Understanding Money, Interest Rates, and Bond Markets

Posted on Mar 23, 2025 in Economy

What is Money?

Money is anything generally accepted as payment for goods and services or in settlement of debts. In barter economies, where goods and services are traded directly, transaction costs are high. Barter economies typically reduce these costs by using a commodity money, a good with value independent of its use as money. Using money allows for specialization, crucial for high productivity.

Functions of Money

Money provides four key services:

  1. Medium of exchange: Facilitates transactions.
  2. Unit of account: Provides a standard measure of value.
  3. Store of value: Retains purchasing power over time.
  4. Standard of deferred payment: Allows for future obligations.

Money is a component of wealth, the sum of a person’s assets less liabilities. Money and wealth differ from income, which is earnings over time.

Criteria for Money

An asset must meet five criteria to serve as money:

  1. Acceptability
  2. Standardized quality
  3. Durability
  4. High value relative to weight
  5. Divisibility

Commodity money has intrinsic value, while fiat money has value only when used as money. Fiat money circulates because it’s legal tender and because of public confidence in its value.

The Payments System

The payments system facilitates economic transactions. It has evolved from commodity money (e.g., gold, silver) to paper currency, checks, and electronic funds (debit cards, ACH, ATMs, e-money).

Monetary Aggregates

The Federal Reserve System defines monetary aggregates:

  • M1: Currency, traveler’s checks, and checking account deposits.
  • M2: M1 plus time deposits (under $100,000), savings accounts, money market deposit accounts, and non-institutional money market mutual fund shares.

Quantity Theory of Money

Increases in the money supply tend to be followed by increases in the price level and a loss of purchasing power. Irving Fisher’s quantity theory of money starts with the equation of exchange: MV = PY, where:

  • M = Money supply
  • V = Velocity of money
  • P = Price level
  • Y = Real GDP

Assuming constant velocity, the equation becomes:

% Change in M + % Change in V = % Change in P + % Change in Y

Or, Inflation rate = % Change in M – % Change in Y

The theory predicts that long-run inflation results from money supply increases exceeding real GDP growth. Hyperinflation (over 100% per year) occurs in countries with very high money supply growth, like Zimbabwe.

Understanding Interest Rates

Lenders charge interest to compensate for:

  1. Inflation
  2. Default risk
  3. Opportunity cost of waiting

Compounding is earning interest on interest. Future value is an investment’s value at a future time. Present value is the current value of future funds, calculated using discounting. The time value of money reflects how payment value changes based on timing.

The price of a financial asset equals the present value of its payments. This principle determines the prices of debt instruments (credit market instruments or fixed-income assets).

Types of Debt Instruments

Four basic categories of debt instruments exist:

  1. Simple loans: Principal plus interest repaid at maturity.
  2. Discount bonds: Face value paid at maturity, but initial price is lower.
  3. Coupon bonds: Regular coupon payments plus face value at maturity.
  4. Fixed-payment loans: Periodic payments of equal amounts, including interest and principal.

Yield to Maturity

The price of a bond or security equals the present value of its payments. Yield to maturity equates the present value of payments with the asset’s price. It’s the interest rate typically referenced in financial markets.

For a simple loan, yield to maturity equals the specified interest rate. For a discount bond, it equates the current price with the present value of the future payment. For a fixed-payment loan, it equates the present value of loan payments to the initial loan amount.

Bond Markets

Corporate and government coupon bonds often have 30-year maturities and are actively traded in secondary markets. Issuers aren’t directly involved in later transactions.

Rising market interest rates increase yields on new bonds, lowering existing bond prices. Falling rates decrease yields, raising prices. Financial arbitrage ensures comparable securities have the same yield.

Rate of Return vs. Interest Rate

The rate of return equals the current yield plus the rate of capital gain. Rising interest rates can cause capital losses for bondholders.

Nominal vs. Real Interest Rates

The nominal interest rate is the stated rate. The real interest rate is adjusted for purchasing power changes. The expected real interest rate equals the nominal rate minus expected inflation. Borrowers benefit when actual inflation exceeds expected inflation, and vice versa.

The U.S. Treasury issues TIPS (Treasury Inflation Protection Securities), indexed bonds where the principal increases with the price level.

Risk Structure of Interest Rates

The risk structure of interest rates relates interest rates on bonds with different characteristics but the same maturities. Key differences include:

  • Default risk (credit risk)
  • Liquidity
  • Information costs
  • Taxation of coupons

The default risk premium is the difference between a bond’s interest rate and a Treasury bond’s rate. Credit rating agencies (e.g., Moody’s, Standard & Poor’s) assign bond ratings. Higher default risk, lower liquidity, higher information costs, and higher tax rates lead to higher interest rates.

Term Structure of Interest Rates

The term structure of interest rates relates interest rates on similar bonds with different maturities. The Treasury yield curve illustrates this relationship.

Key facts about the term structure:

  1. Long-term rates are usually higher than short-term rates.
  2. Short-term rates are sometimes higher than long-term rates.
  3. Rates of all maturities tend to move together.

Theories of Term Structure

Three theories explain the term structure:

  1. Expectations theory: Long-term rates are averages of expected short-term rates. Explains facts 2 and 3, but not fact 1.
  2. Segmented markets theory: Markets for different maturities are separate. Short-term rates are lower due to higher demand. Explains fact 1, but not facts 2 and 3.
  3. Liquidity premium theory (preferred habitat theory): Long-term rates are averages of expected short-term rates plus a term premium. Explains all three facts.

The term structure can forecast future inflation and economic activity.