Financial Flows and Money Markets Economics 71a Spring 2007 Mayo, chapter 1 Lecture notes 2.1

Outline  Finance fundamentals  Investment characteristics Term Liquidity Return Risk States of nature  Money connections  Interest rates

Finance Fundamentals and Functions Firms Consumers Savings Invest Payout Return Time

Finance Fundamentals and Functions Firms Consumers Savings Invest Payout Return Time Intermediaries/Financial Service Firms

Finance Fundamentals and Functions Consumers Savings Borrow Repay loans Return Time Intermediaries/Financial Service Firms

Investment Characteristics  Term Length of time  Liquidity Ease of buying and selling  Return  Risk  States of nature

Money Connections  Money Store of value Transaction medium Unit of account

Monetary Instruments (High to Low Liquidity)  Cash  Debit cards  Checking accounts  Money market accounts  Government bonds  Much less liquid (Are these money?) U.S. Stocks Corporate bonds Gold

Credit Cards  What are they? Not a store of value Not an investment  Roles Transactions Borrowing

Interest Rates  Key price for many financial instruments

Interest Rate Units  Usually in percentage terms  Example Annual interest rate = 8% Time period here = 1 year Lenders lending $100 get $108 in 1 year Borrowers getting $100 loan, pay back $108 in 1 year

Real Interest Rates  Nominal rate of interest Rate before inflation adjustment  Real rate of interest Rate after adjusting for inflation  More later

Interest Rate Determination D = demand for loans Interest Rate Quantity of loans S = lender supply

What happens when the economy “heats up” D = demand for loans Interest Rate Quantity of loans S = lender supply

Shifts in Demand and Supply for Loans and Savings  During good times Firms increase demand for loans People probably increase demands for loans Interest rate rises  What about personal savings? Less clear

Shifts in Demand and Supply for Loans and Savings  Government Borrowing The government is a major player too If it increases or decreases its borrowing the demand for loans will change

Different Interest Rates  Rates vary over Time (maturities) Risk  Probability of default

Time: The Term Structure  Different rates for different horizons 6 month 1 year 2 years 5 years 10 years 30 years

Yield Curve Years into future Time of maturity Interest Rate Annual % 5%

The Yield Curve  The yield curve changes over time  See “The living yield curve”  Inverted yield curves  The yield curve and GDP

Risk/Return Tradeoff Return Risk U.S. Stocks U.S. Corporate Bonds U.S.Government Bonds Emerging Market Stocks

Outline  Finance fundamentals  Investment characteristics Term Liquidity Return Risk States of nature  Money connections  Interest rates