Interests, Money, Loans, and Bonds

Money is any asset that can be used to purchase goods or services

It has three uses: 

• Medium of exchange (determining value)
• Unit of account (comparing cost)
• Store of value (how money can be kept, such as in the bank, personal savings, etc.)

Three Types of Money

• Commodity Money - Money that has value in itself (salt, olive oil, gold)
• Representative Money - Represents something of value (IOU, 
• Fiat Money - Money because the gov't says so, (ex. paper currency, coins)

Six Characteristics of Money

1. Durability
2. Portability 
3. Divisibility 
4. Uniformity
5. Limited supply
6. Susceptibility 

Money Supply - All the money available in the US economy

M1 Money

• Liquid Assets (Liquidity) - Easy to convert to cash 
1. Cash
2. Currency
3. Checkable or demand deposits (checking accounts)
4. Traveler's Checks 

M2 Money 

• M1 Money + Savings Acct. and Money Market Accts. 

Purposes of Financial Institutions

• Store money
• Save money
• Loan money

They Loan Money for Two Reasons:

•  Credit cards
• mortgages

Four Ways to Save Money:

1. Savings account (low interest)
2. Checking account (no interest)
3. Money market account
4. Certificate of Deposit (CD) (fixed rate of interest)

(The last two pays higher interest, but with stricter rules)


Loans

• Banks operate on a fractional reserve system (keep a fraction of funds in the bank and lend out the rest) 

Interest Rates

• Principal - Amount of money borrowed

• Interest - Price paid for the use of borrowed money
1. Simple interest - Paid on the principal
2. Compound interest - Paid on the principal + accumulated interest

How to Calculate Simple Interest

I = P x R x T / 100

1. P stands for Principal
2. R stands for interest rate
3. T stands for time

Rearrange equation as needed to find different variables: 

1. P = I x 100 / R x T
2. R = I x 100 / P x T
3. T = I x 100 / P x R

Five Types of Financial Institutions

1. Commercial Banks
2. Savings and loans institutions
3. Mutual savings bank
4. Credit unions
5. Finance companies 

Investments 

1. Redirecting resources that we would consume now for future purposes 
2. Financial Assets - Claims on property and income of the borrower
3. Financial Intermediaries - Institution that channels funds from savers to borrowers 

Savers ---> Financial Institutions --> Investors

Three Purposes of Financial Intermediaries 

1. Share risk (diversification, spreading out investments to reduce risks)
2. Provide Information 
3. Liquidity - Returns (money an investor receives above and beyond the sum of money that was initially invested) 

Bonds

1. Loans or IOU's that represent debt that the govt or a corporation must repay to an investor
2. Bonds are generally low-risk investments

3 Components of a Bond

1. Coupon Rate - The interest rate that a bond issuer will pay to a bond holder 
2. Maturity - Time at which payment to a bond holder is due 
3. Par Value - Amount that an investor pays to purchase a bond and that will be repaid to the investor at maturity 

Example:

Coupon Rate: 5%
Maturity: 10 years
Par Value: 1,000

Bond = $500

Time Value of Money

• Is a dollar today worth more than a dollar tomorrow? 

1. Yes, because of inflation and opportunity cost 
2. This is the reason for charging and paying interest

The Simple Interest Formula

v = (1 + r)^n x p

Compound Interest Formula

v = (1 + r/k)^nk x p

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

7 Functions of the FED

1. It issues paper currency
2. Sets reserve requirements and holds reserves of banks 
3. It lends money to banks and charges then interest
4. They are a check clearing service for banks
5. Acts as a personal bank for the govt
6. Supervises member banks
7. Controls money supply in the economy