Time Value of Money

• is a dollar today worth more than a dollar tomorrow 

• yes

• why?

• Opportunity cost and inflation
• This is the reason for charging and paying interest 

• let v= future value of the dollar 
• P= present value of the dollar 
• r= real interest rate (nominal rate- inflation rate) expressed as a decimal 
• N= years 
• K= number of times interest is credited per year 

• simple interest formula 

• v=(1+r)^n*p

• the compound interest formula 

• V= (1+ r/k)^nk*p

Assume that inflation is to be 3% and the nominal interest rate on simple interest savings is 1%. Calculate the future value of the dollar after 1 yr.

• step one: calculate real interest rate

• -2%

•step two: Use the simple interest formula to calculate the future value

• $.98 

  

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

1. What happens to the quantity of money demanded when. Interest rates increase 

• quantify demanded falls because individuals would prefer to have interest earning assets instead of borrowed liabilities 

1. What happens when interest rate decreases?

• Increases . There is no incentive to convert cash into interest earning assets

Financial institutions 

Financial assets v. Financial liabilities

Assets: stocks and bonds whose benefit to the owner depends upon the issuer of the asset meeting certain obligations 

Liabilities: liabilities incurred by the issuer of a financial asset to stand behind the issued asset 

Interest rate: the price paid for the use of a financial asset

Stocks v bonds

Stocks:financial asset that conveys ownership in a corporation 

Bonds: a promise to pay a certain amount of money plus interest in the future