time money value

Time Value of Money

Is a dollar today worth more than a dollar tomorrow?
-Yes because of inflation/opportunity cost; this is the reason for charging & paying interest

Let v = future value of $$, p = present value of $$, r = real interest rate (nominal - inflation) expressed as a decimal, n = years, k = # of times interest is credited per year

The Simple Interest Formula
v = ( 1 + r ) ^ n x P

The Compound Interest Formula
v = (1 + r/k) ^ nk x P

-Assume that inflation is expected to be 3 % and nominal interest rate on simple is 1%. Calculate future value of 1$ after a year.
r% = i% - #%     1 = ( 1 - .02)^1 x 1

1. Calculate interest rate first
2. Use compound interest formula

-Demand for money has an inverse relationship between nominal interest rates and quantity of money demanded

 What happens to quantity demanded of $ when interest rates increase?
-Quantity demanded falls (interest earning assets instead of borrowed)

 What happens to quantity demanded when interest rates decrease?
-Quantity demanded increases, no incentives to convert cash

What happens if PL increase?
Money Demand Shifter
1). Changes in price level
-increase money supply --> decrease interest rate --> investment increases --> increase AD
-decrease money supply --> increase interest rate --> investment decreases --> decrease AD

Financial Assets (own; bank holds, legal claim, uses of funds) vs Financial liabilities ( claims against bank, sources of funds)
-interest rate: cost of borrowing money
-stocks vs. bonds

What banks Do
- A bank is a financial intermediary

• uses liquid assets to finance investments of borrowers
• process is known as Frictional Reserve Banking ( a system in which depository institutions hold liquid assets < amount of deposits
• can take form of : currency in bank vaults; bank reserves deposits held at federal reserve
• T- account ( balance sheet ) statements of assets and liabilities