Econ 350 Midterm 1

Shifts in the demand for bonds: EXPECTED INFLATION

an increase in the expected rate of inflations lowers the expected return for bonds, causing the demand curve to shift to the left

Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? -Liquidity preference framework

an increase in the money supply will lower interest rates: the liquidity effect.

Shifts in the demand for bonds: RISK

an increase in the riskiness of bonds causes the demand curve to shift to the left

money

anything that is generally accepted as payment for goods or services or in the repayment of debts, plays an important role in generating business cycles

aggregate price level

average price of goods and services in an economy

common stock

represents a share of ownership in a corporation.

Flat Yield curve

short-and long-term rates are the same

Bonds with the same maturity have different interest rates due to:

-Default risk -Liquidity -Tax considerations

Income tax considerations

-Interest payments on municipal bonds are exempt from federal income taxes.

As the interest rate increases:

-The opportunity cost of holding money increases... -The relative expected return of money decreases... -and therefore the quantity demanded of money decreases.

Medium of exchange must:

-be easily standardized -be widely accepted -be divisible -be easy to carry -not deteriorate quickly

Fiat Money

-currency, checks, and/or electronic entries that are not backed by any commodity or precious metal -Fiat money has no "fundamental" value-it is only valuable because people accept it in exchange. For this reason, sometimes people say fiat money is a "bubble"

Commodity money

-money made up of precious metals or other commodities -Difficult to carry around, potentially difficult to divide, price may fluctuate

Three theories to explain the three facts:

1. Expectations theory explains the first two facts but not the third. 2. Segmented markets theory explains the third fact but not the first two. 3. Liquidity premium theory combines the two theories to explain all three facts.

The theory of the term structure of interest rates must explain the following facts:

1. Interest rates on bonds of different maturities move together over time. 2.When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted. 3. Yield curves almost always slope upward.

Theory of Portfolio Choice

1. The quantity demanded of an asset is positively related to wealth 2. The quantity demanded of an asset is negatively related to expected inflation 3. The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets 4. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets

An $8000 coupon bond with a $400 coupon payment every year has a coupon rate of ________.

5 percent

Real interest rate

adjusted for changes in price level so it more accurately reflects the cost of borrowing.

Which of the following $1000 face-value securities has the highest yield to maturity?

A 12 percent coupon bond selling for $1000

New information that might lead to a decrease in an asset's price might be ________.

an expected decrease in the level of future dividends

Bond equilibrium

Bd=Bs defines the equilibrium price and interest rate.

Total wealth in the economy =

Bs+ Ms=Bd+Md Rearranging: Bs−Bd= Ms−Md

Medium of exchange (definition)

Eliminates the trouble of finding a double coincidence of needs

True or False? Bonds and interest rates are positively correlated.

False. Bond prices and interest move in opposite directions

Expectations Theory

For an investment of $1 i(t)= today's interest rate on a one-period bond i^e(t+1)= interest rate on a one-period bond expected for next period i(2t)= today's interest rate on the two-period bond

Shifts in the supply for bonds: EXPECTED INFLATION

an increase in expected inflation shifts the supply curve for bonds to the right

Effects of the Obama Tax Increase on Bond Interest Rates

In 2013, Congress approved legislation favored by the Obama administration to increase the income tax rate on high-income taxpayers from 35% to 39%. Consistent with supply and demand analysis, the increase in income tax rates for wealthy people helped to lower the interest rates on municipal bonds relative to the interest rate on Treasury bonds.

Shifts in the demand for money

Income Effect & Price-level Effect

M2

M1 + small denomination time deposits + savings deposits and money market deposit accounts + money market mutual fund shares

coupon bond

P=(C/1+i)+(C/(1+i)^2)+(C/(1+i)^3)+(C/(1+i)^n)+(F/(1+i)^n)

Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? -Price-Level effect

PLE predicts an increase in the money supply leads to a rise in interest rates in response to the rise in the price level (the demand curve shifts to the right).

Interest Rate

Price of money

The Global Financial Crisis and the Baa -Treasury Spread

Starting in August 2007, the collapse of the subprime mortgage market led to large losses among financial institutions. As a consequence, many investors began to doubt the financial health of corporations with low credit ratings such as Baa and even the reliability of the ratings themselves. The perceived increase in default risk for Baa bonds made them less desirable at any given price.

Expected Inflation

an increase in the expected price level

In which of the following situations would you prefer to be the lender?

The interest rate is 4 percent and the expected inflation rate is 1 percent.

Unit of Account:

Used to measure value in the economy

Store of Value

Used to save purchasing power over time.

Bond excess supply

When Bd< Bs price will fall and interest rate will rise.

Bond excess demand

When Bd> Bs price will rise and interest rate will fall.

Which of the following is true for a coupon bond?

When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.

Consol or perpetuity

a bond with no maturity date that does not repay principal but pays fixed coupon payments forever

Income Effect

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

Yield curve

a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations

Price-Level Effect

a rise in the price level ( & expected price level) causes the demand for money at each interest rate to increase and the demand curve to shift to the right

Banks:

accept deposits and make loans

Whatever a society uses as money, the distinguishing characteristic is that it must ________.

be generally acceptable as payment for goods and services or in the repayment of debt

Security

claim on the issuer's future income or assets.

share of stock

claim on the residual earnings and assets of the corporation.

interest rate

cost of borrowing or the price paid for the rental of funds.

M1

currency + traveler's checks+ demand deposits +other checkable deposits

Fiscal policy

deals with government spending and taxation US government

bond

debt security that promises to make payments periodically for a specified period of time.

General Electric announces that it is going to cut its dividends by $0.02 per share in the future. This, everything else remaining the same, will cause its current stock price to ________.

decrease

Everything else held constant, if the federal government were to guarantee today that it will pay creditors if a corporation goes bankrupt in the future, the interest rate on corporate bonds will ________ and the interest rate on government securities will ________.

decrease; increase

When the economy slips into a recession, normally the demand for bonds ________, the supply of bonds ________, and the interest rate ________, everything else held constant.

decreases; decreases; falls

An increase in uncertainty for the economy will ________.

depress stock prices due to a higher required return

High interest rates might ________ purchasing a house or car but at the same time high interest rates might ________ saving.

discourage; encourage

Budget deficit

excess of expenditures over revenues for a particular year

Budget surplus

excess of revenues over expenditures for a particular year

The ________ of the term structure of interest rates states that the interest rate on a long-term bond will equal the average of short-term interest rates that individuals expect to occur over the life of the long-term bond, and investors have no preference for short-term bonds relative to long-term bonds.

expectations theory

Income

flow of earnings per unit of time

Discount Bond

i=(F-P)/P F=Face value P=Current Price

Shifts in the demand for bonds: WEALTH

in an expansion with growing wealth, the demand curve for bonds shifts to the right

Shifts in the supply for bonds: Expected profitability of investment opportunities

in an expansion, the supply curve shifts to the right

Shifts in the supply for bonds: GOVERNMENT BUDGET

increased budget deficits shift the supply curve to the right

Shifts in the demand for bonds: LIQUIDITY

increased liquidity of bonds results in the demand curve shifting right

Financial intermediaries:

institutions that borrow funds from people who have saved and in turn make loans to people who need funds.

Checks

instructions for holder of your money (a bank) to transfer money to another person or institution. Eliminates need to carry currency around -Problems: processing of checks and transfer is potentially costly

Bonds whose term-to-maturity is longer than the holding period are subject to ________.

interest rate risk

Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? -Income effect

interest rates rise because increasing the money supply is an expansionary influence on the economy (the demand curve shifts to the right).

According to the efficient markets hypothesis, purchasing the reports of financial analysts ________.

is not likely to be an effective strategy for increasing financial returns

Electronic payment and e-money:

like checks, but transfer happens instantaneously with a complete record (e.g. debit card)

When yield curves are steeply upward sloping, ________.

long-term interest rates are above short-term interest rates

Upward-sloping Yield curve

long-term rates are above short-term rates

Inverted Yield curve

long-term rates are below short-term rates

Financial crises:

major disruptions in financial markets that are characterized by sharp declines in asset prices and the failures of many financial and nonfinancial firms.

Nominal interest rate

makes no allowance for inflation

Monetary policy

management of the money supply and interest rates Federal Reserve

The difference between money and income is that ________

money is a stock and income is a flow

The price of a coupon bond and the yield to maturity are ________ related; that is, as the yield to maturity ________, the price of the bond ________.

negatively; rises; falls

Paper currency:

pieces of paper that are accepted as medium of exchange. May be "backed" by some commodity (e.g. government guarantees conversion of paper into gold) -Problems: easily stolen and difficult to transport

foreign exchange rate

price of one currency in terms of another currency.

Default risk

probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value

When the ________ interest rate is low, there are greater incentives to ________ and fewer incentives to ________.

real; borrow; lend

Does a Higher Rate of Growth of the Money Supply Lower Interest Rates? -Expected-Inflation effect

shows an increase in interest rates because an increase in the money supply may lead people to expect a higher price level in the future (the demand curve shifts to the right).

Patrick places his pocket change into his savings bank on his desk each evening. By his actions, Patrick indicates that he believes that money is a ________.

store of value

Risk

the degree of uncertainty associated with the return on one asset relative to alternative assets

Liquidity

the ease and speed with which an asset can be turned into cash relative to alternative assets

Liquidity

the relative ease with which an asset can be converted into medium of exchange

Risk premium

the spread between the interest rates on bonds with default risk and the interest rates on (same maturity) Treasury bonds

Wealth

the total resources owned by the individual, including all assets

monetary theory

ties changes in the money supply to changes in aggregate economic activity and the price level.

Wealth

total collection of pieces of property that serve to store value

foreign exchange market

where funds are converted from one currency into another

The spread between interest rates on low quality corporate bonds and government bonds ________.

widens significantly during recessions

4 Types of credit market instruments

•Simple Loan •Fixed Payment Loan •Coupon Bond •Discount Bond

Expectations Theory

•The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond. •Buyers of bonds do not prefer bonds of one maturity over another; they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. •Bond holders consider bonds with different maturities to be perfect substitutes.