• <b>United States Federal Reserve</b>

Money and Banking

1. Mathematics of Debt Instruments

In this section, we discuss the mathematics behind present values and future values of debt instruments. A debt instrument is a loan contract that is sold for some dollar amount in the current period, and is repaid with one or more cash flows over time. The present value of a debt instrument is today's value for the promise of some given stream of future cash flows. The present value calculation discounts future cash flows using the interest rate, because money set aside today can earn interest and grow to larger amounts in the future. We also use the related concept of the future value to determine what a savings account or other financial investment will be worth in the future, given some series of cash flows paid to the account over time, and the interest earned on the account.

2. Markets for Assets

In this section, we discuss supply and demand in the market for bonds. The model will determine the quantity of bonds issued and sold in the market, the price of the bond, and the interest rate paid on bonds. We discuss how changes in the market can shift the supply and/or demand for bonds, and therefore affect the equilibrium interest rate and quantity of bonds in the market. We also use the model to demonstrate why different bonds have different interest rates, depending on differences in risk, liquidity, or tax laws.

3. Money Demand Theories

In this section, we explore theories on what influences the quantity of money that consumers and/or business choose to hold. Money is used as a means of payment for goods and services, so consumers' and businesses' decisions for making purchases influence money demand. Money can also be used to store wealth, and so it may be viewed as a substitute for other financial assets such as stocks or bonds. If this is true, then the returns on these substitute financial assets may influence money demand. Understanding the factors than influence money demand is important because these factors influence equilibrium outcomes in the market for money, particularly the interest rate. We will see in a future section that interest rate outcomes influence consumer and investment demand, and therefore macroeconomic outcomes including employment and real GDP. We close this section with some Pencasts on the equilibrium in the market for money, and demonstrate how shifts in demand or supply of money influence interest rates.

4. Term Structure of Interest Rates

We learned in a previous topic that the interest rate paid on a particular bond relative to other bonds in the market depends on many factors, including differences in default risk, differences in liquidity, and differences in tax rules. In this section, we focus on another factor: differences in the time to maturity. Bonds that have maturity dates at longer periods in the future typically (but not always) pay higher returns. The reasons have to do with bond buyers expectations for the future path of interest rates, the degree of uncertainty that bond buyers have over the future path of interest rates, and the degree of risk aversion that bond buyers have. We illustrate the different interest rates paid on bonds with different terms with the yield curve, and discuss what the shape of the yield curve implies for bond buyers expectations.

5. Money Supply and Deposit Multipliers

In this section we learn how a central bank influences the money supply. We learn the difference between the monetary base and the quantity of money in the economy, and also two measures for the quantity of money. We learn in this section how quantity of money depends on deposit multipliers that can lead to expansions or contractions in the money supply, depending on the fraction of reserves held by banks, the ratio of consumers' currency to checking deposits, and the ratio of consumers savings to checking deposits.

6. Policy Models: IS/LM and IS/MP

The IS/LM and IS/MP are macroeconomic models that explain short-run fluctuations in real GDP and the interest rate. These models help explain how recessions occur and they are conducive to exploring monetary policy prescriptions to remedy such short-run problems. The IS curve in each of these models is a graphical relationship explaining how aggregate demand fluctuations impact interest rates and real GDP when the market for goods and services is in equilibrium. The LM and MP curves are both graphical relationships showing how monetary policy and the market for money affects interest rates and real GDP. While each of these representations are equivalent descriptions of the same type of behavior, one model may be more useful than the other, depending on how one wants to think about the conduct of monetary policy.

7. Aggregate Supply / Aggregate Demand

In this section, we discuss the determinants for aggregate demand and aggregate supply for all final goods and services. We develop a graphical model of that shows how real GDP and aggregate price level are determined in equilibrium. We also discuss what other factors can influence demand and supply decisions and demonstrate the effect that it has on the economy in the short-run and the long-run. We combine the model of supply and demand for money with the aggregate supply / aggregate demand model to show how changes in the market for money influence real GDP and price level. The last Pencasts in this series demonstrate how macroeconomic problems may be remedied with monetary policy actions.