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DAY 2 PROBLEM SET Money Problem Set (ANSWERS).pdf

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APMac U4 L3 definition, measurement, and functions of money 

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Define money and its functions.

Calculate (using data as appropriate) measures of money.

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Money makes it possible to compare the value of goods and services, and interest rates provide a measure of the price of money that is borrowed or saved.

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Money is any asset that is accepted as a means of payment.

Money serves as a medium of exchange, unit of account, and store of value.

The money supply is measured using monetary aggregates designated as M1 and M2.

The monetary base (often labeled as M0 or MB) includes currency in circulation and bank reserves.

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APMac Unit 4 Lesson 3 - Definition, Measurement, and Functions of Money

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Start studying APMac Unit 4 Lesson 3 - Definition, Measurement, and Functions of Money. Learn vocabulary, terms, and more with flashcards, games, and other study tools.

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Meaning & Functions of Money | Budget | Money | Banking | CA CPT | CS & CMA Foundation

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Functions of Money and Characteristics of Money

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Mr. Clifford's app is now available at the App Store and Google play. His mobile app is perfect for students in AP macroeconomics or college introductory macro courses. It is designed to help you ace the exam, final, or AP test. The app includes over 60 new economics videos that are not available on YouTube.

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Financial TimesClose Top sections FT.com World Show more World links World Economy UK US China Africa Asia Pacific Emerging Markets Europe Latin America Middle East and North Africa UK S...

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Bonds have an inverse relationship to interest rates. When the cost of borrowing money rises (when interest rates rise), bond prices usually fall, and vice-versa.

At first glance, the negative correlation between interest rates and bond prices seems somewhat illogical; however, upon closer examination, it actually begins to make good sense.

Key Takeaways

Bond Prices vs. Yield

Bond investors, like all investors, typically try to get the best return possible. To achieve this goal, they generally need to keep tabs on the fluctuating costs of borrowing.

An easy way to grasp why bond prices move in the opposite direction of interest rates is to consider zero-coupon bonds, which don't pay regular interest and instead derive all of their value from the difference between the purchase price and the par value paid at maturity.

Zero-coupon bonds are issued at a discountto par value, with their yields a function of the purchase price, the par value, and the time remaining until maturity; however, zero-coupon bonds also lock in the bond's yield, which may be attractive to some investors.

Zero-Coupon Bonds

If a zero-coupon bond is trading at $950 and has a par value of $1,000 (paid at maturity in one year), the bond's rate of returnat the present time is 5.26%: (1,000 - 950) ÷ 950 x 100 = 5.26. In other words, for an individual to pay $950 for this bond, they must be happy with receiving a 5.26% return.

This satisfaction, of course, depends on what else is happening in the bond market. If current interest rates were to rise, where newly issued bonds were offering a yield of 10%, then the zero-coupon bond yielding 5.26% would be much less attractive. Who wants a 5.26% yield when they can get 10%?

To attract demand, the price of the pre-existing zero-coupon bond would have to decrease enough to match the same return yielded by prevailing interest rates. In this instance, the bond's price would drop from $950 (which gives a 5.26% yield) to approximately $909.09 (which gives a 10% yield).

Now that there is an understanding of how a bond's price moves in relation to interest rate changes, it's easy to see why a bond's price would increase if prevailing interest rates were to drop. If rates dropped to 3%, the zero-coupon bond, with its yield of 5.26%, would suddenly look very attractive. More people would buy the bond, which would push the price up until the bond's yield matched the prevailing 3% rate. In this instance, the price of the bond would increase to approximately $970.87.

Given this price increase, you can see why bondholders, the investors selling their bonds, benefit from a decrease in prevailing interest rates. These examples also show how a bond's coupon rate and, consequently, its market price are directly affected by national interest rates. To have a shot at attracting investors, newly issued bonds tend to have coupon rates that match or exceed the current national interest rate.

Zero-Coupon Bond Details

Zero-coupon bonds tend to be more volatile, as they do not pay any periodic interest during the life of the bond. Upon maturity, a zero-coupon bondholder receives the face value of the bond. Thus, the value of these debt securities increases the closer they get to expiring.

Zero-coupon bonds have unique tax implications, too, that investors should understand before investing in them. Even though no periodic interest payment is made on a zero-coupon bond, the annual accumulated return is considered to be income, which is taxed as interest.

The bond is assumed to gain value as it approaches maturity, and this gain in value is not viewed as capital gains, which would be taxed at the capital gains rate, but rather as income.

In other words, taxes must be paid on these bonds annually, even though the investor does not receive any money until the bond maturity date. This may be burdensome for some investors; however, there are some ways to limit these tax consequences.

Bond Prices and the Fed

When people refer to "the national interest rate" or "the Fed," they're most often referring to the federal funds rate set by the Federal Open Market Committee (FOMC). This is the rate of interest charged on the interbank transfer of funds held by the Federal Reserve (Fed) and is widely used as a benchmark for interest rates on all kinds of investments and debt securities.

Fed policy initiatives have a huge effect on the price and the yield of bonds. When the Fed increases the federal funds rate, the price of existing fixed-rate bonds decreases and the yields on new fixed-rate bonds increases. The opposite happens when interest rates go down: existing fixed-rate bond prices go up and new fixed-rate bond yields decline.

What Is the Relationship Between Bond Prices and Interest Rates?

Is It Better to Buy Bonds When Interest Rates Are High or Low?

In general, it is better to buy bonds when interest rates are high if your objective is to maximize returns. When interest rates are high, the yield on a bond is higher, so your investment return will be higher compared to when rates are low.

Do Bonds Go Down When Stocks Go Up?

Typically, when stocks go up, bond prices drop. When stocks go up, it draws investors towards investment in stocks as opposed to bonds. As the demand for bonds decreases, so do their prices, in order to make them more attractive to investors.

The Bottom Line

Interest rates and bond prices have an inverse relationship. When interest rates go up, the prices of bonds go down, and when interest rates go down, the prices of bonds go up. This happens because when new bonds are issued with the higher paying rate (better yield for the investor), it makes existing bonds with the lower rate less attractive. To make these lower-rate bonds more attractive, the price is reduced to entice investors to purchase them.

Correction -August 6, 2023: The correlation between the direction of the federal funds rate and the price and yield of bonds has been corrected to clarify that only new fixed-rate bond yields move, with existing yields holding steady.

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Inverse Relation Between Interest Rates and Bond Prices

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The inverse relation between interest rates and bond prices seems somewhat illogical at first but then starts to make sense upon closer examination.

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What gives a dollar bill its value? - Doug Levinson

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When you deposit money into a bank, do you know what happens to it? It doesn't simply sit there. Banks are actually allowed to loan out up to 90% of their deposits. For every $10 that you deposit, only $1 is required to stay put.

This practice is known as fractional reserve banking. Now, it's fairly rare for a bank to only have 10% in reserves, and the number fluctuates. Since checkable deposits are part of the U.S. money supplies, fractional reserve banking, as you might have guessed, can have a big impact on these supplies.

This is where the money multiplier comes into play. The money multiplier itself is straightforward: it equals 1 divided by the reserve ratio. If reserves are at 10%, the minimum amount required by the Fed, then the money multiplier is 10. So if a bank has $1 million in checkable deposits, it has $10 million to work with for stuff like loans and reserves.

Now, typically, the money multiplier is more like 3, because banks can always hold more in reserves than the minimum 10%. When the money multiplier is higher, like during a boom, this gives the Fed more leverage to move M1 and M2 with a small change in reserves. But when the multiplier is lower, such as during a recession, the Fed has less leverage and must push harder to wield its indirect influence over M1 and M2.

Next up, we'll take a closer look at how the Fed controls the money supply and how that has changed since the Great Recession.

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The Money Multiplier | Macroeconomics Videos

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When you deposit money into a bank, do you know what happens to it? Banks are allowed to lend out up to 90% of it - a practice known as fractional reserve banking. This creates a multiplier effect: when banks loan out your deposits, and those loans are themselves deposited, the banks loan out a percentage of those deposits too, and the process repeats.

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What is money? That may seem like a really simple question, but it's actually kind of complicated. Paper bills and coins, or currency, is obviously money. But it
What is money?
That may seem like a really simple question, but it's actually kind of complicated. Paper bills and coins, or currency, is obviously money. But it doesn't end there.

Technically, "money" is anything that is a widely accepted means of payment. This has changed throughout history. Once upon a time, cattle could be considered money. Or cowry shells. Today, cryptocurrencies like Bitcoin are being added to the mix.

Given that there's no set definition for what makes a commodity money, there are a few measurements for the U.S. money supplies. The first, MB (or "monetary base") measures currency and reserve deposits. This is what the Fed has the most direct control over.

Our next stop will be fractional reserve banking and the money multiplier.

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The U.S. Money Supplies | Macroeconomics Videos

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What is money? That may seem like a really simple question, but it's actually kind of complicated. Paper bills and coins, or currency, is obviously money. But it What is money? That may seem like a really simple question, but it's actually kind of complicated. Paper bills and coins, or currency, is obviously money.

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1. What is money?

2. What are the three types of money?

3. What are the three functions of money?

4. How do we measure money in the US?

5. Can you calculate the present value and future value of money given an amount and a real interest rate?

5. What is the relationship between interest rates and bond prices?

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The Money Project is an ongoing collaboration between Visual Capitalist and Texas Precious Metals that seeks to use intuitive visualizations to explore the origins, nature, and use of money.
We've previously showed you 31 Fascinating Facts About the Dollar's Early History, which highlighted the history of U.S. currency before the 20th century. This was a very interesting period in which we looked at the money used by the first colonists, the extreme bust of the Continental currency, the era of privately-issued bank notes, and Congress' emergency issuance of the fiat "greenback" during the Civil War.

However, the modern era of the U.S. dollar is just as interesting. We have it starting in 1913, when the Federal Reserve Act was passed by Woodrow Wilson. Not only did it establish a new central bank, but it also gave the Fed the authority to issue the Federal Reserve Note, which is now the dominant form of U.S. currency both domestically and abroad.

A New Legal Tender

Leading up to the 20th century, there were four main forms of U.S. currency being used:

Gold and silver coins

Gold and silver certificates

Commercial bank notes, issued by private banks and backed by government bonds

"Greenbacks", a fiat currency declared legal by Congress to help fund the Civil War

In 1913, however, the Federal Reserve Note was authorized as U.S. currency. The new notes were supposed to be backed by gold or other "lawful money", based on the stipulations of the Federal Reserve Act of 1913.

However, this only lasted about 20 years. By the time of the Great Depression, the Fed considered itself to be in a tight spot. It simply did not have enough gold to back all Federal Reserve Notes and Gold Certificates in circulation, and at the same time wanted flexibility with monetary policy to fight deflation and unemployment.

In 1933, the Emergency Banking Act was passed by President Roosevelt, and Executive Order 6102 was also signed. The latter move famously criminalized monetary gold, and ended the gold standard.

After all, if gold can't be legally owned, it can't be legally redeemed.

Modern Paper Money

After a brief return to a pseudo gold standard after WWII, Nixon severed all remaining ties between gold and money in 1971. Since then, U.S. money has been purely fiat, and backed by the government rather than any physical commodity or precious metal.

Some facts on today's paper money:

There is $1.54 trillion of U.S. currency in circulation, and 97% of that is Federal Reserve Notes

Over two-thirds of all $100 bills are held outside the U.S.

Dollar bills can be folded at least 8,000 times, which is 20x more than a normal sheet of paper

That's because dollar bills are made of a special 75% cotton and 25% linen blend, patented by Crane & Co.

The U.S. Bureau of Engraving and Printing produces 38 million notes every day, worth $541 million

The two facilities, located in Washington, D.C. and Fort Worth, Texas use 9.7 tons of ink per day

For 2017, the Fed ordered 7.1 billion new notes, worth $209 billion

More than 70% of these notes are used to replace damaged ones

Notes with smaller denominations ($1, $5, $10) tend to last for shorter periods of time, due to more frequent usage

Coins

The coins used today are similar to U.S. Federal Reserve Notes in that their face values tend to greatly exceed their intrinsic values.

This is because cheaper metals such as copper, zinc, and nickel are used instead of gold or silver.

The average lifespan of a coin is 25 years, according to the U.S. Mint

It's estimated that Americans throw away around $62 million of coins every year

In 2016, the U.S. Mint produced 16 trillion coins, valued at over $1.09 billion

The amount of copper in a penny has fluctuated over the years. It ranges from 0% (in WWII, pennies were made of steel so copper could be used for ammunition) to 95%.

Today's pennies are 2.5% copper, with the remainder being 97.5% zinc

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38 Incredible Facts on the Modern U.S. Dollar

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The Money Project is an ongoing collaboration between Visual Capitalist and Texas Precious Metals that seeks to use intuitive visualizations to explore the origins, nature, and use of money. We've previously showed you 31 Fascinating Facts About the Dollar's Early History, which highlighted the history of U.S. currency before the 20th century.