Core Concepts of Money, Payments, and Interest Rates
What is Money?
Money is anything generally accepted as payment for goods and services (G&S) or in the settlement of debts.
Key Functions of Money
- It acts as a medium of exchange.
- It is a unit of account.
- It is a store of value.
- It offers a standard of deferred payment.
Money, Income, and Wealth
- Money: A component of wealth.
- Income: A person’s earnings over a period of time.
- Wealth: The sum of a person’s assets minus their liabilities.
Transaction Costs and Specialization
Transaction costs are the costs in time or other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services.
Specialization is when individuals produce the goods and services for which they have the best ability.
Barter Economies and Their Inefficiencies
A barter system involves the direct exchange of goods and services for other goods and services. While an economy can function without money, barter economies are highly inefficient due to several factors:
- Double coincidence of wants: This requirement significantly increases transaction costs.
- Multiple prices: Each good has many prices, one for every other good it can be exchanged for.
- Lack of standardization: Goods are not uniform in size, quality, or amount.
- Difficulty accumulating wealth: Storing wealth is challenging when it consists of perishable or bulky goods.
Types of Money
Fiat Money
Fiat money, such as paper currency, has no intrinsic value other than its status as legal tender. The government designates it as an accepted form of payment.
Commodity Money
Commodity money is a good used as money that also has an independent value apart from its use as a medium of exchange.
The Payments System and Money Supply
The payments system is the mechanism for conducting money transactions within an economy.
Checks
A check is a promise to pay on demand money deposited in a financial institution. Its use relies on a foundation of trust.
Monetary Aggregates (Money Supply)
Monetary aggregates are measures of the quantity of money that are broader than just currency. The two main aggregates are:
- M1: The sum of currency in circulation, checking account deposits, and holdings of traveler’s checks.
- M2: Includes all of M1 plus time deposits, savings accounts, money market deposit accounts, and non-institutional money market mutual fund shares.
The Quantity Theory of Money
The quantity theory of money is a theory about the connection between money and prices, which assumes that the velocity of money is constant. It is represented by the equation:
M * V = P * Y
Where:
- M = Quantity of money
- V = Velocity of money
- P = Price level
- Y = Real GDP
The velocity of money can be calculated as V = (P * Y) / M. Nominal GDP is calculated as Real GDP multiplied by the GDP deflator.
Understanding Interest Rate Structures
The Risk Structure of Interest Rates
The risk structure of interest rates describes the relationship among interest rates on bonds that have different characteristics but the same maturity.
Default Risk
Default risk is the risk that a bond issuer will fail to make payments of interest or principal.
Bond Rating
A bond rating is a single statistic that summarizes a rating agency’s view of the issuer’s likely ability to make the required payments on its bonds.
The Term Structure of Interest Rates
The term structure of interest rates describes the relationship among the interest rates on bonds that are otherwise similar but have different maturities. The Treasury yield curve is a graphical representation of this relationship for Treasury bonds.
Key Observations of the Yield Curve
There are three important facts about the term structure of interest rates:
- Interest rates on long-term (LT) bonds are usually higher than on short-term (ST) bonds.
- Interest rates on short-term bonds are occasionally higher than on long-term bonds (an inverted yield curve).
- Interest rates on bonds of all maturities tend to rise and fall together.
Theories on the Term Structure
The Expectations Theory
This theory holds that the interest rate on a long-term bond is an average of the interest rates investors expect on short-term bonds over the lifetime of the long-term bond. It is based on two key assumptions:
- Investors have the same investment objectives.
- For a given holding period, investors view bonds of different maturities as being perfect substitutes for one another.
The Segmented Markets Theory
This theory holds that the interest rate on a bond of a particular maturity is determined solely by the supply and demand for bonds of that specific maturity. Its assumptions are:
- Investors in the bond market do not all have the same objectives.
- Investors do not see bonds of different maturities as perfect substitutes for each other.
The Liquidity Premium Theory
This theory holds that the interest rate on a long-term bond is an average of the interest rates investors expect on short-term bonds over the lifetime of the long-term bond, plus a term premium.
A term premium is the additional interest investors require to be willing to buy a long-term bond rather than a comparable sequence of short-term bonds, compensating them for the extra risk.