Lecture Notes 3

Money and Banking (ECO223) Date: 13/03/2023

1. Money

ˆ Money as in money supply for exchange of goods.

ˆ Wealth vs money.

ˆ Income is a flow of earnings per unit of time.

ˆ Medium of Exchange (nCr)

ˆ The second role of money is to provide a unit of account; that is, money is used

to measure value in an economy.

ˆ Store of value.

ˆ Inflation.

2. Payment Systems

ˆ Commodity Money

ˆ Fiat Money

ˆ Checks

ˆ Electronic Payment

ˆ E-Money: Cards, Smart cards.

ˆ Satoshi Nakamoto Bitcoin.

ˆ Volatile.

ˆ M1 and M2

3. Measuring interest rates

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 ˆ Different debt instruments have very different streams of cash payments (known

as cash flows).

ˆ The concept of present value (or present discounted value) is based on the com-

monsense notion that a dollar paid to you one year from now is less valu-
able than a dollar paid to you today.

ˆ Simple loan.

ˆ Simple present value: P V = CF

(1+i)n .

ˆ 20 million dollar Jackpot. 1 million each year = 9.4 million.

4. Four Types of Credit Market Instruments

ˆ A simple loan

ˆ A fixed-payment loan (also called a fully amortized loan).

ˆ A coupon bond pays the owner of the bond a fixed interest payment (coupon

payment) every year until the maturity date, when a specified final amount (face
value or par value) is repaid.

ˆ A discount bond (also called a zero-coupon bond) is bought at a price below its

face value (at a discount), and the face value is repaid at the maturity date. (No
discount payments)

5. Yield To Maturity

ˆ yield to maturity, which is the interest rate that equates the present value of cash

flow payments received from a debt instrument with its value today.

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 $110
ˆ (1 + i) = $100 .

ˆ P V = 100000, i = 7%, n = 20.

ˆ Coupon Bond

ˆ When the coupon bond is priced at its face value, the yield to maturity equals

the coupon rate.

ˆ The price of a coupon bond and the yield to maturity are negatively related; that

is, as the yield to maturity rises, the price of the bond falls. As the yield to
maturity falls, the price of the bond rises.

ˆ The yield to maturity is greater than the coupon rate when the bond price is

below its face value and is less than the coupon rate when the bond price is above
its face value.

ˆ Perpetuity: Pc = C
ic

ˆ Discount bond and loan are similar.

6. The Distinction Between Interest Rates and Returns

ˆ Rate of return: R = C+Pt+1 −Pt

Pt , or ic + g.

ˆ The only bonds whose returns will equal their initial yields to maturity are those

whose times to maturity are the same as their holding periods (see, for example,
the last bond in Table 2).

ˆ A rise in interest rates is associated with a fall in bond prices, resulting in capital

losses on bonds whose terms to maturity are longer than their holding periods.

ˆ The more distant a bond’s maturity date, the greater the size of the percentage

price change associated with an interest rate change.

ˆ The more distant a bond’s maturity date, the lower the rate of return that occurs

as a result of an increase in the interest rate.

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ˆ Even though a bond may have a substantial initial interest rate, its return can

turn out to be negative if interest rates rise.

ˆ Real vs nominal interest rate.