Ch. 11 Macroeconomics Final Exam

Calculating Price of Bond

(Interest Payment / Yield) = Price of Bond

Calculating Yield

(Interest Rate / Price of Bond) = Yield

Diversifying Assets to Reduce Risk

- Accepts funds from savers & pool this money into a portfolio of diversified financial instruments (stocks, bonds, etc.), reducing overall risk & at the same time permitting savers access to their funds when needed. - Can also offer securities with different risk profiles to savers, from relatively safe CDs & savings accounts to more risky domestic & foreign stocks. - ^ in doing so, these institutions allow a greater flow of funds between savers & borrowers, greatly increasing the efficiency of investment in the economy.

Financial Intermediaries in the Loanable Funds Market Model

- Banks - Mutual Funds - Insurance Companies

Demand Curve of the Loanable Funds Market Model

- Demand comes from people who want to purchase goods and services, such as taking out a loan to go to college, taking out a mortgage on a house, or who, as entrepreneurs, want to start or expand a business. - Firms are borrowers, too. Firms may want to invest in new plants, additional equipment, expanded warehouse facilities, or engage in additional research and development on new products. - Demand for loanable funds slopes downward because when the interest rate is high, fewer projects will have a rate of return high enough to justify the investment. As interest rates fall, more projects become profitable and the amount of funds demanded rises.

Liquidity

- How quickly, easily, & reliably an asset can be converted into cash - Money is the most liquid asset

Bond Prices & Interest Rates

- Inversely Related = when interest rates go up, bond prices go down (vice versa)

Functions of Money

- Medium of Exchange - Unit of Account - Store of Value

Unit of Account

- Money provides a yardstick for measuring & comparing the values of a wide variety of goods & services. - Eliminates the problem of double coincidence of wants associated with barter.

Roles of Financial Institutions

- Reducing information costs - Reducing transaction costs - Diversifying assets to reduce risk

Bonds

- The form in which most loanable funds are in - Between a seller (the company or government issuing the bond) & a buyer - Fluctuate in response to forces of the marketplace interest rates = determines the yield - A form of debt used to fund a business - Bond contracts include: 1). Coupon Rate (interest rate of the bond) 2. Maturity Date 3). Face Value of the bond (the value at maturity)

Yield

- The percentage return earned over the life of the bond - Change when bond prices change

Money Must Be...

- Value must be easy to determine - Divisible - Durable - Widely accepted

What makes up M1?

1). Currency makes up about half of M1 - Banknotes are more than 90% of currency - Coins make up just a small part of M1 2). Checking accounts make up other half of M1

M2

A broader definition of money that includes "near monies" that are not as liquid as cash, including deposits in savings accounts, money market accounts, and money market mutual fund accounts.

Medium of Exchange

A function of money in which goods & services are sold for money, then the money is used to purchase other goods & services

Market for Loanable Funds

A simple model that describes the financial market for saving & investment

Movements Along the Demand Curve

Amount of loanable funds demanded increases when the interest rate decrease; vice versa

Shifts in Demand for Loanable Funds

Anything that changes the rate of return on potential investment will cause the demand for loanable funds to change: - investment tax incentives - technological advances - regulations - product demand - business expectations

What is Money?

Anything that is accepted in exchange for goods & services or for the payment of debt

Income or Asset Prices

As incomes rise, people generally save a larger proportion of their income, all else equal. Asset prices, however, tend to work the other way. As home prices and stock values increase, people feel wealthier (without necessarily having more income) and will spend more and save less. The opposite effects occur when incomes fall or asset prices fall.

Supply Curve of the Loanable Funds Market Model

Because interest rates are the price (reward) that savers receive, higher interest rates result in more saving (funds) supplied to the market. This results in an upward-sloping supply curve much like other supply curves we studied earlier, and is just another example of people reacting to incentives. - Amount of loanable funds supplied decreases when the interest rate decreases; vice versa

In the loanable funds market model, the demand curve represents...

Borrowers - Borrowers (primarily businesses) have potential profit-making investment opportunities, & this leads to their demand for funds

Incentives to Save

Governments and companies offer various incentives to individuals to save, such as retirement contribution plans and other tax incentives. Adjusting such incentives will change the level of savings accordingly.

Government Deficits

Governments borrow money by issuing bonds, which are then purchased by individuals and investors using their savings. Therefore, when governments borrow, they do so by reducing the amount that the private sector saves, which decreases the supply of loanable funds. Subsequently, interest rates rise, which crowds out consumption and investment.

Which of the following scenarios would be most likely to cause the shift in the supply for loanable funds from S0 to S1, shown in the following diagram? (shift to the right)

Households decide to save more. If households decide to save more, this will increase the supply of loanable funds. This will cause a decrease in interest rates and an increase in the amount of funds traded.

Which of the following scenarios would be most likely to cause the shift in the supply for loanable funds from S0 to S1, shown in the following diagram? (shift to the left)

Households deciding to save less If households decide to save less, this will decrease the supply of loanable funds. This will cause an increase in interest rates and a decrease in the amount of funds traded.

Flat Money

Money without intrinsic value but nonetheless accepted as money because the government has decreed it to be money

Which of the following scenarios would be most likely to cause the shift in the demand of loanable funds from D0 to D1, shown in the following diagram? (shifting to the left)

Increase in business taxes This will decrease the demand for loanable funds & cause a decrease in both interest rates and the amount of funds traded

Shifts in Supply of Loanable Funds

Occurs when a factor increases or decreases the country's willingness to save at any given interest rate: - economic outlook - incentives to save - income or asset prices - government deficits

Teaser Rates

Promotional low interest rates offered by lenders for a short period of time to attract new customers and to encourage spending

Reducing Transaction Costs

Providing standardized financial products, including: - Saving accounts - Stocks - Bonds - Annuities - Mortgages - Futures - Options

Calculating Return on Investment

Return on Investment = (Earnings - Amount Invested) / Amount Invested

In the loanable funds market model, the supply curve represents...

Savers - Savers spend less than they earn & supply the excess funds to the market

Reducing Information Costs

Screening, evaluating, & monitoring firms to see that they are creditworth & use the borrowed funds loaned in a prudent manner

Face Value

The amount of money a buyer will get back once a bond matures

Barter

The direct exchange of goods and services for other goods and services

Compounding Effect

The effect of interest added to existing debt or savings leading to substantial growth in debt or savings over the long run.

Maturity Date

The fixed future date when the seller of a bond pays the buyer the face value of that bond

Coupon Rate

The fixed rate of interest that a seller pays the buyer based on the face value of a bond

Store of Value

The function that enables people to save the money they earn today & use it to buy the goods & services they want tomorrow. (Money is saved & used for future purchases)

M1

The narrowest definition of money that measures highly liquid instruments including currency (banknotes & coins), demand deposits (checks), & other accounts that have check-writing or debit capabilities.

Economic Outlook

The state of the economy, whether favorable or unfavorable, as measured by economic indicators, including interest and unemployment rates

Which of the following scenarios would be most likely to cause the shift in the demand of loanable funds from D1 to D0, shown in the following diagram? (shift to the right)

an increase in investment tax credits An increase in investment tax credits will increase the demand for loanable funds. This will cause an increase in both interest rates and the amount of funds traded.

When the interest rate increases, the amount of loanable funds supplied to the market...

increases; this is a movement up and to the right along the supply curve. The amount of loanable funds supplied increases when the interest rate increases and vice versa. These are movements along the supply curve, not shifts.