MONEY AND
INTEREST RATES
Chapter 2
OBJECTIVES
01 explain the role of money in the economy
02 enumerate the key functions of money
03 know the difference between supply and
demand for money
04 learn the basics of Time Value of Money
explain the nature and determination of
05 interest rates
understand the relations of interest rates and
06 risk
MONEY
01
an asset of the holder, it is an item or commodity generally
accepted as means for payment of goods, services, or
debts.
it is composed of bills, coins, and electronic entries stored in
02
checking and/or savings accounts
in today’s world, money does not only come in physical form
03
but can be found solely in digital forms, which banks honor
CHARACTERISTICS AND FUNCTIONS
Store of Value Item of Worth Means of Exchange
It must not be perishable, It has an intrinsic value, such It must be possible to
and must be in a practical as that of a precious metal, exchange freely and value
size that can be stored and which acts as guarantee to must be stable as possible. It
transported easily. be accepted. helps when it is divisible and
has denominations so
change can be given.
CHARACTERISTICS AND FUNCTIONS
Unit of Account Standard of Deferred
Payment
It can be used to record It can facilitate exchange at
wealth possessed, traded, or a given point by providing a
spent personally and medium of exchange and
nationally. It must have one unit of account.
recognized authorized issuer
of money so not all can
issue.
SUPPLY The Money Supply
AND M1
• the most liquid form of money used as a form
DEMAND
of exchange. This includes:
FOR MONEY 1. Currency in circulation - physical cash held
Money facilitates the flow of by the public
resources in the 2. Demand deposits - money in the checking
macroeconomy. Not enough
accounts that you can access instantly
money and too much
money either affect 3. Other checkable deposits - some types of
economy as a whole. accounts that allow you to write checks or
use a debit card
[Link]’s checks - issued by non-bank
institutions
SUPPLY The Money Supply
AND M2
• these are money that are relatively easy to
DEMAND
convert into cash
FOR MONEY
Money facilitates the flow of • is a measure of the money supply that
resources in the includes a broader set of financial assets
macroeconomy. Not enough
than M1.
money and too much
money either affect
economy as a whole. • it is used by economists and central banks to
estimate the amount of money available in
the economy for spending and investment.
• it includes M1 + savings deposits, small time
SUPPLY The Money Supply
AND
DEMAND M3
• "big money"—large-scale liquidity used by
FOR MONEY
corporations, banks, and other institutions
Money facilitates the flow of
resources in the
macroeconomy. Not enough
• this includes all M2 + large time deposits,
money and too much institutional money market funds, repurchase
money either affect
agreements, and other large liquid assets
economy as a whole.
held by corporations and financial institutions
SUPPLY The Money Supply
AND
DEMAND L (which stand for Liquidity)
FOR MONEY
• refers to the broadest measure of liquidity in
Money facilitates the flow of
an economy
resources in the
macroeconomy. Not enough
money and too much • this includes treasury securities, commercial
money either affect
papers, government and corporate bonds,
economy as a whole.
and banker’s acceptance
Treasury Securities Commercial Paper
- used to raise funds for government spendings such - used to raise short-term funds for payroll or
as: inventory
• Treasury Bills: Short-term (mature in 1 year or • Maturity: Typically 30 to 270 days
less); sold at a discount, pay no interest. • Unsecured (no collateral)
• Treasury Notes and Bonds: Longer-term, interest- • Only issued by companies with strong credit
bearing ratings
Government & Corporate Bonds Banker’s acceptance
• issued by governments or corporations to fund • issued by banks usually to facilitate
long-term projects, operations, or refinance international trade where the exporter receives
debt cash by selling the banker’s acceptance in the
market
SUPPLY The Money Demand
AND Transaction Demand
DEMAND • money demanded for day-to-day payments
FOR MONEY through balances held by households and
firms such as food, bills, rent, wages,
Money facilitates the flow of
resources in the
supplies, etc.
Precautionary Demand
macroeconomy. Not enough
money and too much • money demanded as a result of
money either affect unanticipated payments
economy as a whole.
• happens in case of unexpected expenses or
emergencies such as medical emergencies,
car repairs, job loss, or unexpected bills
SUPPLY The Money Demand
AND
DEMAND
Speculative Demand
FOR MONEY • money demanded because of expectations
Money facilitates the flow of about interest rates in the future
resources in the
macroeconomy. Not enough
money and too much • in simple terms, people hold onto cash
money either affect instead of investing it now, because they
economy as a whole.
think better investment returns will be
available later
DEMAND FOR MONEY
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Role of Time Value
- Managers are always challenged with opportunities to earn
positive rates of return on their funds.
- Through TVM, managers can play with the timing of cash inflow
and outflow in economic consequences.
- It is based on the belief that an amount is worth more than an
amount that will be received in some future date.
Role of Time Value
- It dictates managers with financial values and decisions which
can be:
FUTURE VALUE TECHNIQUES – measures cash flows at the
end of a project’s life. It uses compounding to find the future
value of each cash flow at the end of investment’s life.
PRESENT VALUE TECHNIQUES – measures cash flows at
the start of a project’s life.
Comparison between FV and PV
- FV is the amount of cash you will receive at a
given future date.
- PV is the amount of cash you have today, just like
the amount of cash on hand you have currently.
Basic Patterns of Cash Flows :
SINGLE AMOUNTS - FV
Future Value is the value at a given future date of
a present amount placed on deposit today and
earning interest at a specified rate.
Basic Patterns of Cash Flows :
SINGLE AMOUNTS - FV
The amount of future value depends on the rate of
interest earned and the length of time a given
amount is left on deposit.
If you have P500 today into an account that pays 5% annual interest,
how much would you have in the account at the end of exactly 10 years?
- Compound interest indicate that the amount of
interest earned on a given deposit has become
part of the principal at the end of specified period.
- Principal refers to the amount of money on which
the interest is paid.
Example:
If Fred Moreno places P100 in a savings account
paying 8% interest compounded annually, at the
end of 1 year he will have P108 in the account.
Example:
If Fred Moreno were to leave this money in the
account for another year, he would be paid interest
rate of 8% on the new principal of P108.
Therefore, at the end of second year, he will have
P116.64 in the account.
Equation:
Problem:
Jane Farber places P800 in a savings account
paying 6% interest compounded annually. She
wants to know how much money will be in the
account at the end of 5 years.
Basic Patterns of Cash Flows :
SINGLE AMOUNTS - PV
Present Value is the current peso value of a future
amount – the amount of money that would have to
be invested today at a given interest rate over a
specified period to equal the future amount.
Basic Patterns of Cash Flows :
SINGLE AMOUNTS - PV
This process is often referred to as discounting
cash flows. It is concerned with answering:
If I can earn % percent on my money, what is the
most I would be willing to pay now for an
opportunity to receive FV peso amount in periods
from today?
Equation:
Annual rate of return is variously referred to as the
discount rate, required return, cost of capital, and
opportunity cost.
Example:
Stu Dent has an opportunity to receive P300 one
year from now. If he can earn 6% on his investment
in the normal course of events, what is the most he
should pay now for this opportunity?
Example:
Stu Dent has an opportunity to receive P300 one
year from now. If he can earn 6% on his investment
in the normal course of events, what is the most he
should pay now for this opportunity?
Answer: P283.02
Board Problem: (Timeline)
Pam Valenti wishes to find the PV of P1,700 that will
be received 8 years from now. Pam’s opportunity
cost is 8 percent.
Board Problem: (Timeline)
Pam Valenti wishes to find the PV of P1,700 that will
be received 8 years from now. Pam’s opportunity
cost is 8 percent.
Answer: P918.42
Basic Patterns of Cash Flows :
ANNUITIES
This is a stream of equal periodic cash flows, over
a specified time period. These cash flows can be
inflows of returns earned on investments or
outflows of funds invested to earn future returns.
Types of Annuities
Ordinary Annuity – this is where cash flows
occur at the end of each period.
Annuity Due – this is where cash flows occur at
the beginning of each period.
FV of Ordinary Annuity
Franz wishes to determine how much money she
will have at the end of 5 years if she chooses
ordinary annuity.
She has P1,000 deposit annually, at the end of
each of the next 5 years, into a savings account
paying 7% annual interest.
FV of Ordinary Annuity
Equation: P x (
FV of Ordinary Annuity
To compute, get the FV interest factor for an ordinary
annuity and multiply by the present value amount.
= 1,000 x 5.7507
= 5,751. 74
FV Interest Factor is a multiplier used to calculate the
future value of an ordinary annuity at a specified
interest rate over a given period of time.
PV of Ordinary Annuity
Belle Company, a small producer of plastic toys,
wants to determine the most it should pay to
purchase a particular ordinary annuity.
The annuity consists of cash flows of P700 at the
end of each year for 5 years. The firm requires the
annuity to provide a minimum return of 8%.
PV of Ordinary Annuity
Equation: P x (
PV of Ordinary Annuity
To compute, get the PV interest factor for an ordinary
annuity and multiply by the present value amount.
= 700 x 3.9927
= 2,794.90
PV Interest Factor is a multiplier used to calculate the
present value of an ordinary annuity at a specified
interest rate over a given period of time.
FV of an Annuity Due
- Cash flows of an annuity due occurs at the
beginning of the period.
Equation: P x (
- This equation says that future value interest factor
for an annuity due can be found merely by multiplying
the FV interest factor for an ordinary annuity at the
same percent and number of period by (1+i).
FV of Annuity Due
Franz wishes to determine how much money she
will have at the end of 5 years if she chooses
ordinary due.
She has P1,000 deposit annually, at the beginning
of each of the next 5 years, into a savings account
paying 7% annual interest.
FV of Annuity Due
Franz wishes to determine how much money she will have at the end of 5
years if she chooses ordinary due.
She has P1,000 deposit annually, at the end of each of the next 5 years, into
a savings account paying 7% annual interest.
Answer: 1,000 x 6.1532 = 6,153.29
PV of an Annuity Due
- Cash flows of an annuity due occurs at the
beginning of the period.
Equation: P x (
- This equation says that present value interest factor
for an annuity due can be found merely by multiplying
the PV interest factor for an ordinary annuity at the
same percent and number of period by (1+i).
PV of Annuity Due
Belle Company, a small producer of plastic toys,
wants to determine the most it should pay to
purchase a particular ordinary annuity.
The annuity consists of cash flows of P700 at the
beginning of each year for 5 years. The firm
requires the annuity to provide a minimum return of
8%.
PV of Annuity Due
Belle Company, a small producer of plastic toys, wants to
determine the most it should pay to purchase a particular ordinary
annuity.
The annuity consists of cash flows of P700 at the beginning of
each year for 5 years. The firm requires the annuity to provide a
minimum return of 8%.
Answer: 700 x 4.312127 = 3,018.49
INTEREST RATES
Borrower Lender
it is the premium that it serves as a reward for
must be paid in order to waiting and allows lender
acquire goods sooner and to calculate the future
pay for them later benefit (future payments
earned) of extending a
loan or saving a fund
today
DETERMINATION OF INTEREST
RATES
- it depends upon the demand for and supply of loanable funds.
Investors Consumers
They demand funds in They demand funds
order to finance capital because of a positive
assets that would increase rate of time preference or
output and generate becasue they prefer
higher profits consumption today
rather than later
• if short-term interest rates push up and
IMPACT OF
down, it effects are felt by the economy
CHANGING
INTEREST
• if interest rates fluctuate all the time, the
RATES
economy will become volatile
• short-term interest rates
are relevant for loans
• when interest rates rise, it makes loans less
with short lenght of affordable while high interest on savings
repayment
accounts encourages saving rather than
spending
• long-term interest rates • when interest rates fall, it makes loans
are relevant for
cheaper hence to spend more money while
longpterm borrowings
like 10-30 years saving becomes less attractive if interest
rates are low
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