Money & Banking - Ch 4

In a competitive market, shortages tend to be eliminated quickly. Why?

Because it is in self interest of both buyers and sellers to increase the price.

In a competitive market, surpluses tend to be eliminated quickly. Why?

Because it is in the self interest of both buyers and sellers to lower the price.

The federal government imposes a tax of​ $10 per bond on bond sales and bond purchases.

Both the demand and supply curves shift to the left.

How does diversification reduce the risk of a financial​ portfolio

By allocating savings among many different​ assets, if one asset class performs​ poorly, the rest of the portfolio may perform well.

Law of Supply

Ceteris Paribus, a higher price makes it more profitable for firms to sell more. This is why the supply curve slopes upward.

Law of Demand

Ceteris Paribus, a higher price means consumers are less willing and able to purchase the good. This is why the demand curve slopes downward.

How would the following events affect the demand for loanable funds in the United​ States? Widespread use of handheld computers helps reduce business costs.

Expected profitability would​ rise, so the demand for loanable funds would rise.

How would the following events affect the demand for loanable funds in the United​ States? Many U.S. cities increase business taxes to help close their budget deficits.

Net expected profitability would​ fall, so the demand for loanable funds would fall.

In the loanable funds​ model, why is the demand curve downward​ sloping? Why is the supply curve upward​ sloping?

The demand curve is downward sloping because the higher the interest​ rate, the less the demand for borrowing. The supply curve is upward sloping because the higher the interest​ rate, the more willing suppliers of loanable funds will be to lend money.

The Federal Reserve publishes a forecast that the inflation rate will average​ 5% over the next five years.​ Previously, the Fed had been forecasting an inflation rate of​ 3%.

The demand curve shifts to the left and the supply curve shifts to the right.

Investors believe that the level of risk in the stock market has declined.

The demand curve shifts to the left.

Briefly explain what typically happens to interest rates during a recession

The demand for bonds​ decreases, while the supply of bonds decreases by a greater magnitude than​ demand, resulting in a lower equilibrium interest rate

According to an article in the Economist about interest rates on European government bonds in​ 2016, investors were concerned​ that, European equities are almost​ 20% below their levels of a year​ ago; commodities have plunged in​ price; the default rates on corporate bonds are rising. What is the most likely impact on European government bonds as a result of the factors listed in the​ article?

The demand for government bonds increased.

In a large open​ economy, how would each of the following events affect the equilibrium interest​ rate? Taxes on businesses are expected to be increased in the future.

The demand for loanable funds would​ decrease, decreasing the interest rate.

In a large open​ economy, how would each of the following events affect the equilibrium interest​ rate? A natural disaster causes extensive damage to​ homes, bridges, and​ highways, leading to increased investment spending to repair the damaged infrastructure.

The demand for loanable funds would​ increase, increasing the interest rate.

In what sense do investors face a​ trade-off between risk and​ return?

The higher the risk that an asset​ has, the lower the demand for the asset. This raises the yield or return if the asset performs well.​ Low-risk assets have a high​ demand, which lowers their yield or return.

How would the following events affect the demand for loanable funds in the United​ States? The government eliminates the tax deduction for interest homeowners pay on mortgage loans.

The increase in the expected​ after-tax real interest rate would reduce the demand for loanable funds.

In reality, interest rate tends to decrease during recessions. What does this imply about the magnitude that each curve shifts?

The shift of the supply curve has a greater magnitude than the shift of the demand curve.

The federal government runs a series of budget surpluses.

The supply curve shifts to the left

The economy experiences a period of rapid​ growth, with rising corporate profits.

The supply curve shifts to the right

In a large open​ economy, how would each of the following events affect the equilibrium interest​ rate? The government proposes a new tax on​ saving, based on the value of​ people's investments as of December 31 each year.

The supply of loanable funds would​ decrease, increasing the interest rate.

In a large open​ economy, how would each of the following events affect the equilibrium interest​ rate? The World Cup soccer matches are being​ televised, and many people stay home to watch​ them, reducing consumption spending.

The supply of loanable funds would​ increase, decreasing the interest rate.

Price Level

a higher price level reduces money's purchasing power -> more money is needed to restore the original purchasing power.

Income

growing economy and more wealth -> more money is needed for transactions.

Many economists assume that a boom in the stock market is a sign that profitable business opportunities are expected in the future. In other​ words, the expected return on stocks increases. As a​ result, the equilibrium interest rate will be _____

higher

According to an article in the Wall Street Journal in early​ 2016, U.S. government bonds maturing in more than 25 years returned a negative​ 1.2% in the month through Thursday ... after chalking up a​ 8.7% gain between January and March.... The reversal reflects a shift in financial​ markets' preoccupation from the prospect of a recession to the risk of higher inflation. An increase in expected inflation will ______ the nominal interest rate on both​ short-term and​ long-term bonds. The longer the maturity of a​ bond, the _____ the change in price as a result of a change in market interest rates. As a​ result, capital losses on​ long-term bonds will be _____ than capital losses on​ short-term bonds.

increase, greater, greater

A recession tends to decrease wealth in society and reduce profitable investment opportunities for firms. This means S shifts _______ and D shifts ______.

leftward, leftward

According to an article in the Wall Street Journal in early​ 2016, U.S. government bonds maturing in more than 25 years returned a negative​ 1.2% in the month through Thursday ... after chalking up a​ 8.7% gain between January and March.... The reversal reflects a shift in financial​ markets' preoccupation from the prospect of a recession to the risk of higher inflation. An increase in expected inflation will shift the demand curve ______ and the supply curve ______, resulting in a new equilibrium with a _____ price.

leftward, rightward, lower

Who the buyer is In the bond​ market, the buyer is the _______ and in the loanable funds​ market, the buyer is the _______.

lender, borrower

The supply and demand model is used to represent a market with

many buyers and many sellers (i.e., a competitive market)

Fisher Effect

nominal interest rates move in the same direction as expected inflation.

The term black swan event refers to _____ events that have a _____ effect on society or the economy.

rare, large

Bond Market

remember that bond prices and interest rates move in opposite directions.

Budget deficits are financed by the Treasury Department issuing more bonds; thus, S will shift _______ and the interest rate will _______.

rightward, increase

Market Risk

risk common to all asset types. Also called systematic risk.

Idiosyncratic Risk

risk that pertains to a particular asset. Also called unsystematic risk.

Quantity Demanded (Qd)

the amount consumers are willing and able to purchase at a given price.

Quantity Supplied (Qs)

the amount sellers are willing and able to sell at a given price.

What the price is In the bond​ market, the price is _________ and in the loanable funds​ market, the price is _________.

the bond price, the interest rate

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.

The bond market model is best suited when

the focus is the short-term nominal interest rate.

The money market model is best suited when

the focus is the short-term nominal interest rate.

The government runs a large deficit, holding everything else constant. As a​ result, the new equilibrium interest rate on bonds ______, and the equilibrium quantity of bonds _______.

will increase, will increase

Why does the supply curve slope upward?

· Ceteris Paribus, a higher price -> lower interest rate -> less costly for firms to borrow, thus firms are more willing and able to issue bonds -> increase in Qs

Which of the following would shift the supply curve for bonds to the​ right?

· Government borrowing increases. · Firm's expected profitability increases. · Subsidies to business increase.

Which of the following would shift the demand curve for bonds to the​ left?

· Households' wealth decreases. · The expected return on stocks increases. · Expected inflation increases.

What are the determinants of asset​ demand?

· The liquidity of the investment compared with other investments. · The total amount of savings to be allocated among investments. · The expected rate of return and the degree of risk for an investment compared to alternative investments.

Ceteris Paribus

· holding everything else constant (wealth, risk, liquidity, etc.)

The liquidity preference model originates from Keynes' The General Theory in 1936. Assume people store wealth in either of two assets:

-Bonds (which earn interest) -Money (which does not earn interest but is liquid.)

Why does the demand curve slope downward?

1. Each price level corresponds to a particular interest rate. 2. that interest rate corresponds to the expected return.

Diversification

Investors typically divide their wealth among many different assets to reduce risk

___________ is the risk that is common to all assets of a certain​ type, while __________ is the risk that pertains to a particular asset rather than to the market as a whole

Market risk, Idiosyncratic risk

What the good is In the bond​ market, the good is the _____ and in the loanable funds​ market, the good is the _______.

bond, use of funds

Who the seller is In the bond​ market, the seller is the _______ and in the loanable funds​ market, the seller is the _______.

borrower, lender

A rise in expected inflation

causes interest rates to rise.

Step 1: A rise in expected inflation decreases expected returns... Step 2: and reduces the real cost of borrowing... Step 3:

causing the price of bonds to fall and the equilibrium interest rates to rise

In a large open economy

changes in the demand and supply for loanable funds are large enough to affect the world real interest rate.

In a small open economy

the quantity of loanable funds supplied or demanded is too small to affect the world real interest rate.

Expected Return (+)

the return expected over the next period on one asset relative to alternative assets.

Wealth (+)

the total resources owned by the individual, including all assets

Information Costs (-)

this refers to the difficulties that can exist when trying to learn about a potential investment. All else being equal, investors will accept a lower return on an asset that has lower costs of acquiring information