3 things to know about financial assets before test day
10/8/2021 Jacob Reed
Here is a quick review of a minor topic in Macroeconomics that bridges some of the gaps between the money market, and loanable funds market. This content review covers topic 4.1 in the AP Macroeconomics Course Exam Description (CED).
1. What are financial assets?
Stocks, bonds, and money are all financial assets. They are claims of ownership over something of value. Stocks represent ownership of a corporation. Investors often purchase shares of a corporation’s stock with hopes that the stock will increase in value in the future. Bonds, on the other hand are a loan to a corporation (or government, etc). When an investor purchases a bond, they have loaned the corporation money and will be paid back plus interest as the loan matures.
2. What is liquidity?
Liquidity is the ability to purchase goods and services with one’s assets. Stocks and bonds are assets that lack liquidity because you cannot buy groceries, gasoline, or movie tickets with stocks and bonds. You must first sell them (liquidate them), then use the money gained from the sale to purchase the desired goods and services.
Money (see the M1 money supply) is liquid and currency (paper and coin money) is the most liquid of any asset. Currency can be immediately used to purchase goods and services.
3. How do interest rates impact bonds and money?
Investors can purchase or sell bonds for money. The interest rate (found in the money market or loanable funds market) is the rate of return (called a yield) investors earn when they purchase bonds. If a bond pays $50 per year when the equilibrium interest rate is 5%, that bond will sell for $1000 (since $50 is 5% of $1000). If the equilibrium interest rate increases to 10%, the bond’s price will decrease to just $500 (since $50 is 10% of $500). If the equilibrium interest rate falls to 2.5%, the price of the bond will increase to $2000 (since $50 is 2.5% of $2000). Interest rates and bond prices are inversely related. When interest rates rise, bond prices fall; and when interest rates fall, bond prices rise.
Since bonds are not liquid, many people chose to hold some or all of their wealth as money instead of purchasing bonds. When they do hold money, people lose the opportunity to earn the equilibrium interest rate from purchasing bonds. That means the interest rate is the opportunity cost for holding money. This is why the demand for money in the money market is downward sloping.