available funds to
people and firms who have a need of funds

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 The Bond Market and Interest Rates

• A security (financial instrument) is a claim

on the issuer’s future income or assets.
• A bond is a debt security that promises to
make payments periodic for a specified
period of time.
• An interest rate is the cost of borrowing or
the price paid for the rental of funds.

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 Figure 1 Interest Rates on Selected
Bonds, 1950–2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

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 The Stock Market

• Common stock represents a share of

ownership in a corporation.
• A share of stock is a claim on the
remaining earnings and assets of the
corporation.

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 Figure 2 Stock Prices as Measured by the
Dow Jones Industrial Average, 1950–2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

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1-9 © 2016 Pearson Education Ltd. All rights reserved.
 Why Study Financial Institutions
and Banking?
• Financial intermediaries: institutions that
borrow funds from people who have saved and in
turn make loans to other people.
– Banks: are financial institutions that accept deposits and
make loans.
– Other financial institutions: insurance companies, finance
companies, pension funds, mutual funds and investment
companies
• Financial innovation: the development of new
financial products and services
– Can be an important force for good by making the
financial system more efficient

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 Why Study Financial Institutions
and Banking?
• Financial crises: major disruptions in
financial markets that are characterized by
sharp declines in asset prices and the
failures of many financial and nonfinancial
firms.
• Asian Financial Crisis 1997.
• Global Financial Crisis 2008.

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 Why Study Money and Monetary Policy?
• Money, also referred to as the money supply,
is defined as anything that is generally
accepted as payment for goods or services or
in the repayment of debts
• Evidence suggests that money plays an
important role in generating business cycles.
• Recessions (unemployment) and expansions
affect all of us.
• Monetary theory ties changes in the money
supply to changes in aggregate economic
activity and the price level.
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 Money, Business Cycles, and
Inflation
• The aggregate price level is the average
price of goods and services in an economy
• A continual rise in the price level (inflation)
affects all economic players
• Data shows a connection between the
money supply and the price level

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 Figure 3 Money Growth (M2 Annual Rate) and the
Business Cycle in the United States 1950–2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

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 The Federal Reserve’s Monetary
Aggregates assets
that have
M1 check-
M2
includes the writing
most liquid and other
assets assets
Currency
Small Den. Dep. that can
Traveler’s Checks
Savings and MM be turned
Demand Deposits
Money Market Mutual into cash
Other Check. Dep Funds Shares quickly
and at
very little
cost
M3

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 Figure 4 Aggregate Price Level and the Money
Supply in the United States, 1950–2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

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 Money and Interest Rates

• Interest rates are the price of money

• Prior to 1980, the rate of money growth
and the interest rate on long-term Treasury
bonds were closely tied
• Since then, the relationship is less clear but
the rate of money growth is still an
important determinant of interest rates

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 Figure 5 Average Inflation Rate Versus Average Rate
of Money Growth, Selected Countries, 2003-2013

Source: International Financial Statistics. http://www.imf.org/external/data.htm

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 Figure 6 Money Growth (M2 Annual Rate) and Interest
Rates (Long-Term U.S. Treasury Bonds), 1950–2014
As the money growth rate rose in the 1960s and
1970s, the long-term bond rate rose with it.
However, the relationship between money growth
and interest rates has been less clear-cut since 1980.

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

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 Fiscal Policy and Monetary Policy

• Monetary policy is the management of the money

supply and interest rates
– Conducted in the U.S. by the Federal Reserve System
(Fed)
• Fiscal policy deals with government spending
and taxation
– A budget deficit is an excess of government expenditures
with respect to tax revenues for a particular time period,
typically a year, while a budget surplus arises when tax
revenues exceed government expenditures. The
government must finance any budget deficit by borrowing

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 Figure 7 Government Budget Surplus or Deficit
as a Percentage of Gross Domestic Product,
1950–2013

Source: Economic Report of the President, Table B79 at http://www.gpoaccess.gov/eop/tables09.html

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 The Foreign Exchange Market

• The foreign exchange market: where

funds are converted from one currency into
another
• The foreign exchange rate is the price of
one currency in terms of another currency.
• The foreign exchange market determines
the foreign exchange rate.

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 Figure 8 Exchange Rate of the U.S.
Dollar, 1970–2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

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 The International Financial System

• Financial markets have become increasingly

integrated throughout the world.
• The international financial system has great
impact on domestic economies:
– How a country’s choice of exchange rate policy
affect its monetary policy?
– How capital controls impact domestic financial
systems and therefore the performance of the
economy?
– Which should be the role of international
financial institutions like the IMF?

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 How We Will Study Money, Banking,
and Financial Markets
• A simplified approach to the demand for
assets
• The concept of equilibrium
• Basic supply and demand to explain
behavior in financial markets
• The search for profits
• An approach to financial structure based on
transaction costs and asymmetric
information
• Aggregate supply and demand analysis

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 Appendix 1:

Defining Aggregate Output, Income, the

Price Level, and the Inflation Rate
Aggregate Output: the total production of goods
and services in a particular country
Income: money received, especially on a regular
basis, for work or through investments
the Price Level: the average of all prices of
goods and services currently being produced in
the economy.
the Inflation Rate: the rate of change of the price
level, usually measured as a percentage change
per year
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 Aggregate Output and Income
• Aggregate Output: the total production of
goods and services in a particular country
• The most commonly reported measure of
aggregate output, the gross domestic
product (GDP), is the market value of all
final goods and services produced in a
country during one year.
• Aggregate income, the total income of
factors of production (land, labor, and
capital) from producing goods and services
in the economy during one year, is equal to
aggregate output.
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 Real versus Nominal Magnitudes

• When the total value of final goods and

services is calculated using current prices,
the resulting GDP measure is referred to as
nominal GDP. The word nominal indicates
that values are measured using current
prices.

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 Real versus Nominal Magnitudes
• A more reliable measure of economic production
expresses values in terms of prices for an arbitrary
base year, currently 2005. GDP measured with
constant prices is referred to as real GDP, the
word real indicating that values are measured in
terms of fixed prices.
0 - ‫ار‬$‫سع‬$‫ منحيثأ‬$‫لقيم‬$$‫القتصاديعنا‬$$‫إلنتاج ا‬$ ‫كثر موثوقية ل‬$‫ويعبر مقياسأ‬
‫لمحلي‬$$‫لناتج ا‬$$‫لىا‬$$‫ ويشار إ‬.2005 ‫ليا‬$$‫ا‬$‫لتيهيح‬$$‫ ا‬،‫لتعسفية‬$$‫ألساسا‬$$‫نة ا‬$$‫س‬
‫لي‬$$‫إلجما‬$$‫لمحليا‬$$‫لناتج ا‬$$‫ ا‬$‫نه‬$‫لثابتة علىأ‬$$‫ار ا‬$‫ألسع‬$$‫ا‬$$$‫قاسب‬$$‫لذيي‬$$‫ليا‬$$‫إلجما‬$$‫ا‬
‫لثابتة‬$$‫ار ا‬$‫ألسع‬$$‫ا‬$$$‫قاسب‬$$$‫ ت‬$‫لقيم‬$$‫نا‬$‫لىأ‬$$‫شير إ‬$$$‫لمة حقيقية ت‬$$‫ي وهيك‬ ، ‫لحقيق‬$$‫ا‬.

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 Aggregate Price Level

• The aggregate price level is a measure of

the average of all prices of goods and
services currently being produced in the
economy.
• Three measures of the aggregate price level
are commonly faced in economic data:
– The GDP deflator
– The PCE deflator Personal Consumption
Expenditure Deflator is a measure of inflation
based on changes in personal consumption
– The Consumer Price Index (CPI)

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 Where to get the data?

Aggregate Output, Income, the Price

Level, and the Inflation Rate

World Bank
Department of Statistics of Malaysia (DOSM)
Central Banks i.e.
Federal Reserve Bank
Bank Negara Malaysia
Bank of Indonesia

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 Chapter 2
An Overview
of the Financial
System

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 Preview

• This chapter presents an overview of the study of

financial markets and institutions.
‫• يقدم هذا الفصل لمحة عامة عن دراسة األسواق والمؤسسات المالية‬

1-33 © 2016 Pearson Education Ltd. All rights reserved.

 Learning Objectives

• Compare and contrast direct and indirect

finance.
• Identify the structure and components of
financial markets.
• List and describe the different types of
financial market instruments.
• Recognize the international dimensions of
financial markets.

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 Learning Objectives

• Summarize the roles of transaction costs,

risk sharing, and information costs as they
relate to financial intermediaries.
• List and describe the different types of
financial intermediaries.
• Identify the reasons for and list the types of
financial market regulations.

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 Function of Financial Markets

• Performs the essential function of

channeling funds from economic players
that have saved surplus funds to those that
have a shortage of funds
• Direct finance: borrowers borrow funds
directly from lenders in financial markets by
selling them securities

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 Function of Financial Markets

• Promotes economic efficiency by producing

an efficient allocation of capital, which
increases production
• Directly improve the well-being of
consumers by allowing them to make
purchases when they need them most

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 Figure 1 Flows of Funds Through the
Financial System
The arrows show that funds flow from
lender-savers to borrower-spenders
through two routes: direct
finance, in which borrowers borrow
funds directly from lenders in financial
markets by selling securities,
and indirect finance, in which a
financial intermediary borrows funds
from lender-savers and then
uses these funds to make loans to
borrower-spenders.

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 Structure of Financial Markets
• A firm or an individual can obtain funds in a
financial market in two ways:
• Debt and Equity Markets
– Debt instruments (maturity)the number of
years until that instrument’s expiration date
– Equities (dividends) $‫ألسهم‬$$‫أرباح ا‬
• Primary and Secondary Markets
– Investment banks guarantee securities in primary
markets.‫ق‬$‫ألسوا‬$$‫يا‬$$$‫لية ف‬$$‫لما‬$$‫قا‬$‫ألورا‬$$‫تأمينا‬$$$‫الستثمار ب‬$$‫نوك ا‬$$$‫ ب‬$‫وم‬$‫ق‬$$$‫ت‬
‫ألولية‬$$‫ا‬.
– Brokers and dealers work in secondary markets.‫عمل‬$$‫ي‬
‫لثانوية‬$$‫قا‬$‫ألسوا‬$$‫يا‬$$$‫لتجار ف‬$$‫لوسطاء وا‬$$‫ا‬.
1-39 © 2016 Pearson Education Ltd. All rights reserved.
 A firm or an individual can obtain funds in a financial
market in two ways:
1) Debt Market: The most common method is through the
issuance of a debt instrument, such as a bond or a Mortgage, A
debt instrument is short-term if its maturity term is less than a
year and long-term if its maturity term is ten years or longer.
Debt instruments with a maturity term between one and ten
years are said to be intermediate-term.

2) Equity market: The second method of raising funds is

through the issuance of equities, such as common stock and
equities are considered to be long-term securities because they
have no maturity date

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 Structure of Financial Markets
• Secondary markets can be organized in two ways:
• Exchanges and Over-the-Counter (OTC) Markets:
– Exchanges(where buyers and sellers of securities
meet in one location to conduct trades): NYSE,
Chicago Board of Trade
• An exchange‫لبورصة‬$$‫ا‬is a counterparty to all trades
• Standardized price and execution‫لتنفيذ‬77‫لموحد وا‬77‫ر ا‬7‫لسع‬77‫ا‬
• Regulatory oversight
– OTC markets: Foreign exchange, Federal funds
• No centralized place where trades are made, but
the market is made of participants in the market
trading among themselves
• Participating dealers (treasury market dealers)
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 Structure of Financial Markets

• Another way of distinguishing between

markets is on the basis of the maturity of
the securities traded in each market.
• Money and Capital Markets:
– Money markets is a financial market in which
only short-term debt instruments with maturity
terms less than one year are traded
– Capital markets the market in which longer-
term debt instruments and equity instruments
with maturities of one year greater are traded

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 Financial Market Instruments

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 Financial Market Instruments

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1-45 © 2016 Pearson Education Ltd. All rights reserved.
 Internationalization of Financial Markets
• Foreign Bonds: bonds sold in a foreign country and
denominated in that country’s currency
• a bond denominated in US dollars issued by a German
company in the United States
• Eurobond: A bond denominated in a currency other than the
currency of the country in which it is sold
• for example, a bond denominated in U.S. dollars sold in
London
• Eurocurrencies: foreign currencies deposited in banks
outside the home country
– Eurodollars: U.S. dollars deposited in foreign banks outside the
U.S. or in foreign branches of U.S. banks
• World Stock Markets:
– Also help finance the federal government

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 Function of Financial
Intermediaries: Indirect Finance
• Lower transaction costs (time and money
spent in making financial transactions)
– Economies of scale
– Liquidity services: services that make it easier
for customers to conduct transactions.
• Reducing investor exposure to risk
-Risk Sharing (Asset Transformation) They
create and sell assets with risk characteristics
that people are comfortable with
– Diversification

1-47 © 2016 Pearson Education Ltd. All rights reserved.

 Function of Financial
Intermediaries: Indirect Finance
• Asymmetric information problems: one party often does
not know enough about the other party to make accurate
decisions
– Adverse Selection (before the transaction): (occurs
when the potential borrowers are most likely to
produce an undesirable outcome are the one who most
actively seek out loan.
– Moral Hazard (after the transaction): the risk that the
borrower might engage in activities that are
undesirable from the lenders point of view Because
moral hazard lowers the probability that the loan will
be repaid, lenders may decide that they would rather
not make a loan.

1-48 © 2016 Pearson Education Ltd. All rights reserved.

 Function of Financial
Intermediaries: Indirect Finance
• Deal with asymmetric information problems:
– Adverse Selection (before the transaction): try
to avoid selecting the risky borrower by
gathering information about them
– Moral Hazard (after the transaction): ensure
borrower will not engage in activities that will
prevent him/her to repay the loan.
• Sign a contract with restrictive agreements.

1-49 © 2016 Pearson Education Ltd. All rights reserved.

 Function of Financial
Intermediaries: Indirect Finance
• Conclusion:
– Financial intermediaries allow “small” savers and
borrowers to benefit from the existence of
financial markets.

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 Types of Financial Intermediaries

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 Types of Financial Intermediaries

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 Financial Intermediaries in Malaysia?

http://www.bnm.gov.my/index.php?ch=fs&pg=fs_mfs_list&ac=118&lang=en

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 Regulation of the Financial System

• To increase the information available to

investors:
– Reduce adverse selection and moral hazard
problems
– Reduce insider trading (SEC)

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 Regulation of the Financial System

• To ensure the soundness of financial

intermediaries by implemented six types of
regulations:
– Restrictions on entry (chartering process).
– Disclosure of information.
– Restrictions on Assets and Activities (control
holding of risky assets).
– Deposit Insurance (avoid bank runs).
– Limits on Competition (mostly in the past):
• Branching
Restrictions on Interest Rates

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 Regulation of the Financial System

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 Lets look at the banking sector

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1-58 © 2016 Pearson Education Ltd. All rights reserved.
1-59 © 2016 Pearson Education Ltd. All rights reserved.
1-60 © 2016 Pearson Education Ltd. All rights reserved.
 Financial Markets Database

• Bloomberg
• Thomson-Reuters Datastream
• Securities Commission Malaysia
• Yahoo Finance
• Google

In next class, lets explore some of the financial

database!

1-61 © 2016 Pearson Education Ltd. All rights reserved.

 Quick Activity

• Each of the group find one financial

institution in UAE. Explore its main
operation, structure, subsidiaries (if any),
main shareholders
• Each group will need to put all the
information and present it in an Instagram
page with hashtag #EMB

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 Lets explore some financial
statements
• Maybank FYE2018
• Maybank Investment Bank FYE2017

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 Maybank FYE2018

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 Maybank FYE2018

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 Maybank FYE2018

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 Maybank Investment Bank FYE2017

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 Maybank Investment Bank FYE2017

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 Chapter 3
What Is Money?

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 Preview

• In this chapter, we develop precise

definitions by exploring the functions of
money, looking at why and how it
promotes economic efficiency, tracing how
its forms have evolved over time, and
examining how money is currently
measured.

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 Learning Objectives

• Describe what money is

• List and summarize the functions of
money
• Identify different types of payment
systems
• Compare and contrast the M1 and M2
money supplies

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 MONEY
• Money bewitches people. They fret for it, and
they sweat for it. They devise most ingenious
ways to get it, and most ingenious ways to get
rid of it. Money is the only commodity that is
good for nothing but to be gotten rid of. It will
not feed you, clothe you, shelter you, or
amuse you unless you spend or invest it. It
imparts value only by parting. People will do
almost anything for money, and money will do
almost anything for people. Money is
captivating, calculating, masquerading puzzle.
Creeping Inflation, Business Review, August 1957, p.3 Federal Reserve Bank of
Philadelphia

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 • Some interesting notes from AKPK
(Agensi Kaunseling dan Pengurusan Kredit)

• Good article to DIGEST – “The Brand Trap”

https://muslimvillage.com/2017/02/11/122148/
the-brand-trap/

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 FACTS & FIGURES
• 2011 – POWER! Launched 🡪 financial education
programme – Uni students, young adults and
individuals already in workforce
• End of 2013 – 62,818 individuals with RM4.5
billions debt 🡪 AKPK Debt’s Mgmt Program
• 2014 – 20,000 cases of Debt Mgmt Program (47-
60% Malays), 60-70% Male, 39% age range 30-40
• On average, 60 Malaysians are declared bankrupt
everyday
• Household debt?
http://www.thestar.com.my/business/business-
news/2016/04/02/household-debt-on-the-rise/
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1-75 © 2016 Pearson Education Ltd. All rights reserved.
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1-77 © 2016 Pearson Education Ltd. All rights reserved.
 Meaning of Money

• Money (or the “money supply”): anything

that is generally accepted as payment for
goods or services or in the repayment of
debts.
• A rather broad definition

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 Meaning of Money

• Money (a stock concept) is different from:

– Wealth: the total resources owned by the
individual, that serve to store value
– Income: flow of earnings per unit of time
(a flow concept)

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 Functions of Money
• Medium of Exchange:
– Money acts as a medium of exchange and
Removes the trouble of finding a double
coincidence of wants in barter economy. now
goods and services are purchased and sold with
the help of money
– Promotes specialization
• A medium of exchange must:
– be easily standardized
– be widely accepted
– be divisible
– be easy to carry
– not damage quickly

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 Functions of Money

• Unit of Account:
– money is used to measure value in an economy.
We measure the value of goods and services in
terms of money
 A Store of Value:
– Money Is Used to save purchasing power over
time, from the time money is received until the
time it is spent You know that you do not need to
spend it immediately because it will still hold its
value
– Money is the most liquid of all assets but loses
value during inflation.

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 Evolution of the Payments System
• Commodity Money: valuable, easily
standardized and divisible commodities
(e.g. precious metals, cigarettes)
• Money made up of precious metals or
another valuable commodity is called
commodity money
• gold, and silver are examples of commodity
money
• Fiat Money: paper money commanded by
governments as legal tender

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 Evolution of the Payments System

• Checks: an instruction to your bank to

transfer money from your account
• Electronic Payment (e.g. online bill
pay).
• E-Money (electronic money):
– Debit card
– Stored-value card (smart card)
– E-cash

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 INTRODUCTION TO MONEY

Micro-documentary:
How Our Monetary System Works And Fails

http://www.youtube.com/watch?v=JUFxsZF5E48

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 Are We Headed for a Cashless
Society?
• Predictions of a cashless society have been
around for decades, but they have not
come to fruition.
• Although e-money might be more
convenient and efficient than a payments
system based on paper, several factors
work against the disappearance of the
paper system.
• However, the use of e-money will likely
still increase in the future.

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 Will Bitcoin Become the Money
of the Future?
• Bitcoin is type of electronic money (widely
known as cryptocurrency – digital
currency) created in 2009 by Satoshi
Nakamoto through the concept of ‘peer-
to-peer electronic cash system’
• Cryptocurrencies are not minted or
printed. It is a digital currency in which
encryption techniques are used to
regulate the generation of units of
currency and verify the transfer of funds.

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 Will Bitcoin Become the Money
of the Future? (cont..)
• A cryptocurrency is mined by a node
through solving a complex mathematical
problems issued by the organization behind
the currency. The quickest to solve the
problem is rewarded with Bitcoin – added to
the ledger in visible on the Blockchain.
• The reliance on Blockchain – the platform
that support the existence of Bitcoin or any
other cryptocurrencies. Blockchain is to
cryptocurrency as to what internet is for
email.

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 Will Bitcoin Become the Money
of the Future? (cont..)
• Current supply of Bitcoin is around 13.25
million, with current protocol it is
estimated the supply should surpass 19
million by 2022.
• Although Bitcoin functions as a medium of
exchange it is unlikely to become the
money of the future because it performs
less well as a unit of account and a store
of value. Really??

1-88 © 2016 Pearson Education Ltd. All rights reserved.

 The “value” of cryptocurrency

• Acceptance of it as medium of exchange

within a ‘community’
• More participation, increase complexities
in mining process push up its values
• Increased popularity, deemed as good
store of value (many willing to exchange
it with $$$ - especially those that do not
possess the mining skills)
• Driven by speculative interest. What
happen if the interest dies?

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 as at 17 September 2019
as at 25 September 2017

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 Adopted from Prof Dato Ahamed Kameel Mydin Meera – Presentation on cryptocurrency

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 Adopted from Prof Dato Ahamed Kameel Mydin Meera – Presentation on cryptocurrency

1-92 © 2016 Pearson Education Ltd. All rights reserved.

 Measuring Money

• How do we measure money? Which

particular assets can be called “money”?
• Construct monetary aggregates the
measures of the money supply in a
country using the concept of liquidity:
– M1 (most liquid assets) = currency +
traveler’s checks + demand deposits + other
checkable deposits

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 Measuring Money

• M2 (adds to M1 other assets that are not

so liquid) = M1 + small denomination time
deposits + savings deposits and money
market deposit accounts + money market
mutual fund shares

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 The Federal Reserve’s
Monetary Aggregates

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 The Federal Reserve’s Monetary
Aggregates
M1
M2

Currency
Small Den. Dep.
Traveler’s Checks
Savings and MM
Demand Deposits
Money Market Mutual
Other Check. Dep Funds Shares

M3

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 The Federal Reserve’s Monetary
Aggregates
• M1 versus M2: Does it matter which
measure of money is considered?
• M1 and M2 can move in different
directions in the short run (see figure).
• Conclusion: the choice of monetary
aggregate is important for policymakers.

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 Figure 1 Growth Rates of the M1 and
M2 Aggregates, 1960–2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2

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 Definition of monetary aggregates in Malaysia
M1 = Currency in Circulation + Demand Deposits

M2 = M1 + Narrow Quasi Money

where Narrow Quasi-Money = Savings Deposits + Fixed
Deposits + NIDs(negotiable instrument deposits) +
Repos + Foreign Currency Deposits + other deposits

M3: M2 + deposits placed with other banking institutions

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 Payment system

A payment system consists of instruments,

banking procedures, and typically interbank
funds transfer systems that ensure and
facilitate the circulation of money. In
essence, it facilitates corporations,
businesses and consumers to transfer funds
to one another. (Bank for International
Settlements (BIS))

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 Payment System in Malaysia

Payment system is defined as any system or arrangement for the transfer, clearing or settlement of funds or securities in the Central Bank of
Malaysia Act 2009.

In essence, it facilitates corporations, businesses and consumers to transfer funds to one another.

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 Payment System in Malaysia (cont..)

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 Payment System in US
Non cash payment

The estimated number of noncash payments,

excluding wire transfers, was 122.8 billion in 2012,
with a value of $79.0 trillion.

Trends in noncash payments are influenced by

many factors, including technological and financial
innovations, changes in consumer and business
financial behaviour, the business cycle, the
composition of economic activity, regulatory
developments, and population growth.

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 Payment System in US (cont..)

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 KHALAS!

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INTEREST RATES

What do interest rates mean and what is their role in valuation?

INTEREST RATES

We will be looking into today:-

 Understanding interest rates

 Measuring interest Rates
 The Distinction Between Interest Rates and Returns
 The Distinction Between Real and Nominal Interest
Rates
INTEREST RATES

Interest rates are among the most closely

watched variables in the economy. It is
imperative that what exactly is meant by the
phrase interest rates is understood.
In this chapter, we will see that a concept
known as yield to maturity (YTM) is the most
accurate measure of interest rates.

is the total rate of return that will have been earned by a bond when it
makes all interest payments and repays the original principal
How many INTEREST RATES?
Putting the role of interest rates into
the perspective of VALUATION

1. FUTURE VALUE
2. PRESENT VALUE
Future Values: Compounding
• Assume that the interest rate is 10% p.a.

• What this means is that if you invest $5 for one

year, you have been promised

$5.00*(1.10) =$5.50 next year

• Investingfor another year promises to produce 5.50

*(1.10) = $6.05 in 2-years
Or, $5.50*(1.10)^2 = $6.05

111
 Value of $5 Invested

More generally, with an investment of $5 at

10% we obtain
1 Year $5*(1+0.10) $5.5

2 years $5.5*(1+0.10) $6.05

3 years $6.05*(1+0.10) $6.655

4 Years $6.655*(1+0.10) $7.3205

112
 Examples: Future Value of a Lump Sum

FV  PV * (1  i ) n
• Your bank offers a CD with an
interest rate of 3% for a 5 year
investment.
• You wish to invest $1,500 for 5
 $ 1500 * (1  0 .03 ) 5
years, how much will your  $ 1738 .1111145
investment be worth?
n 5
i 3%
PV 1,500
FV ?
Result 1738.911111
113
 Important note on the Frequency of
Compounding
• Different financial products have different compounding
frequency

4‫نضرب السنة ب‬
4 ‫ونقسم الفائدة على‬

  PV*
FV=

114
 Important note on the Frequency of
Compounding
• For investments, normally it is compounded once in a year
– per annum

• BUT, for credit instruments, i.e. credit cards carry a rate of

interest of 18% per year compounded monthly

• 18% = Stated Annual Interest Rate also known as the

Annual Percentage Rate (APR), but notice: “compounded
monthly”

• Need to calculate the Effective Annual Rate to be

comparable
115
 The Frequency of Compounding
• Formula for computing effective annual rate when there are multiple
compounding periods is:

• If the credit card charges an APR of 18% per year compounded monthly, the
(real) monthly rate is 18%/12 = 1.5%, the EAIR (1+0.015)12 - 1 = 19.56%
• 18% vs 19.56%!

116
Effective Annual Rates of an APR of 18%

Equal APR with different frequency of compounding have different EPR:

Annual Frequency of Annual Effective

Percentage rate Compounding Rate
18 1 18.00

18 2 18.81

18 4 19.25

18 12 19.56

18 52 19.68

18 365 19.72

The higher the frequency of compounding, the higher will the EPR be

117
The Frequency of Compounding
• Many lenders and borrowers do not have a clear
understanding of APRs, but institutional lenders and
borrowers do

• Institutions are therefore able to extract a few basis

points from consumers

118
 The Frequency of Compounding
• FIsprofit from differences in the lending and borrowing
rates. Overheads, bad loans and competition results in
a narrow margin. Small rate gains therefore result in a
large increases in institutional profits

• In
the long term, ill-informed consumers lose because of
compounding

119
Lets look at real life examples

120
The dependency of Malaysian households on credit services is proxied by
the 71.4% revenue from credit and service charge income received by
Courts Malaysia in its financial year 2017
Measuring Interest Rates
•Recall the concept of present value:
a dollar paid to you one year from now is less
valuable than a dollar paid to you today (time
value of money)

• Why:
a dollar deposited today can earn interest
and become $1 x (1+i) one year from today.
Simple Present Value

PV = today's (present) value

CF = future cash flow (payment)
i = the interest rate
CF
PV = n
(1 + i )
Simple Present Value - Discounting

$100 $100 $100 $100

Year 0 1 2 n

PV 100 100/(1+i) 100/(1+i)2 100/(1+i)n

Four Types of Credit Market
Instruments
• Simple Loan
• Fixed Payment Loan
• Coupon Bond
• Discount Bond
YIELD TO MATURITY (YTM)
The most
accurate
measure
Definition:
The interest rates that equates the PV of cash flows
received from a debt instrument with its value
TODAY.

 Financial economists consider it to be the MOST

accurate measure of interest rates.
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
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
FP FP FP FP
LV =  2
 3
 ...+
1 + i (1 + i ) (1 + i ) (1 + i ) n
Fixed Payment (FP) Loan

FP Loan where the loan principal and interest are

repaid in several payments, often monthly, in equal
dollar amounts over the loan term.

The PV of FP loan is calculated as the sum of the PV

of all cash flows

Recall that, simple Loans require payment of one amount

which equals the loan principal plus the interest.
 Fixed Payment (FP) Loan Application

You decide to purchase a new home and need a $100,000 mortgage. You take out
a loan from the bank that has an interest rate of 7%. What is the yearly payment
to the bank to pay off the loan in 20 years?

Loan value = $100,000

Annual interest rate = 0.07
Number of payment (years) n = 20
Hence, the yearly payment to the bank is $9,439.29

Here, n = 20 since it is yearly payment, if it is monthly payment what will n be?

REFER TO PAGE 116 TEXTBOOK
Coupon Bond
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=    . . . + 
1+i (1+i ) 2 (1+i )3 (1+i ) n (1+i ) n
 Coupon Bond
• When the coupon bond is priced at its face value, the yield to maturity equals
the coupon rate. Higher the price, the lower yields maturity.// if I sell less than
face value, more yields maturity
• 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.
 Coupon Bond
Coupon rate = 10% = C/F= $100/$1000

Example 3.4 (p85)

Find the price of a 10% coupon bond with a face value of $1,000, a 12.25% yield to
maturity and eight years to maturity.

n = years to maturity = 8
FV = face value of the bond = 1,000
i = annual interest rate = 12.25%
PMT = yearly coupon payments = 100
PV = ? $889.20 REFER TO PAGE 117 TEXTBOOK
• CONSOL or perpetuity: a bond with no maturity date that does
not repay principal but pays fixed coupon payments forever,
mean its continuous
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
Discount Bond doesn't have coupon and
buy in discount
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.
One-Year Discount Bond* (Bond price=P = $900, Face
value=F = $1000).

*NORMALLY USED IN VALUING TREASURY BILLS

 The Distinction Between Interest
Rates and Returns
• Thereturn equals the yield to maturity only if the
holding period‫ل‬$$‫ ا‬equals the time to maturity.
• A rise
in interest rates is associated with a fall in
bond prices, resulting in a capital loss if time to
maturity is longer than the holding
period=investment period. (n>h)
• The more distant a bond’s maturity, the greater
the size of the percentage price change
associated with an interest-rate change‫ان‬$$‫لما ك‬$$‫ك‬
‫ر‬$‫لسع‬$$‫تغير ا‬$$‫لمئوية ل‬$$‫لنسبة ا‬$$‫ ا‬$‫لما زاد حجم‬$$‫ ك‬،‫د‬$‫بع‬$‫لسند أ‬$$‫اقا‬$‫ستحق‬$‫ا‬
‫لفائدة‬$$‫ر ا‬$‫ع‬$$‫تغيير س‬$$$‫لمرتبط ب‬$$‫ا‬
The Distinction Between Interest
Rates and Returns
• 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.
Because IR if increase ,cash flow will decrees yearly
• This is what we call as – interest rate risk.
• the potential that a change in overall interest rates
will reduce the value of a bond ,as interest rates rise
bond prices fall
 The Distinction Between Interest Rates
and Returns $‫جعيه‬$‫ را‬$‫هام‬

n = 1 (remaining maturity for calculating price next year)

Coupon = 100 (10% of $1000)
FV = $1000 (face or par value)
i = 20% (current/prevailing market rate)
Press PV for Bond price = $917
Maturity and the Volatility of Bond
Returns: Interest-Rate Risk
• Pricesand returns for long-term bonds are more
unpredictable‫قلبا‬$$$‫كثر ت‬$‫ أ‬than those for shorter-term
bonds.
• There is no interest-rate risk for any bond whose
time to maturity matches the holding period.
(n=h),Mean holding period is the target period so
Interest Rate Risk - Recap

• The riskiness of an asset’s return that

results from interest rate changes.
• Major concern of managers of financial
institutions and investors
• Remember the fact about the behavior of
bond markets:
Prices and returns of long-term bonds are more
volatile than those for shorter-term bonds
The Distinction Between Real and
Nominal Interest Rates
• Nominal interest rate: the interest rate without the
adjustment of inflation
• Real interest rate is an interest rate that has been
adjusted to remove the effects of inflation to reflect
the cost of borrowing and its more accurate.
• Exante real interest rate is adjusted for expected changes in
the price level
• Expost real interest rate is adjusted for actual changes in
the price level
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.
 Figure 1 Real and Nominal Interest Rates (Three-Month
Treasury Bill), 1953–2014

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.
Reinvestment Risk when the interest rate
change, so we can reinvest in the same interest rate

• Occurs if a series of short bonds are held

over a long holding period
• i at which reinvest uncertain
• Gain from i , lose when i 
• ‫كل ما زادت الفائدة كل ما كان عائد العادة االستثمار اعلى‬
Global perspective
• In November 1998, rates on Japanese
6-month government bonds were negative (-0.004%)!
Extremely an unusual event.
• Indicating that investors were willing to pay more than
they would receive in the future. WHY?
• Best explanation is that investors found the convenience of
holding the bills as a store of value during poor economy
condition —more convenient than cash. But that can only
go so far—the rate was only slightly negative. More people
demand for it, which push down the rate to negative!
What we have learned?

• Measuring Interest Rates: We examined several

techniques for measuring the interest rate required
on debt instruments.
• The Distinction Between Real and Nominal Interest
Rates: We examined the meaning of interest in the
context of price inflation.
• The Distinction Between Interest Rates and
Returns: We examined what each means and how
they should be viewed for asset valuation.
Applying YOUR understanding

Data Analysis Problems – p 130 textbook

Each Group to email to [email protected] by

15 Nov 2018 by 5 p.m. with an email title;

“Group No – Meaning of Interest Rates”

 Chapter 5
The Behavior of
Interest Rates

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20-
151
 Preview

• In this chapter, we examine how the overall

level of nominal interest rates is determined
and which factors influence their behavior.

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 Learning Objectives

• 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

• 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

• 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
Holding all other factors constant:
1. an increase in wealth raises the quantity
demanded of an asset
2. an increase in an asset’s expected return
relative to an alternative asset raises the
quantity demanded of the asset.
3. if an asset’s risk rises relative to alternative
assets, its quantity demanded will fall
4. The more liquid an asset is relative to
alternative assets, the more desirable it is and
the greater the quantity demanded will be.

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 Theory of Portfolio Choice

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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

1-158 © 2016 Pearson Education Ltd. All rights reserved.

 Figure 1 Supply and Demand for
Bonds
Price of Bonds, P ($)

1,000
(i = 0%) Bs
With excess supply, the
950 bond price falls to P *
(i = 5.3%) A I

900
(i = 11.1%) B H
C

P * = 850
(i * = 17.6%)

800 D
G
(i = 25.0%)

With excess demand, the

750
F E bond price rises to P *
(i = 33.0%)
Bd

100 200 300 400 500

Quantity of Bonds, B
($ billions)

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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

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 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

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 Figure 2 Shift in the Demand Curve
for Bonds in a business cycle expansion with growing
income and wealth, the demand for bonds
Price of Bonds, P rises and the demand curve for bonds shifts
to the right.
A′
An increase in the demand for
A bonds shifts the bond demand
curve rightward.
B′

C′

D′

D
E′

E
d B2d
B 1

Quantity of Bonds, B

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 Shifts in the Demand for Bonds

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 Shifts in the Supply of Bonds

• 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

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 Shifts in the Supply of Bonds

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 Figure 3 Shift in the Supply Curve
for Bonds in a business cycle expansion, the supply
of bonds increases and the supply curve
Price of Bonds, P shifts to the right.
B s1 B2s
I

I′

H
H′
C
An increase in the supply of
C′ bonds shifts the bond supply
curve rightward.
G
G′

F′

Quantity of Bonds, B

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 Figure 4 Response to a Change in
Expected Inflation
Step 1. A rise in expected inflation shifts
Price of Bonds, P the bond demand curve leftward . . .
B1s
Step 2. and shifts the bond supply curve
rightward . . .
B2s
Step 3. causing the price of bonds to fall
and the equilibrium interest rate to rise.

1
P1 When expected inflation rises, the
supply curve shifts from Bs 1 to Bs
2 2, and the demand curve shifts
P2
from Bd 1 to Bd 2. The equilibrium
moves from point 1 to point
B1d
B d
2 2, causing the equilibrium bond
Quantity of Bonds, B price to fall from P1 to P2 and
the equilibrium interest rate to rise

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 Figure 5 Expected Inflation and Interest Rates
(Three-Month Treasury Bills), 1953–2014

Sources: Federal Reserve Bank of St. Louis FRE D database: http://research.stlouisfed.org/fred2. Expected inflation calculated using
procedures outlined in Frederic S. Mishkin, “The Real Interest Rate: An Empirical Investigation,” 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.

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 Figure 6 Response to a Business
Cycle Expansion Step 1. A business cycle expansion
shifts the bond supply curve
rightward . . .
Price of Bonds, P
B1s Step 2. and shifts the bond demand
curve rightward, but by a lesser
amount . . .
B2s Step 3. so the price of bonds falls
and the equilibrium interest rate
rises.

In a business cycle expansion,

P1
1
when income and wealth are rising,
2 the demand curve shifts rightward
P2
from Bd 1 to Bd 2. If the supply
curve shifts to the right more than
B d
1
B2d the demand curve, as in this
Quantity of Bonds, B
figure, the equilibrium bond price
moves down from P1 to P2 and the
equilibrium interest rate rises

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 Figure 7 Business Cycle and Interest Rates
(Three-Month Treasury Bills), 1951–2014

Source: Federal Reserve Bank of St. Louis FRE D database: http://research.stlouisfed.org/fred2

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