Chapter 1

Preliminaries
Trade-Offs

- Consumers: Limited incomes. Their interest is their well being. Make trade-off
decisions that would maximize well-being.

- Workers: Decide when to enter the workforce, or make a trade-off decision btw
working now and having money or pursuing education and making money later. Make
choice of where to work based on benefits/advantages/disadvantages/etc. Choose
preference of hours worked (labor vs leisure).

- Firms: Limitations of capacity/resources. Quantity vs Quality?

Market: Buyers and Sellers.

- Buyers: consumers (G & S) and firms (labor, capital, raw materials to produce G & S)
- Sellers: firms (G & S), workers (labor services), resource owners (raw materials)
Arbitrage: Buying at a low price at one locations and selling at a higher price in
another. (The possibility of arbitrage prevents prices of gold in different locations from
differing significantly, and thus creates a world market for Gold).
Perfectly competitive market: Has many buyers and sellers, so much so that no
single buyer or seller has any impact on price. (Ex: wheat, corn)

- In a perfectly competitive market, the market price will usually prevail.

- The market prices of most goods will fluctuate, sometimes very rapidly. Especially
goods sold in competitive markets. (Wheat, soybeans, coffee, oil, gold, silver, lumber)
Noncompetitive market: The oil market.
Extent of a market: Boundaries of a market (geographic and range).

- Geographic: Prices of gas will vary depending on expense to ship over various
distances, prices of homes depending on location, etc.

- Range: On the other hand, gasoline will not be sold in the same market as diesel
fuel, because regular cars cannot make any use of diesel fuel, and vice-versa.

Market definition is important for 2 reasons:

1. A company must understand who its actual and potential competitors are for the
various products that it sells or might sell in the future. It must also know the product
boundaries and geographical boundaries of its market in order to set price,
determine advertising budgets, and make capital investment decisions.
2. It can be important for public policy decisions.
Real VS Nominal Prices
We need to measure prices relative to an overall price level. We must correct for
inflation when comparing prices across time. (aka measuring prices in real rather than
nominal terms).
Nominal Price: current-dollar price; the absolute price; aka Retail Price.
Real Price: constant-dollar price; the price adjusted for inflation.

When comparing price changes, use Real Price.

Consumer Price Index (CPI): An aggregate measure of prices. Records how the cost
of a large market basket of goods purchased by a typical consumer changes over
time. Percentage changes in the CPI measure the rate of inflation in the economy.
Producer Price Index (PPI): Records (on average) how prices at the wholesale level
change over time. Percentage changes in the PPI measure cost inflation and predict
future changes in the CPI.

From MyLab & Mastering:

Q: Suppose that the Japanese yen falls against the US dollar - that is, it will take fewer
dollars to buy a given amount of Japanese yen. Explain why this decrease
simultaneously decreases the real price of Japanese cars for US consumers and
increases the real price of US automobiles for Japanese consumers.
A: As the value of the yen falls relative to the dollar, the purchase of a Japanese
automobile priced in yen requires fewer dollars, and the purchase of a US automobile
priced in dollars requires more yen.

Chapter 2
The Basics of Supply and Demand
Without government intervention, supply and demand will come into equilibrium to
determine Market Price of a good, and the total quantity produced.
On graph: Vertical axis shows the Price (P) of a good, measures in dollars per unit.
Horizontal axis shows Total Quantity Supplied (Q), measured in the number of units per
period.

2.1 Supply and Demand

Supply Curve (S): Shows the quantity of a good that producers are willing to sell at a
given price, holding constant any other factors. Slopes upward: the higher the price, the
more that firms are able and willing to produce and sell.
Qs=c+dP
Changes in price result in movements along the Supply curve (aka change in the
quantity supplied).
The distance Price and Cost is Profit Margin.
Other variables that affect Supply
Changes in these variables will shift the Supply curve (aka change in supply)

- Costs of production: Lower costs make production more profitable, encouraging

existing firms to expand production and enabling new firms to enter the market. If
market price P stays constant while costs go down, we would observe a greater
quantity supplied.

Production costs , output . Entire supply curve shifts to the right.

- Interest Rates: Low interest rate will influence company to invest in more product/
inventory.

Interest rates , output .

- Technology: Innovation will result in higher productivity.
4

Demand Curve (D): Shows how much of a good consumers are willing to buy as the
price per unit changes. Slopes downward: consumers are (usually) ready to buy more if
the price is lower.
Qd=a-bP
Movements along the demand curve = change in quantity demanded
Variables that shift Demand:
(aka change in demand)

- Income: Greater incomes will permit consumers to spend more money on any good.
Income, Quantity demanded.
- Prices of substitutes: Increase in the price of one leads to an increase in Qd of the
other.

Pb, Qb so Qa.
- Prices of complements: Increase in the price of one leads to a decrease in Qd of
the other.

Pb, Qb so Qa.
- Interest Rates: High interest rates will influence consumers to save their money.
- Weather & trends
- Expectations

2.2 The Market Mechanism

Equilibrium: P*=Q* (aka Market-Clearing price)
The Market Mechanism is the tendency in a free market for the price to change until
the market clears; until the Q demanded and the Q supplied are equal. Because there
is no excess demand or supply, there is no pressure for price to change further.
Market Surplus: Quantity supplied exceeds the quantity demanded. In order to sell the
surplus, producers will have to bring price back down to P* which will bring Qd back up
to Q*.
Market Shortage: Quantity demanded exceeds the quantity supplied.
5

For the Supply-Demand model to work, a market must be competitive. (aka buyers and
sellers have little market power individually).

2.3 Changes in Market Equilibrium

A shift of both S and D will result in a slight increase in Price, but a large change in Q.
From MyLab & Mastering:
Steel and Aluminum are substitutes. If the price of steel increases, other things
remaining the same, we would expect the price of aluminium to increase and the
equilibrium quantity of aluminum to increase.

2.4 Elasticities of Supply and Demand

Elasticity: Measures the sensitivity of the impact on the dependent variable with
respect to change in the independent variable. It is a number that tells us the
percentage change that will occur in one variable in response to a 1-percent increase in
another variable.
Price Elasticity of Demand
Ep = (%Qd)/(%P) = (Q/Q)/(P/P) = (Q)/P)x(P/Q)

Percentage change in Quantity demanded/Percentage change in Price

Qd=a-bP
Demand curve is negative-sloping. Hence, the slope (Q/P) should always be
negative. (Slope=rise/run)
When | PED | = 0.5 (<1), Price (Px) is inelastic. (more vertical)

%Qd < %P
When | PED | = 2 (>1), Px elastic. (more horizontal)

%Qd > %P
In general, the price elasticity of demand for a good depends on the availability of other
goods that can be substituted for it. When there are close substitutes, a price increase
will cause the consumer to buy less of this good and more of the substitute. Demand
will then be high price elastic. (Example: shampoo). When there are no close
substitutes, demand will tend to be price inelastic. p.31
6

From MyLab & Mastering:

Total Demand - Domestic Demand = Export Demand

2.5 Short-Run vs Long-Run Elasticities

From MyLab & Mastering:
Q: For many goods, the long-run price elasticity of supply is larger than the short-run
elasticity. The long-run price elasticity of supply is typically larger because:
A: in the short run, some firms may be constrained by their productive capacity.
Q: Why do long-run elasticities of demand differ from short-run elasticities?
A: Because durable goods last a relatively long time, and it takes time for
consumers to respond to price changes.
For most industries, supply is less elastic in the short run than in the long run.

Cyclical Industries: Industries that manufacture products whose demands fluctuate

sharply in response to short-run changes in income.

Chapter 3
Analysis of Competitive Markets

3.1 Consumer and Producer Surplus

Consumer Surplus: measures the total net benefit to consumers.

- We cant always assume that those consumers who are able to buy the good are the
ones who value it most highly, because sometimes A > B, and sometimes A < B.

(If people who want a good wait in line to obtain it, this opportunity cost of their time
should be included as part of lost consumer surplus).
Producer Surplus: the benefit that lower-cost producers enjoy by selling at the market
price
Deadweight Loss: An inefficiency caused by price controls; the loss in PS exceeds the
gain in CS.

3.2 The Efficiency of a Competitive Market

Market Failure: Prices fail to provide proper signals to consumers and producers; the
unregulated competitive market is inefficient. Happens because of:
1. Externalities: Produ./Consu. costs/benefits do not show as part of Market price.
2. Lack of information: Consumers lack info about quality/nature of a product.

3.3 Minimum Prices

A way to raise prices above the market-clearing level.
Minimum Wage: The distance between Qs and Qd is unemployment.

3.4 Price Supports and Price Quotas

From MyLab & Mastering:
In a perfectly competitive market in which no market failure occurs and no government
policy interferes with the equilibrium price and quantity, deadweight loss is zero and
the sum of producer and consumer surplus is maximized.
Economic efficiency is achieved when aggregate consumer and producer surplus is
maximized.

Chapter 6
Supply of Labor to the Economy: The Decision to Work
The demand for a good is a function of 3 factors:
1. The opportunity cost of the good
2. Ones level of wealth
3. Ones set of preferences

Opportunity Cost of leisure: The cost of spending an hour watch TV is what one could
earn if one had spent that hour working. Thus, the opportunity cost of one hour of
leisure is equal to ones wage rate.
Wealth and Income: total income = total wealth
Income Effect: If income increases, holding wages constant, desired hours of work will
go down/desired hours of leisure will go up. W, H (-)

Substitution Effect: If income is held constant, an increase in the wage rate will raise
the price and reduce the demand for leisure, thereby increasing work incentives.
(Leisure hours and work hours are substituted for eachother). W, H (+)

10

Indifference curves:
1. Utility B represents more happiness than level A. Every level of leisure consumption
is combines with a higher income on B than on A.
2. Indifference curves do not intersect.
3. Indifference curves are negatively sloped because if either income or leisure course
are increased, the other is reduced in order to preserve the same level of utility. (16
hours).
4. Indifference curves are convex (steeper at the left than at the right). This reflects the
assumption that when money income is relatively high and leisure hours are
relatively few, leisure is more highly valued.

11

128$ = equivalent to 16 hours x 8$

Budget line: Y=wH+v
(Where v= unearned income)
Wage rate = slope of budget line

12

The budget line will ONLY rotate if w increases. (Y=wH+v)

Reservation Wage: the wage below which a person will not work, and represents the value
placed on an hour of lost leisure time.

13

Chapter 7
Uncertainty and Consumer Behaviour
Expected Value aka E(x): uncertain situation (weighted average) of the payoffs or
values associated with all possible outcomes.
Risk Averse: Prefers certainty over risk. Has a diminishing marginal utility of income.

- Stable waged jobs

- life/health/car insurance
Risk Neutral: Indifferent between certain and uncertain outcomes. Constant marginal
utility of income.
Risk Loving: Prefers uncertain to certain, even if the risky outcome is less than the
risk-averse outcome.

Risk Premium: Maximum amount of $ that a risk-averse person will pay to avoid taking
a risk.
Higher risk = higher risk premium

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Indifference Curve: f (Expected income, variability of income).

7.3 Reducing Risk

Three ways both consumers and businesses reduce risks: Diversification, Insurance,
and Obtaining more information about choices and payoffs.
1. Diversification: Allocating your resources to a variety of activities whose outcomes
are not closely related. As long as you can allocate your resources toward a variety
of activities whose outcomes are not closely related, you can eliminate some risk.

Esp. useful for negatively correlated variable (heaters vs air conditioners)

Esp. important for stock market investors, but in general stock prices are positively
correlated variable, so you still face risk.
Mutual Funds: Organizations that pool funds of individual investors to buy a large
number of different stocks.
2. Insurance: Risk-averse people are willing to pay to avoid risk. Buying insurance
assures a person of having the same income whether or not there is a loss.
Law of Large Numbers: Although single vents may be random and largely
unpredictable, the average outcome of many similar events can be predicted.
Actuarial Fairness: When the insurance premium is equal to the expected payout.

15

3. The value of complete information: The difference between the expected value of
a choice when there is complete information and the expected value when
information is incomplete.

7.4 The Demand for Risky Assets

Asset: something that provides a flow of money or services to its owner.

- The monetary flow that one receives from asset ownership can take the form of an
explicit payment.

Rental income, dividend on shares of common stock.

- Implicit: takes the form of an increase of decrease in the price of value of the asset.
Increase in the value of an asset: capital gain.
Decrease: capital loss.
Risky Asset: provides a monetary flow that is at least in part random. (Not known with
certainty in advance).

- ex: Apartment building, corporate bonds.

Riskless (or risk-free) Asset: Pays a monetary flow that is known with certainty.

- ex: Savings accounts, short-term certificates of deposit, treasury bills.

Asset Returns: the total monetary flow it yields - including capital gains or losses - as
fraction of its price.
Real return on an asset: nominal return less the rate of inflation.
Although stocks have a higher expected return that treasury bills, they also carry much
more risk.
The higher the expected return on an investment, the greater the risk involved. As a
result, the risk-averse investor must balance expected return against risk.

The budget line: The expected return on the portfolio Rp increases as the standard
deviation of that return increases.

16

Slope (aka the price of risk): tells us how much extra risk an investor must incur to
enjoy a higher expected return.

Curve U3 yields the greatest amount of satisfaction and U1 the least amount: For a given
amount of risk, the investor earns a higher expected return on U3 than on U2 and a
higher expected return on U2 than on U1. Of the three indifference curves, the investor
would prefer to be on U3. This position, however, is not feasible, because U3 does not
touch the budget line. Curve U1 is feasible, but the investor can do better. Our investor

17

will do best by choosing a combination of risk and return at the point where an
indifference curve is tangent to the budget line (U2).

Buying stocks on margin

The investor borrows money because she wants to invest more than 100% of her
wealth in the stock market. Buying stocks on margin in this way is a form of leverage:
the investor increases her expected return above that for the overall stock market, but at
the cost of increased risk.

7.5 Bubbles
Bubble: An increase in the price of a good based not on the fundamentals of demand
or value, but instead on a belief that the price (of stocks, for example) will keep going
up. Comes with the idea that it can eventually be sold, at a profit.
Informational Cascade: An assessment based on the actions of others, which in turn
were based on the actions of other, etc.

7.6 Behavioural Economics

Basic theory (adjusted) of consumer demand:
1. A tendency to value G or S in part based on the setting one is in
2. A concern about the fairness of an economic transaction
3. The use of the simple rules of thumb as a way to cut through complex economic
decisions.
Reference Point: Depends on the setting in which the purchasing decision occurs.
Can develop because of: past consumption of a good, our experience in a market, our
expectation about how prices should behave, and even the context in which we
consume a good. Different Examples of reference points:
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1. Endowment Effect: The fact that individuals tend to value an item more when they
happen to own it than when they do not.
2. Loss Aversion: The tendency of individuals to prefer avoiding losses over acquiring
gains. The loss hurts more than the perceived benefit from the gain.
3. Framing: A tendency to rely on the context in which a choice is described when
making a decision. (Pretty packaging, a good slogan, etc)
Fairness and the Ultimatum Game: sharing 100$ fairly with a stranger. When a body
of people set a maximum willingness to pay, demand will go down and will eventually
bring price down. If enough workers do not feel that their wages are fair, there will be a
reduction in the supply of labor, and wage rates will increase.
Rules of Thumb and Biases in decision making: Useful for matters in which we have
little experience (like giving 15% tip).
1. Anchoring: The impact that a suggested piece of information may have on your
final decision. (Setting a price at 19.95$ because it is under 20$)
2. Rules of Thumb: Help to save time and effort and result in only small biases.
(Shipping costs ignored when assessing the real total cost of an online purchase)
3. The Law of Small Numbers: Tendency to overstate the probability that a certain
event will occur when faced with relatively little information. (Or even completely
disregarding the possibility of a particular event because the probability of it
happening was very small).

19

Chapter 8
Overview of the Financial System
Financial Markets: Bond and Stock Markets
Have the essential economic function of channelling funds from households, firms, and
governments, who have saved surplus funds by spending less than their income
(lender-savers), to those who have a shortage of funds because they wish to spend
more than they can earn (borrower-spenders).

- Direct Finance: Borrowers borrow funds directly from lenders in financial markets by
selling them securities, which are claims on the borrowers future income or assets.

- Indirect Finance: Financial intermediaries borrow funds from lender-savers and then
use these funds to make loans to borrower-spenders.

Securities are assets for the person who buys them but liabilities (IOUs or dets)
for the individual or firm that sells/issues then.

- Bonds: Debt securities that promise to make payments periodically for a

specified period of time.

- Stocks: Securities that entitle the owners to a share of the companys profits and
assets.
Financial Intermediaries: Banks, insurance companies, pension funds

Structure of Financial Markets

A firm of individual can obtain funds in a financial market in two ways: issuing a debt
instrument (bond or mortgage), or by raising funds by issuing equities (common stock).
Debt Market
Debt Instrument: A contractual agreement by the borrower to pay the holder of the
instrument fixed dollar amounts at regular intervals (I+i) until a specified date (maturity
date).

- Short term: maturity is less than a year

- Intermediate term: maturity is between 1 and 10 years

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- Long term: maturity is 10 years or longer.

Equity Market
Equities: Claims to share i the net income (income after expenses and taxes) and the
assets of a business. Often make periodic payments (dividends) to their holders and
are considered long-term securities because there is no maturity date. Owning stocks
also means that you own a portion of the firm and thus have the right to vote on issues
important to the firm and to elect is directors.

An equity holder is a residual claimant. The corporation must pay all its debt holders
before it pays its equity holders. But, equity holders benefit directly from any increases
in the corporations profitability or asset value, because equities confer ownership rights
on the equity holders. (Debt holders will always only receive their fixed dollar
payments).
Primary Market: a financial market in which new issues of a security (such as a bond
or a stock) are sold to initial buyers by the corporation or government agency borrowing
the funds.

- Behind closed doors, an investment bank guarantees the price of a corporations

securities (underwrites) and then sells them to the public.
Secondary Market: A financial market in which securities that have been previously
issued can be resold. Make it easier to sell financial instruments (they make the
financial instruments more liquid). This increased liquidity makes them more desirable
and thus easier for the issuing from to sell in the primary market. Also, they determine
the price of the security that the issuing firm sells in the primary market.

- Toronto Stock Exchange (TSX)

- Securities brokers and dealers are crucial to a well-functioning secondary market.
Brokers: agents of investors who match buyers with sellers of securities.
Dealers: link buyers and sellers by buying and selling securities at stated prices.
A corporation does not acquire any new funds when its securities are sold in the
secondary market.

21

Secondary markets can be organized in two ways:

1. By organizing exchanges: buyers and sellers of securities meet in one central
location to conduct trades.
2. By having an over-the-counter (OTC) market: dealers at different locations who
have an inventory of securities stand ready to buy and sell securities OTC to anyone
who comes to them and is willing to accept their prices. Very competitive.
Money Market: A financial market in which only short-term debt instruments are traded.

- Government of Canada treasury bills: They pay a set amount at maturity and have
no interest payments. But they effectively pay interest by initially selling at a discount.
(Pay 9,600$ in May 2013 for a one-year treasury bill that can be redeemed in May
2014 for 10,000$). Most liquid of all because they are most actively traded. Also the
safest because there is almost no possibility of default.

- Certificates of deposit (CD): Pays annual interest of a given amount and at maturity
pays back the original purchase price. Are negotiable, and can be resold in a
secondary market. (5000$ to 100 000$)

- Commercial paper: Unsecured short-term debt instrument issued by large banks

and corporations. The interest rate the corporation is charged reflects the firms level
of risk. Finance paper (short-term promissory notes) can also be issued.
(denominations of 50 000$). Mostly issued on a discounted basis.

- Repurchase agreements (Repos): Short-term loans (maturity of less than 2 weeks)

for which treasury bills serve as collateral (an asset that the lender receives if the
borrower does not pay back the loan). (Mostly large corporations)

- Overnight funds: Overnight loans by banks to other banks.

Capital Market: The market in which longer-term debt and equity instruments are
traded.

- Corporate stocks: Equity claims on the net income and assets of a corporation.
- Residential mortgages: Loans to households or firms to purchase housing land, or
other real structures, where the structure or land serves as collateral for the loans.

- Corporate Bonds: Long-term bonds issued by corporations with very strong credit
ratings.

22

- Government of Canada bonds: Intermediate-term bonds and long-term bonds are

issued by the federal government to finance its deficit. Most liquid security traded in
the capital market.

- Canada savings bonds (CSBs): floating-rate bonds, available in denominations

from 100$ to 10 000$ and offered exclusively to individuals, estates, and specified
trusts.

- Provincial and Municipal government bonds: Issued in order to finances schools,

roads, other large programs.

- Government agency securities: Long-term bonds issued by various government

agencies, to assist municipalities to finance mortgages, farm loans, or powergenerating equipment.

- Consumer and bank commercial loans

Money market securities are usually more widely traded than longer-term securities,
and thus tend to be more liquid. Also, short-term securities have smaller fluctuations in
prices than long-term securities (which makes them safer investments).

Internationalization of Financial Markets

Eurobond: A bond denominated in a currency other than that of the country in which
it is sold.

Indirect Finance
Financial intermediation: Involves a financial intermediary that stands between the
lender-savers and the borrower-spenders and helps transfer funds from one to the
other. Can substantially reduce transaction costs.
Transaction costs: The time and money spent in carrying out financial transactions.
Economies of scale: reduction in transaction costs per dollar of transactions as the
size (scale) of transaction increases.
Liquidity services: services that make it easier for customers to conduct transactions.
Risk sharing (or Asset Transformation): Financial intermediaries create and sell
assets with risk characteristics that people are comfortable with, and then use the funds
they acquire by selling these assets to purchase other assets that may have far more
risk.
23

Asymmetric information: One party (in financial markets) often does not know enough
about the other party to make accurate decisions.
Adverse Selection: The problem created by asymmetric information before the
transaction occurs. Potential borrowers who are the most likely to produce an adverse
outcome (bad credit risk) are the ones who most actively seek out a loan and are thus
most likely to be selected.
Moral hazard: The problem created by asymmetric information after the transaction
occurs. The risk (hazard) that the borrower might engage in activities that are
undesirable from the lenders point of view because they make it less likely that the loan
will be paid back. (Conflict of interest is an example of a moral hazard).
Financial intermediaries can alleviate these problems. They:
1. Provide liquidity services
2. Promote risk sharing
3. Solve information problems
4. Can achieve economies of scope (they can lower the cost of information production
for each service by applying one information resource to many different services).

Regulation of the Financial System

Three reasons:
1. To increase the information available to investors
2. To ensure the soundness of the financial system
3. To improve control of monetary policy

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Chapter 9
An Economic Analysis of Financial Structure
8 facts:
1. Stock are not the most important source of external financing for businesses.
2. Issuing marketable debt and equity securities is not the primary way in which
businesses finance their operations.
3. Indirect finance, which involves the activities of financial intermediaries, is many
times more important than direct finance in which businesses raise funds directly
from lenders in financial markets.
4. Financial intermediaries, particularly banks, are the most important source of
external funds used to finance businesses.
5. The financial system is among the most heavily regulated sectors of the economy.
6. Only large, well-established corporations have easy access to securities markets to
finance their activities.
7. Collateral is a prevalent features of debt contracts for both households and
businesses.
8. Debt contracts typically are extremely complicated legal documents that place
substantial restrictions on the behaviour of the borrower.

Transaction Costs
Solutions of high transaction costs:

- Economies of scale: Bundle the funds of many investors together so that they can
take advantage of economies of scale. Reduces transaction costs for each investor.

Mutual fund
- Expertise: liquidity services, expertise in computer technology
Collateral: Property promised to the lender if the borrower defaults.
Net worth (aka Capital Equity): Diff. btwn firms assets and its liabilities.

25

Principal-Agent Problem: Affects Equity Contracts (claims to a share in the profits

and assets of a business). May occur when the manager in control (agent) may act in
their own interest rather than in the interest of the shareholder-owner (principal)
because the agent has less incentive to maximize profits than the principal.
Costly state verification: The monitoring of firms activities process can be expensive
in terms of time and money. Costly state verification makes the equity contract less
desirable, and it explains in part why equity is not a more important element in our
financial structure.

26

Chapter 10
Understanding Interest Rates
Four basic types of credit market instruments:
1. Simple Loan: Lender provides borrower with funds that must be payed back at
maturity along with an additional interest payment.
2. Fixed-payment loan (aka Fully Amortized Loan): Lender provides borrower with
funds, which must be repaid by making the same payment every period consisting
of part of the principal and interest for a set number of years. (installment loans and
mortgages)
3. Coupon bond: Pays the owner of the bond a fixed interest payment (coupon
payment) every year until the maturity date, when a specified final amount (face
value) is repaid. Coupon Rate: dollar amount of the yearly coupon payment
expressed as a percentage of the face value of the bond. (canada and corporate
bonds).
4. Discount bond (aka zero-coupon bond): Bought at a price below its face value (at
a discount), and the face value is repaid at the maturity date. A discount bond does
not make any interest payments, it just pays off the face value.
Yield to Maturity: The interest rate that equates the PV of cash flow payments received
from a debt instrument with its value today. The most important and accurate way to
calculate interest rate.

YTM on a Simple Loan: For simple loans, the simple interest rate = the yield to
maturity.

27

YTM on a Fixed-Payment Loan:

YTM on a Coupon Bond: Same as fixed-payment calculation.

1. When the coupon bond is priced at its FV, the yield to maturity equals the coupon
rate.
2. The price of a coupon bond and the yield to maturity are negatively related. As the
YTM rises, the price of the bond falls and vice-versa.
3. The YTM is greater than the coupon rate when the bond price is below its face
value.
28

YTM on a Consol (or Perpetuity): A perpetual bond with no maturity date and no
repayment of principal.

Yearly coupon payment (C) / price of the security (Pt) = Current yield (ic).

29

YTM on a Discount Bond: YTM is negatively related to the current bond price. A fall in
the yield to maturity means that the price of the discount bond has risen.

Current bond prices and interest rates are negatively related: when the interest rate
rises, the price of the bond falls, and vice versa.

The distinction between Interest Rates and Returns

Rate of Return: Accurately measures how well a person does by holding a bond or any
other security over a particular time period. Defined as the payments to the owner plus
the change in its value, expressed as a fraction of its purchase price.
The return on a bond will not necessarily equal the yield to maturity on that bond.

30

Returns will differ from the interest rate especially if there are sizeable fluctuations in the
price of the bond that produce substantial capital gains or losses.
Prices and returns for long-term bonds are more volatile than those for shorter-term
bonds.
Interest-rate Risk: Riskiness of an assets return that results from interest-rate
changes.

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The distinction between Real and Nominal interest rates

Real interest rate: The interest rate that is adjusted by subtracting expected changes in
the price level (inflation) so that is more accurately reflects the true cost of borrowing.

Fisher equation: i=ir+ e >>>

ir = i - e

ir = cost of borrowing
Example:
If nominal interest rate is 8% and the expected inflation rate is 10%
The real interest rate is -2% (0.08-0.10). As a lender: Although you will be receiving 8%
more dollars at the end of the year, you will be paying 10% more for goods. The result is
that you will be able to buy 2% fewer goods at the end of the year, and you will be 2%
worse off in real terms. As a borrower: you will have to pay 2% less back.
When the real interest rate is low, there are greater incentives to borrow and fewer
incentives to lend.

Real returns: Inflation is subtracted from the nominal return. Indicates the amount of
extra goods and services that can be purchased as a result of holding the security.

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Chapter 11
The Behaviour of Interest Rates
Asset: a piece of property that is a store of value.
Determinants of Asset demand:
1. Wealth (+)
When wealth increases, the quantity of assets we demand increases.
2. Expected Return (+): The expected return on one asset relative to alternative
assets.
E(R)a, E(R)others remains the same, Dothers
3. Risk (-): Degree of uncertainty associated with the return on one asset relative to
alternative assets.
Riska, Da, Dothers
4. Liquidity: The ease and speed with which an asset can be turned into can relative
to alternative assets.
Liquiditya, Da, Dothers
Theory of Portfolio Choice: Tells us how much of an asset people want to hold in their
portfolio. Holding all other factors constant:
1. Quantity demanded of an asset is positively related to wealth
2. Quantity demanded of an asset is positively related to its expected return relative to
alternative assets.
3. Quantity demanded of an asset is negatively related to the risk of its returns relative
to alternative assets.
4. Quantity demanded of an asset is positively related to its liquidity relative to
alternative assets.

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Supply
Demand in the Bond market

and

Negative relationship between bond prices and interest rates means that when we see
that the bond price rises, the interest rate falls.

If a 1000$ bond sells for 950$:

- Interest rate and expected return is : (1000-950)/950 = 0.053 = 5.3%

- At a price of 900$: (1000-900)/900 = 0.111 = 11.1%
Expected return is higher, so quantity demanded of bonds will be higher. (Portfolio
theory)
The
rather
prices. Is

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Asset market approach:

emphasizes stocks of assets
than flows in determining asset
now the dominant
methodology used by

economists because correctly conducting analyses in terms of flows is very tricky,

especially when we encounter inflation.

Changes in Equilibrium Interest Rates

Shift of the demand curve: Occurs when the quantity supplied/demanded changes at
each given price/interest rate in response to a change in one of these factors:
1. Wealth
When the economy is growing rapidly in a business cycle expansion and wealth is
increasing, the Q of bonds demanded at each bond price/interest rate increases and
demand curve shifts to the right.
If households save more, wealth increases and demand curve shifts to the right.
2. Expected returns on bonds relative to alternative assets
Higher expected interest rates in the future lower the expected return for long-term
bonds, decrease the demand, and shift the demand curve to the left.
Lower expected interest rates in the future increase the demand for long-term bonds
and shift the demand curve to the right.
A increase in expected rate of inflation lowers the expected return for bonds, causing
their demand to decline and the demand curve to shift to the left.
3. Risk of bonds relative to alternative assets
An increase in the riskiness of bonds causes the demand for bonds to fall and the
demand curve to shift to the left.
An increase in the riskiness of alternative assets causes the demand for bonds to rise
and the demand curve to shift to the right.
4. Liquidity of bonds relative to alternative assets
Increased liquidity of bonds results in an increased demand for bonds, and the demand
curve shifts to the right.
Increase liquidity of alternative assets lowers the demand for bonds and shifts the
demand curve to the left.

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When one of these factors change, there will be a new equilibrium value for the interest
rate.
Shift of the Supply curve:
1. Expected profitability of investment opportunities
In a business cycle expansion, the supply of bonds increases, and the supply curve
shifts to the right. In a recession, when there are far fewer expected profitable
investment opportunities, the supply of bonds falls and the supply curve shifts to the left.
2. Expected inflation
Real interest rate = nominal interest rate - inflation.
If inflation rises, the real cost of borrowing falls. An increase in expected inflation causes
the supply of bonds to increase and the supply curve to shift to the right.
3. Government activities

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Higher government deficits increase the supply of bonds and shift the supply curve to
the
right.

Government surpluses decrease the supply of bonds and shift the supply curve to the
left.

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Changes in interest rate due to Expected Inflation

Fisher Effect: When expected inflation rises, interest rates will rise.
If expected inflation rises, the expected return on bonds relative to real assets falls for
any given bond price and interest rate.

i = ir + e
8=5+3
8=_+5

When e , Bs and Bd because investors wont want to invest knowing that e will
increase. P .
When Bs and Bd price will always be lower. The change in Q will depend.

Changes in the interest rate due to a business cycle expansion

In a business cycle expansion, the amount of goods and services being produced in the
economy rises, so national income increases. When this occurs, business will be more
willing to borrow because they are likely to have many profitable investment
opportunities for which they need financing. Hence, at a given bond price, the quantity
of bonds that firms want to sell will increase.

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When Bs and Bd , Q will always be higher, and change in Price/interest rate

depends on whether the supply curve shifts more than the demand curve or vice versa.

Supply and Demand in the Market for Money

The Liquidity Preference Framework: determines the equilibrium interest rate in
terms of the supply and demand for money.

- 2 main categories of assets that people use to store their wealth:

1. Money
2. Bonds
Bs + Ms = Bd + Md
Rewritten: Bs - Bd = Md - Ms
If the market for money is in equilibrium, the right-hand side of the equation equals zero,
implying that Bs = Bd meaning that the bond market is also in equilibrium.
i , Md because the opportunity cost of holding money is higher.

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Changes in Equilibrium Interest Rates

Shifts in Demand of Money
Income Effect: As an economy expands and income rises, wealth increases and
people will want to hold more money as a stole of value. Also, as the economy expands
and income rises, people will want to carry out more transactions using money, with the
result that they will also want to hold more money.
A higher level of income causes the demand for money at each interest rate to increase
and the demand curve to shift to the right.
Income , Md .
Price-Level Effect: When the price level rises, the same nominal quantity of money is
no longer as valuable; it cannot be used to purchase as many real goods or services. To
restore their holdings of money in real terms to their formal level, people will want to
hold a greater nominal quantity of money.
A rise in the price level causes the demand for money at each interest rate to increase
and the demand curve to shift to the right.
Price level , Md .

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Shifts in Supply of Money

An increase in the money supply engineered by the Bank of Canada will shift the supply
curve for money to the right.
When the money supply increases, interest rates will decline.
Ms , i
Income Effect: When income (and money supply) is rising during a business cycle
expansion, interest rates will rise.
Md, i
Price-Level Effect: When the price level increases, interest rates will rise.
Md, i
Expected Inflation Effect: When expected inflation rate increases, interest rates will
rise.
(i = ir + e )

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a) Liquidity effect dominates the other effects so that the interest rate falls. The liquidity
effect operates quickly to lower the interest rate, but as time goes by the other
effects start to reverse some of the decline. Because the liquidity effect is larger than
the others, the interest rate never rises back to its initial level.
b) Has a smaller liquidity effect that the other effects, with the expected inflation effect
operating slowly because expectations of inflation are slow to adjust upward.
Initially, the liquidity effect drives down the interest rate. Then the income, pricelevel, and expected inflation effects begin to raise it. Because these effects are
dominant, the interest rate eventually rises above its initial level. In the short run,
lower interest rates result from increased money growth, but eventually they end up
climbing above the initial level.
c) Has the expected inflation effect dominating as well as operating rapidly because
people quickly raise their expectations of inflation when the rate of money growth
increases. The expected inflation effect begins immediately to overpower the
liquidity effect, and the interest rate immediately starts to climb. Over time, as the
income and price-level effects start to take hold, the interest rate rises even higher,
and the eventual outcome is an interest rate that is substantially above the initial
interest rate. The result shows clearly that increasing money supply growth is not
the answer to reducing interest rates; rather, money growth should be reduces in
order to lower interest rates!

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