BYU Final Study Guide Everything You Need To Know

International Banking facilities

Can accept time deposits from foreigners but are not subject to either reserve requirements or restrictions on interest payments

Futures trading has been dominated by markets in which city

Chicago

Secondary Markets

Claims that have already been issued or sold by one investor to another

SB7.10 If the forward exchange rate for the pound in terms of dollars is higher than today's spot rate, then we would expect the(A)pound to depreciate(B)dollar to depreciate(C)dollar to appreciate

(A) pound to depreciate

SB15.3 An increase in Treasury cash holdings(A)reduces currency in the hands of the public(B)reduces the federal budget deficit(C)increases the federal budget deficit(D)increases the monetary base

(A)reduces currency in the hands of the public

Shelly West is a miller. She is afraid that corn prices will rise between now and August. What strategy could she adopt to limit her risk?

(B&C) Purchase a call option & Enters into the futures contracts

SB13.6 An exchange of expected future returns on debt instruments denominated in different currencies is called(A)exchange rate risk(B)risk management(C)currency swap(D)banker's acceptance

(C)By definition, currency swap is an exchange of expected future returns on debt instruments denominated in different currencies.

option premium

(fee) the price you pay to buy an option

Advancement of other policy objectives

Controlling money supply and encouraging home ownership are among the non-financial reasons that the government regulates financial markets

Bank Assets

1. Reserves 2. Securities 3. Loans

M1

Currency, demand deposits, traveler's checks, and other checkable deposits

There are __________ Federal home Loan Bank Districts

12

They payment system continues to evolve because

A & B (laws have changed & of technological advances

Portfolio

A collection of assets

Depreciation

A decrease or loss in value

The activities of financial intermediaries can be explained by:

D. both A & B (Borrowers and savers desire for various financial services and the cost of providing financial services

Globalization

A major development over the past two decades has been the increasing international integration of the financial system, a process referred to as globalization

Financial System

A network of markets and institutions to bring savers and borrowers together

Interest

A sum paid or charged for the use of money or for borrowing money

The organizer of the Bank of the United States was

Alexander Hamilton

Diversification

Allocating savings among many different assets

Bank runs impose costs on society by

Disrupting the ongoing relationship between banks and borrowers, increasing the cost of gathering information about small borrowers, leading to a contagion effect that can result in a bank panic

deductible

Amount you must pay before you begin receiving any benefits from your insurance company

direct Finance

An individual saver holds financial claims issued directly by an individual borrower

Kazuko Hosoki, arbiter of all things fashionable, announces that all things French are out and all things Japanese are in. The Japanese Yen should

Appreciate

Chapter 15

Banking Regulation: Crisis and Response

Chapter 16

Banking in the International Economy

Inter-district bank mergers are approved by the

Board of Governors

Coupon Bond

Borrowers issuing a coupon bond make multiple payments of interest at regular intervals, such as semiannually or annually, and repay the face value at maturity

Eurodollars

Dollar-denominated deposits at foreign banks or foreign branches of American banks

Under the following conditions, assume that the reserve requirement on checkable deposits is 0.20 and banks want to hold 2% of their demand deposits as excess reserves. Further assume that the general public wants to hold $0.10 of currency and $2 of time deposits for every $1 of checkable deposits, the M1 money multiplier is approximately

3.4375

What would be the expected real after-tax return on a security that pays 9% interest rate if the expected inflation rate is 3% and the individual faces a marginal tax rate of 25%?

3.75%

The natural rate of unemployment currently stands at approximately

4%

You win the lottery, and as a result, you wealth increases from 500,000 to 1,500,000. With the additional 1,000,000, you decide to increase your stock holdings from $50,000 to $450,000. What is your wealth elasticity of demand for this asset?

4.00

The expected after-tax real rate of return on a tax-exempt bond is 6%. Assuming a tax rate of 25% and a nominal interest rate of 12%, the expected rate of inflation is

6%

What is the after-tax return on a security whose before tac is 8%? Assume that the marginal tax rate is 25%

6%

A two-year discount bond with a face value of $20,000 that sells for $17,000 today has a yield to maturity of

8.47%

If the expected inflation is 4% and the expected real return on your investments is 5%, the nominal interest on that investment is

9%

Discount Bond

A bond that sells below its par value; occurs whenever the going rate of interest is above the coupon rate

Discount Bond

A borrower also repays a discount bond in a single payment

General Account

A broker or agent's personal or business account, not to be commingled with trust funds.

loan commitment

A written agreement that commits the lender to make a loan to the borrower provided the borrower satisfies the terms and conditions of the commitment.

SB15.9 Monetizing the government debt occurs when the(A)Fed buys Treasury bonds to finance the budget deficit(B)Treasury transfers its deposit accounts from commercial banks to the Fed(C)Treasury deposits tax revenues in its tax and loan (T&L)accounts(D)Fed sells Treasury bonds to finance the budget deficit

A)Fed buys Treasury bonds to finance the budget deficit

Chapter 25

Aggregate Demand and Aggregate Supply

Which of the following statements is true about an agency office?

An agency office can accept funds from foreign depositors

Appreciation

An increase in the value of a currency

Cash Markets

Are markets in which actual claims are bought and sold with immediate settlement; the buyer pays money to the seller in exchange for the asset

Checks

Are promises to pay definitive money on demand and are drawn on money deposited with a financial institution

Idiosyncratic risk/ Unsystematic risk

Assets also carry their own risk called Idiosyncratic risk, for example the price of an individual stock may be influenced by factors such as discoveries, strikes, or lawsuits that influence the profitability of the firm and its share value

U.S Treasury Securities

Bonds and bond-like securities issued by the U.S. Treasury when it borrows.

U.S. Government Agency Securities

Bonds issued by various government agencies such as Ginnie Mae, the Federal Farm Credit Bank etc.

The principal-agent view of motivation in bureaucratic organizations was developed by

Buchanan and Tullock

In 60 Days, you will be leaving for a vacation in France. Your budget is tight, but at the current exchange rate, you can just afford the trip. A friend then points out to your that exchange rates are subject to change. If the dollar falls relative to the euro, you will have to cancel your trip. What might you do to protect your vacation

Buy a call option on euros

If C is the coupon Payment, F is the face value of the bond, and P is its current price, the coupon rate is

C/F

You purchase a 10-year U.S savings bond at your local bank. This would be an example of a _________ market instrument purchased in the ____________ market

Capital; primary

Chapter 28 Inflation:

Causes and Consequences

Depository institutions

Commercial banks and thrift institutions; financial institutions that accept deposits from the public

Depository Institutions Deregulation and Monetary Control Act of 1980

Congress eased the anticompetitive burned on bank and helped to provide fairness in the financial services industry

The too-big-to-fail policy was applied to which of the following banks

Continental Illinois

The central bank of the European Community is called the

European Central Bank

Short-term debt

Have maturity of less than one year

Expected profitability of capital

Higher expected profitability leads firms to want to borrow more to finance capital investments: the supply curve shirts to the right

Speedback 1.7 Look at question 24 on page 29 of your textbook, which asks you to calculate real GDP for the year 2003 in terms of 1993 dollars. (Review the discussion under objective 9 for this lesson.) The correct answer is A. $720 billion B. $600 billion C. $1.3 trillion D. $800 billion

D. $800 billion

Chapter 10

Information and Financial Market Efficiency

Capital Markets

Debt instruments that have a maturity of greater than one year are traded in capital markets. Equities , which have no fixed maturity, are also traded in capital markets.

Money

Is anything that people are willing to accept in payment for goods and services or to pay off debts

Studies show that rates of return on stock have been abnormally high during

January

___________ and _________ are the largest source of Eurodollar deposits today

Japan: South Korea

Explain how banks can affect the money multiplier by altering reserves and discount loans (loans banks get directly from the Fed).

Just as the nonbank public holds some fraction of its deposits in currency, the banks may not loan out all of their excess reserves; that is, they may hold some fraction of excess reserves on deposit above the amount required by the Fed. A variety of factors can influence bank decisions to hold excess reserves or to obtain discount loans from the Fed which must be paid back, thus expanding and contracting bank reserves.

People hold money during inflationary episodes, when other assets prove to be better store of values. This is explained by the fact that money is

Liquid

Mortgages

Loans from banks and building societies that are used to buy land and buildings such as offices and shops.

Long-term debt

Maturity of more than ten years

Monetary Agregate

Measure of money (M1, M2, M3)

Define each of the terms describing various financial instruments listed in the appendix to Chapter 3 of the textbook.

Meeting objective 5 in this lesson involves learning about many important kinds of financial instruments described in the appendix to chapter 3. You can learn more about each of these instruments by going to the Internet and searching for expanded definitions and discussions of each of the terms listed. You are not expected to become an expert on each term, but you do need to know the basic definitions.

Chapter 20

Monetary Policy Tools

Chapter 2

Money and the Payment System

Return on assets (ROA)

Net Income/Total Assets

lender of Last resort

One of the functions of the Fed: It provides funds to troubled banks that cannot find any other sources of funds.

Chapter 9

Derivative Securities and Derivative Markets

Chapter 6

Determining Market Interest Rates

speculators

People who invest in a risky venture in the hope of making a large profit

Chapter 11

Reducing Transaction Costs and Information Costs

price controls

System of pricing determined by the government

Which of the following is NOT an assumption of the efficient markets hypothesis

Technical analysis have rational expectations

Which of the following private agencies promotes uniform accounting principles

The Financial Accounting Standards Board

Principal

The amount of money borrowed

principal

The amount of money borrowed

vault cash

The currency a bank has on hand in its vault and cash drawers.

Federal reserve System

The federal reserve act of 1913 created a central bank for the untied states

High employment

The goal of high employment extends beyond the Fed to other branches of the federal government.

Intermediate targets

The primary monetary targets in the financial marketplace, which are money supply, long-term interest rates, and bank credit

currency-deposit ratio

The ratio of the amount of currency that people choose to hold to the amount of demand deposits they hold at banks.

Commodity Money

These physical goods were the dominant means by which trade was accomplished and were known as commodity money

Liabilities

These promises are the financial liabilities for the borrower that is, both a source of funds and a claim against the borrowers future income

Chapter 12

What Financial Institutions Do

cost-push inflation

When prices rise due to an increase in the cost of production.

Open Market Trading Desk

a group of private securities traders that the Fed has selected to participate in open market operations

disinflation

a reduction in the rate of inflation

A change in the tax laws forces businesses to depreciate equipment less quickly, and at the same time the demand for money increases because banks make it more difficult to obtain a credit card. How will the aggregate demand curve be affected by these two events?

both of these events will lead to a shift to the left in the aggregate demand curve

member banks

commercial banks that are members of, and hold stock in, the Fed

Assuming no fault, debt reduces monitoring cost by

eliminating the need to conduct costly audits of profits

Higher expected inflation should

increase the nominal interest rate, but its impact on the real interest rate is uncertain

Real Interest rates

interest rates adjusted for inflation

The income that you receive from ma bond is the

interest you receive plus the expected future capital gain (or loss)

The existence of unexploited profits indicates

that markets are not efficient

Nominal Interest Rates

the interest rates actually observed in financial markets

discount rate

the minimum interest rate set by the Federal Reserve for lending to other banks.

Fads

what noise traders pursue

The FDIC initially insured deposits up to__________ and now insures them up to ____________

$2500, $100,000

SB11.1 When a bank issues a checkable deposit and loans the funds out to a business, it has transformed(A)a financial asset for a saver into a liability for a borrower(B)one liability into another liability(C)a short-term liability to a borrower into a long-term asset to a saver(D)a financial liability for a saver into a financial asset for a borrower

(A )a financial asset for a saver into a liability for a borrower

SB4.1An individual purchases a corporate bond that is currently returning 12%. If the expected inflation rate is 5%, and the individual's tax rate is 30%, the real rate of return (after taxes and inflation are accounted for) is(A)3.4%(B)7%(C)8.4%(D)-18%s

(A) (12%-.3*12%)-5%=3.4%

Speedback 1.2 Which of the following statements best describes the economic meaning of risk? (A)the level of uncertainty of an asset's return(B)the difficulties that banks have in making profitable loans(C)the profits earned by gamblers(D)the problems involved in converting assets into cash

(A) the level of uncertainty of an asset's return

SB10.9Which type of insurance incurs the lowest risk?(A)life insurance(B)property and casualty(C)risk is the same for both

(A)Due to the law of large numbers, Life insurers face relatively low risk in the aggregate. Refer to the checkpoint discussion on page 261.

SB5.5A rise in expected inflation will most likely result in which of the following(A)a reduction in the real future value of physical assets ,increasing the demand for bonds(B)a rise in the nominal future value of physical assets, resulting in higher capital gains for such assets and reducing the demand for bonds(C)a rise in the price of both stocks and bonds

(B)a rise in the nominal future value of physical assets, resulting in higher capital gains for such assets and reducing the demand for bonds

SB12.7Savings institutions (savings and loan associations) are regulated today by(A)the Federal Savings and Loan Insurance Corporation(B)the Office of Thrift Supervision(C)the Federal Reserve Board(D)state banking regulatory agencies

(B)the Office of Thrift Supervision

SB12.2 A credit crunch may occur when(A)banks raise interest rates on business loans(B)the government lifts Regulation Q ceilings on passbook savings(C)households and firms are more willing to borrow from banks(D)disintermediation occurs

(C)A credit crunch occurs when credit is restricted at the prevailing rate, whatever it is

Sb13.4What is the dominant currency of the Euro market?(A)Yen(B)Euro(C)Dolla

(C)The U.S. dollar remains the dominant currency in the Euromarkets.

Sb13.10Which of the following countries hold the largest total of foreign liabilities and assets?(A)Japan(B)China(C)U.K.(D)France

(C)The United Kingdom holds the largest total of foreign liabilities and assets.

Speedback 3.8A rise in interest rates of two percentage points will produce the greatest reduction in the present value of which of the following securities?(A) a 30-day Treasury bill(B)a 20-year Treasury bond(C)a 30-year Treasury bond(D)a 5-year Treasury note

(C)Whenever the number of years during which the expected stream of returns increases, the present value of that stream of returns falls.(Review the box called 'Consider This' on page 72 of the textbook).

SB10.1Factoring(A)is calculating the optimal par values of stocks and bonds(B)has been declared illegal under the Factoring Reform Act of 1994(C)is purchasing accounts receivable at a discount(D)involves selling stocks and using the proceeds to buy bonds

(C)is purchasing accounts receivable at a discount

SB14.8 Over periods of several years, the primary determinant of changes in the money supply is changes in(A)discount loans(B)the required reserve ratio(C)the nonborrowed monetary base(D)the money multiplier

(C)the nonborrowed monetary base(D)the money multiplier

Speedback 1.10Which of the following forms of money is considered legal tender in the United States?(A)credit cards(B)electronic funds transfers(c)checks(D)Federal Reserve Notes

(D) Federal Reserve Notes

SB7.5The explanation of exchange rate determination in the short run is based on the assumption that(A)short-run exchange rates are based on equivalent exchanges of actual goods and services(B)changes in price levels are unimportant in the short run(C)nominal exchange rates remain constant in the short run(D)the short-run exchange rate is defined as the price of financial assets in one currency relative to the price of financial assets in another currency

(D) the short-run exchange rate is defined as the price of financial assets in one currency relative to the price of financial assets in another currency

Speedback 3.10Which of the following is a coupon bond?(A)a U.S. savings bond(B)a zero-coupon bond(C)a Treasury bill (T-bill)(D) a 20-year Treasury bond

(D)T-bills, U.S. savings bonds, and zero-coupon bonds are all discount bonds, not coupon bonds. Discount bonds are sold below their face value and redeemed at face value if held to maturity.

Sb14.4 In which of the following cases would a Federal open market purchase not increase the monetary base?(A)The Fed buys securities from the nonbank public, which deposits the checks for the proceeds in the banking system but leaves the balance on deposit without spending it.(B)The Fed buys securities from the nonbank public, which holds the proceeds in currency.(C)The Fed buys securities from the nonbank public, which deposits the checks for the proceeds in the banking system.(D)The Fed sells securities to the nonbank public

(D)The Fed sells securities to the nonbank public

SB13.9 To organize foreign activities, U.S. banks can use which of the following?(A)branches(B)Edge Act Corporations(C)interests in foreign financial firms(D)all of these options

(D)U.S. banks may use any of these options.

Sb14.3 The monetary base is equal to(A)all currency in circulation plus checkable deposits in depository institutions(B)checkable deposits in depository institutions plus reserves held by banks(C)all currency in circulation plus all deposits in depository institutions(D)all currency in circulation plus reserves held by banks

(D)all currency in circulation plus reserves held by banks

SB10.7Individuals assuming greater risk when covered by insurance is called:(A)risk pooling(B)risk hazard(C)adverse(D)moral hazard

(D)moral hazard

SB12.1Perhaps the most important reason why the U.S. created the Federal Reserve System in 1913 was to(A)enable banks to keep their reserves on deposit at the Fed(B)prevent banks from selling securities to their own trust accounts(C)provide open market purchases and sales of Treasury securities by the central bank(D)provide a lender of last resort

(D)provide a lender of last resort

Savers

(lenders) are suppliers of funds, providing funds to borrowers in return for promises of repayment of even more funds in the future)

subsidiary U.S. bank

- Subject to U.S. regulations - Owned by a foreign bank

Using the info above, What is the profit from the contract to the holder of the account?

-$10

SB17.7Which of the following statements about the Fed's Open Market Committee is correct?(A)Federal open market operations affect prices of Treasury securities, but not corporate securities.(B)The district Federal Reserve banks conducted open market operations before 1935.(C)An open market purchase of Treasury securities reduces their price.(D)The FOMC was created by the Federal Reserve Act of 1913

.(C)An open market purchase of Treasury securities reduces their price

What is the capital asset ratio of this bank?

0.19

A Rado watch costs $700 in New York City and 812.50 Swiss francs in Zurich. If 1.25 Swiss francs equal 1, then the real exanchange rate is approximately

1.08

According to the capital asset pricing model, what would be the value of beta if the risk-free rate is 2%, the risk premium on the market portfolio is 8%, and the expected return on the asset is 12%

1.25

If the actual inflation rate is 5%. the real equilibrium federal funds rate is 3%, the inflation gap and the output gap is 1%, the Taylor rule would recommend a federal funds rate target of

10

Intermediate-term debt instruments have a maturity between one year and

10 years

Suppose that your friends, Alex and Evan, wish to borrow $2,000 from you to finance the purchase of a used car. You propose a two-year 8% installment loan with the first payment due one year from now and the second payment due two years from today. What are the two equal payments that Alex and Evan will make to you if they accept the loan?

1121.54

The number of Federal Reserve districts creased by the Federal Reserve Act was

12

A British asset is offering a 7% yield. A comparable U.S. asset is offering a 5% yield. If capital is highly mobile, what is expected dollar appreciation or depreciation rate?

2% appreciation

Assume that individuals want to hold $2 of currency for every $5 of checkable deposits and banks want to hold $2 of excess reserves for every $100 of checkable deposits is 8%, the money multiplier would be

2.8

Price stability

when the aggregate price level is changing only slowly

Explain the conditions for both short-run and long-run equilibrium in the AD-AS model.

Equilibrium is a state of balance in which there are no immediate pressures to change. Thus the short-run AD-AS equilibrium can be represented as the output and the aggregate price level (P) at the point where the SRAS curve crosses the AD curve (page 600 of the textbook). Remember that GDP, or Y-Y*, is just an all-purpose symbol for measuring national income, which is the part of GDP that actually becomes income earned by the factors of production. Long-run AD-AS equilibrium occurs at the output level where the SRAS curve and the AD curve intersect at a point on a vertical LRAS curve (page 601 of the textbook).

Default

Failure to pay back a loan

Overnight loans between banks are called

Federal Funds

The government agency that is responsible for supervising bank holding companies is the

Federal Reserve System

Investment banks

Financial institutions that assist firms in the process of issuing securities to investors. Investment banks also advise firms engaged in mergers and acquisitions, and they are active in the business of selling and trading securities in secondary markets.

Which of the following criteria makes a good suitable for use as a medium of exchange

For use as a medium of exchange a good should satisfy all of the above

Eurocurrency deposits

Foreign currency on deposit in a bank, on which the bank pays interest in the same foreign currency

Which of the following countries allows universal banking

Germany

information

Give facts about borrowers and expectations about returns on financial assets

The Banking Act of 1933, which prohibited commercial banks from participating in underwriting corporate securities and brokerage activities, is also called the

Glass-Stegall Act

Over the counter (OTC) Markets

Have no centralized place for auction trading. Instead, OTC dealers buy and sell via computerized trading

David Ortega is an investment banker with a reputation for predicating which junk bonds are likely to default. the junk bonds that he recommends will likely enjoy___________ demand because those bonds are characterized by ________ _________.

Higher, lower risk

Which of the following statements is true about international regulation of banking

Home country authorities have primary responsivity for regulating banks

Analyze the historical record of monetary policy actions taken by the Fed.

How well has the Fed performed historically? The discussion on pages 486 through 494 of the textbook reviews the shifting emphasis on alternative Fed policy targets and particularly reviews the vacillation between using interest rates or monetary growth targets as the Fed's primary policy tool. While economists and some members of the Board of Governors occasionally argue for some other alternative target or for a hybrid target containing a mix of economic indicators, the management of the Fed's policies, just as in the case of all economic policy making, remains far more art than science.

Assets

IOU's are financial assets for savers

Discuss how futures transactions can be used to manage risk.

In addition to a straightforward purchase of a futures contract, managers and investors may wish to minimize risk through hedging, or assuming a futures market position equal and offsetting to a position in a cash market. The success of a hedging strategy can be affected by basis risk or different movements in the interest rates on the hedged instrument and the rate on the futures instrument.

Standard of Differed Payment

In credit transactions, money can facilitate exchange at a given point in time by providing a medium of exchange and unit of account.

Board of Governors

In the Federal Reserve System, a seven-member board that makes most economic decisions regarding interest rates and the supply of money.

Contractual saving institutions

In the United States, controlling assets of $925 Billion in 2003, insure policyholders against events other than death

Businesses with stock trading on the New York Stock Exchange are required to make detailed financial disclosures. Why does the NYSE impose this requirement?

Information costs are reduced, so the demand for bonds rises

Suppose you read in the newspaper that the Attorney General has announced a stepped-up effort to enforce insider trading laws. What will happen to the value of bonds?

Information costs will fall, demand will shift to the right, and bond prices will rise.

The narrowest definition of the money supply in the United States is

M1

Which of the following would be considered an intermediate Fed target

M2

Intermediate-term debt

Maturity between one and ten years

Of money's four functions, the one that defines money to be money is the

Medium of exchange function

Store of Wealth:

Money allows value to be stored easily, assuming that money does not lose its value rapidly. By serving as a store of wealth, money reduces liquidity costs

Most of the Fed's earnings come from

None of these: interest on discount loans, fees for checking clearing, The Fed does not have any earnings. It receive appropriations from Congress

Debt Instrument

Official term for bond or other long-term debt

Chapter 19

Organization of Central Banks

Rate of Capital Gain

Over any given holding period (the length of time for which the bond is held), an investor may receive a different rate of capital gain or loss than expected originally.

Chapter 3

Overview of the Financial System

Which of the following chairmen of the Board of Governors served during the 1980's

Paul Volcker

maturity

Period of time at the end of which time deposits will pay a stated rate of interest

Explain the role of financial intermediaries in providing risk sharing, liquidity, and information services to both savers and borrowers.

Picture a group of savers in a box on the left of a diagram. Now picture a bunch of lenders in a box on the right side of a diagram. Then draw a box in the middle and call it a financial intermediary, which could be a bank or a credit union or other similar financial institution. The intermediary intermediates, that is, it helps both savers and borrowers meet their goals by creating IOUs (like certificates of deposit) that are assets to savers (lenders) and liabilities to borrowers. When funds flow from savers into a financial intermediary, we say that financial intermediation takes place. When funds flow out of a financial intermediary, we say that financial disintermediation takes place. When disintermediation takes place at an accelerated rate, as when funds flowed out of the Savings and Loan associations during the 1980s, financial disaster can occur, as the S&Ls discovered in the crisis that resulted.

The ________ is always a voting member of the FOMC

President of the NEw York Federal Reserve Bank

Commercial banks

Privately owned financial institutions that accept demand deposits and make loans and provide other services for the public

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994

Provided a consistent nationwide standard for interstate expansion after September 1995. As of that time, states could permit interstate mergers within their own borders, and bank holding companies could begin acquiring banks in other states.

Which of the following agencies was created by FIRREA

RTC

Prime Rate

Rate of interest banks charge on short-term loans to their best customers

Differentiate between real and nominal interest rates.

Recall from lesson 1 the difference between nominal and real values in economics. Nominal values are values stated in current dollars, (or amounts that have not been adjusted for inflation). Real values are nominal values adjusted for inflation. Thus, to find the real rate of interest we must take the nominal rate and subtract the (expected) rate of inflation. The only problem is that we don't always know what the actual rate of inflation is going to be; we must make our best guess. If we are a lender, for instance, and we don't take the expected rate of inflation into account, we could end up getting paid back in dollars worth less than what dollars today are worth. Economists recognize the need to pay attention to the real rate of interest, which is the optimal criterion for comparing investments. Thus, in addition to finding the total rate of return and comparing yields to maturity, we must consider the real total rate of return, after adjusting for inflation.

Monetary Policy

Refers to the management of the money supply and its links to prices, interest rates, and other economic variables

Real rate of return

Reflects the amount of additional goods and services an investor can buy from earnings on a financial instrument

Discuss regulation of international banks.

Regulating international banking is a difficult task. Accounting rules and regulations vary from country to country as does culture and tradition. These social and financial reporting differences create an environment in which regulation is difficult. In attempts to implement more international banking regulation, two agreements have been implemented within the international banking community. The Basel agreement of 1987 is a treaty between twelve industrialized nations. It establishes uniform capital requirements for the banks of participating countries. The Basel II agreement of 2003 extended the 1987 agreement.

Financial Futures

Require settlement at a specified future date for a price determined today

Financial futures

Require the settlement of a purchase of a financial instrument at a specified date, with the price determined at the outset

Debt

Requires the borrower to repay the amount borrowed, the principal, plus a rental fee or interest

Identify the characteristics associated with risk-averse savers, risk-neutral savers, and risk-loving savers.

Research has shown that most people are risk-averse; that is, in general, people shun risk. But not everyone shuns risk! Some people relish the roller-coaster ride of shooting for the high gain, sometimes forgetting the old maxim that the higher the possible gains, the higher the potential loss. Note the differences among risk-averse savers, risk-neutral savers, and risk-loving savers in the textbook. Savers pay a price in terms of lower yields on certain kinds of financial assets in order to reduce the risk they are willing to bear.

Narrow Banking

Restrictions on banks that would require them to hold only short-term government bonds.

In Summer 2002, the Congress approved which of the following regulations that required U.S. companies to quickly disclose director/officers transactions in company stock, and auditors conflicts of interests

Sarbanes-Oxley Act

market/ systematic risk

Savers cannot eliminate risk entirely because assets share some common risk called market or systematic risk

Economic Analysis Involves:

Setting out what is to be explained (the problem) Proposing how the problem is to be explained (the theory) Examination of actual data to evaluate the theory

Medium of Exchange

Settlement of debts for goods or services in terms of what is excepted as a tender

According to the expectations theory, expected inflation should make the yield cure

Steeper

According to the preferred habitat theory, expected inflation should make the yield cure

Steeper

According to the segmented market theory, expected inflation should make the yield cure

Steeper

cold turkey

Stopping all at once.

List the components of the Fed's balance sheet that determine increases and decreases in the monetary base and explain how these increases or decreases occur.

Study the summary equations on page 420 of the textbook. The first equation shows that the base (Federal Reserve Notes plus reserves) equals the sum of the assets on the left side of the balance sheet, minus the liabilities other than currency and reserves on the liabilities side. In other words, since the balance sheet must balanced, the base will be a residual, arithmetically determined by subtracting all nonbase liabilities from the sum of total liabilities. If you are puzzled by this task, spend enough time on it until you see how the arithmetic works out. You might actually add and subtract the appropriate numbers in table 18.1 on page 418 of the textbook to prove to yourself how this exercise works. The second equation on page 420 of the textbook simply spells out what we have just said by defining the base as a residual in the balance sheet. The purpose of defining the base as a residual quantity in the Fed's balance sheet is to be able to explain changes in the following asset categories of the Fed's balance sheet: securities and discount loans Fed float (by using only the positive difference, or the float, we don't have to list DACI on the liabilities side, one less factor to worry about!) gold and SDR certificate accounts other Fed assets Treasury currency outstanding (TCO refers to coins minted by the Treasury and held by the Fed which affect the base just like changes in Federal Reserve Notes outstanding.) The components of the Fed's balance sheet that lead to decreases in the monetary base are all on the liabilities side. If Fed liabilities (other than reserves and currency in circulation) rise, the monetary base shrinks. It will be obvious to you that this result must occur if you realize why the base is a residual after subtracting all of the nonbase liabilities from the sum of total Fed assets. If these nonbase liabilities rise, then the base must shrink so the balance sheet will balance. Now consider Treasury cash holdings (currency held by the Treasury not in circulation), U.S. Treasury deposits at the Fed, foreign and other deposits at the Fed, and other liabilities and capital accounts. Regarding U.S. Treasury deposits at the Fed—when a taxpayer pays taxes the check initially goes into a "tax and loan account" of the Treasury at a commercial bank. When the Treasury needs to pay its bills, it transfers these account funds to the Fed, which then serves as the Treasury's banker.

tariffs

Taxes on imports or exports

Basis risk is the risk

That arises from a change in the spread between the rate on the hedged instrument and the rate on the instrument actually traded

FOMC

The Federal Open Market Committee is the most powerful committee of the FED, because it makes the decisions that affect the economy as a whole by manipulating the money supply.

Explain the duties of the twelve regional Fed banks.

The Federal Reserve Act divided the United States into twelve districts, each of which has a federal reserve bank. The main duties of the twelve regional Fed banks are outlined on page 437 of the textbook. The regional Fed banks collect and disseminate economic data and conduct research on financial institutions. Each regional Fed bank has an economics research staff and publishes various reports affecting the district in which the bank is located. Other duties include the management of check clearing and making discount loans to banks within the district.

Chapter 17

The Money Supply Process

Chapter 5

The Theory of Portfolio Allocation

Edge Act corporations

The United States to specialize in international banking and foreign financial transactions. Established in 1913.

Purchasing Power Parity (PPP)

The amount of money needed in one country to purchase the same goods and services in another country

exercise price

The cost per share at which an option or a warrant holder may buy or sell the underlying security. Syn. strike price.

Federal Reserve System

The country's central banking system, which is responsible for the nation's monetary policy by regulating the supply of money and interest rates

Default Risk Premium

The difference between the interest rate on a U.S. Treasury bond and a corporate bond of equal maturity and marketability.

Financial Instruments

The financial system achieves this transfer by creating IOU's known as Financial Instruments

Yield to maturity

The interest rate that equates the present value of the asset's returns with its prices today is called the yield to maturity

The Fed makes a $2 million discount loan to First City Bank. The monetary base and the Fed's balance sheet will change as follows:

The monetary base increases by $2 million, and the assets and liabilities of the Fed increase by $2 million

Exchanges

The most common type of auction market is an exchange, which is a specified central location at which traders agree to meet

Financial Innovation

The process of adaptation in response to market conditions is financial innovation

Ali Niakoui believes that an important factor in deciding whether to expand his business is what the inflation rate will be over the next three years. How can he use the term structure to decide what inflation will be

The slope of the yield curve indicates expected inflation A steep yield curve is associated with a higher expected inflation A flat yield curve is associated with a lower expected inflation

Present Value

The solution to this problem is the concept of present value, a measure that provides a way to compare interest rates on different instruments

Explain how options are used to manage risk.

The success of reducing risk from fluctuating prices depends on basis risk, the extent to which prices of a hedged asset match the prices of the underlying asset.

interest rate effect

The tendency for increases in the price level to increase the demand for money, raise interest rates, and, as a result, reduce total spending and real output in the economy (and the reverse for price-level decreases).

Eurodollars

U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks

International banking facilities are

U.S. institutions that cannot conduct domestic banking services

Explain how investors use the theory of risk structure and the theory of term structure for economic forecasting.

Under what economic circumstances would risk premiums likely rise? Investors may use risk premiums as a signal of anticipated changes in the economy. Risk premiums will rise when people expect an economic downturn, when default-risk is sure to increase. Then, if risk premiums are headed downward, that could mean investors expect better times ahead and are less worried about whether borrowers will repay loans. Investors may also use term structure of interest rates as an indication of economic events. The main points to remember in using term structure for economic forecasting, as outlined in the textbook, include the following: Remember that both the expectations theory and the preferred-habitat theory provide clues about the expected future pattern of nominal (not real) interest rates. If real interest rates are expected to remain fairly constant, then, as Hubbard states, "an upward yield curve means that inflation is expected to rise." Real rates are equal to nominal rates minus the rate of inflation. If real rates remain constant, then the offsetting factor in rising interest rates must be inflation.

An asset, the value of which is used to keep track of other values, is a

Unit of account

Commercial Bank Loans

When a commercial bank extends or makes a loan, money is created. When a loan is paid off, money is destroyed. When the bank extends a loan, both assets and liabilities are increased.

Nominal Interest Rate Parity Condition

When domestic and foreign assets have identical risk, liquidity, and information characteristic, their nominal returns (measured in the same currency) also must be identical

An increase in bond prices will cause

a decrease in the quantity of loanable funds supplied

For barter to take place, two traders would have to have

a double coincidence of wants

A rise in the nominal interest rate could have been caused by

a rise in the expected inflation rate or the real interest rate

Public Interest View

a theory of central bank decision making that holds that officials act in the best interest of the public

Dual banking System

allows commercial banks to obtain charters from the federal government or a state government

Credit Market Instruments

also called debt instruments, such as those issued by banks, the government, and corporations were introduced in Chapter 3.

The Fed monitors compliance with its reserve requirements by checking a bank's

average daily deposits against its average daily reserves over the pervious two weeks

Secondary Markets

can be organized as exchanges, can be organized as over-the-counter markets, provide liquidity and risk sharing

currency in circulation

cash held by the public

All else being held constant, an unexpected decrease in aggregate demand will

cause a recession

The exchange rate is important because

changes in exchange rates affect the value of U.S good, services, and assets

misperception theory

changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output

The M1 definition of the money supply includes

checkable deposits

Bank Liabilities

checkable deposits, nontransaction deposits, borrowings, bank capital

Key Services provided by the financial system to savers and borrowers include all of the following except

collateral

Citibank created negotiable CD's to compete with

commercial paper

to reduce the impact of its transactions on the monetary base, the U.S. Treasury

communicates its planned transactions to the Fed so that the Fed can plan defensive open market operations

venture capital firms

companies that invest in start-up businesses with high growth potential in exchange for a share of ownership

bank holding companies

company that owns and controls one or more banks

Which of the following is NOT a goal of monetary policy

competitive markets

Federal regulation of banking is necessary when federal deposit insurance is in force because

deposit insurance reduce the incentive for depositors to monitor banks

primary credit

discount loans available to healthy banks experiencing temporary liquidity problems

The number of the FOMC meets each year is

eight

If the dollar appreciates against the yen, U.S. exports should

fall

The law of one price would be LEAST likely to hold for which of the following goods?

haircuts (tangible)

The Federal Open Market Committee (FOMC) was created by Congress

in the 1930's

The author lists five broad groups of financial institutions. Finance companies would fall in the category of

investment institutions

forward transactions

involve the exchange of bank deposits at some specified future date

The likely direction of international financial regulation

is regulation by function

The Federal Reserve

is responsible for regulating the money supply, which is the total quantity of money in the economy.

Any income that the Fed earns above and beyond the amount needed to cover its operating expenses

is returned to the Treasury

long-run aggregate supply (LRAS) cureve

is vertical at y*

Clackamas Cement Company has gone to the bank seeking a series of loans to finance the massive expansion of its business. If Clackamas's expansion proves successful, it will be able to repay its loans in full earning a healthy profit for the bank. If its expansion fails, Clackamas will default, sticking the bank with large losses. The bank is MOST likely to finance Clackamas when the bank_________ covered by federal deposit insurance and has________ capital

is; inadequate

When we say that money is neutral in the long run, we mean that

it leaves real output unchanged in the long run

Treasury tax and loan accounts

keeps tax receipts in the banking sector by depositing them into select banks that meet certain criteria.

Which of the following is NOT a way to reduce information costs

lending to all those seeking to borrow

If the dollar appreciates against the yen, Japanese goods become

less expensive to Americans

The currency held by the nonbank public is _____________ the amount of checkable deposit held

less than half

Generally, the percentage of reserves that large banks hold in the form of vault cash is

less than the percentage held by small banks

Which of the following is considered an operating target

monetary base

Difficulties encountered by lenders in monitoring how borrowers spend the proceeds from their loans are called

moral hazard

Loans that are made to a healthy financial institution sufferings from short-term liquidity problems are called

primary credit loans

hedging

protecting against cost increases with contracts that allow a company to buy supplies in the future at designated prices

Monetizing the debt involves the

purchase of Treasury securities by the Fed

Federal Reserve Regulation K

regulates the international activities of member banks

reserve requirements

regulations on the minimum amount of reserves that banks must hold against deposits

Which of the following was NOT a contributing factor to the savings and loan crisis

regulatory accounting practices that were stricter than generally accepted accounting practices

According to the author, which of the following is NOT a reform that is currently under active discussion among policymakers

restricting bank branching

Venture capital firms overcome the free-rider problem by

restricting trading in shares of the companies they invest in

If interest rates fall, the current price of a bond should

rise

In question 13, the yield on Sophtwear bonds will

rise

Empirical Evidence indicates that most investors are

risk averse

What three important financial services do banks provide their customers

risk sharing, liquidity, and information

Which depository institution specializes in real estate loans

savings and loan associations

Theory of Portfolio Allocation

seek to answer questions about portfolio choice and predicts how a saver distributes his or her savings across alternative investments

A lender who is worried that the cost of its funds might rise during the term of a loan it has made, can hedge against this rise by

selling futures contracts on treasury bills

Borrowings

short term loans in the federal funds markets

Repurchase Agreements

short-term sales of government securities with an agreement to repurchase the securities at a higher price

Many economists argue against price controls because

shortages often arise

short-run supply aggregate (SRAS) curve

slopes upward

Federal Reserve Float

temporary increase in bank reserves that results when checks are credited to the reserve account of the depositing bank before they are debited from the account of the banks on which they are drawn

economic growth

the ability of the economy to increase the production of goods and services

Term Premium

the additional interest investors require in order to be willing to buy a long-term bond rather than a comparable sequence of short-term bonds

futures price

the agreed-upon price to be paid on a futures contract at maturity

Government Borrowing

the amount of funds borrowed by the government in the financial markets

Present Value

the amount of money you would need to deposit now in order to have a desired amount in the future

Bond Market

the collective buying and selling of bonds; most bond trading is done over the counter, rather than in organized exchanges

standardization

the contract contain exact specifications

Transaction costs

the costs that parties incur in the process of agreeing to and following through on a bargain

Information Costs

the costs that savers incur to determine the creditworthiness of borrowers and to monitor how they use the funds acquired

Vault Cash

the currency a bank has in its vault and cash drawers

bank reserves

the currency banks hold in their vaults plus their deposits at the Federal Reserve

International transaction currency

the currency of choice in selling international tracastions

The significance of the failure of the Hunt brothers' scheme to corner the silver market was that it undermined confidence in

the financial health of broker-dealers

Loanable Funds

the flow of resources available to finance capital accumulation

short position

the futures trader who commits to delivering the asset

Long Position

the futures trader who commits to purchasing the asset

call option

the option to buy shares of stock at a specified time in the future

World Real interest rate

the real interest rate that prevails in the international capital market

Diversification will not reduce the risk on a portfolio of assets when

the returns are perfectly positively correlated

Interest rate risk

the risk of capital losses to which investors are exposed because of changing interest rates

open market sale

the sale by the Fed of government bonds to the public for the purpose of reducing bank reserves and the money supply

Exchange

the trade of things of value between the buyer and the seller so that each is better off as a result

Smoothly functioning secondary markets are important for a well functioning financial system because

they provide risk sharing, liquidity, and information services

Auction Markets

competitive bidding by a large number of traders set prices

Program trading is

computer based

The insurance premiums that are paid on deposits by the savings and loans and commercial banks to the FDIC are

higher for savings and loans

The largest component of production costs is typically

labor

Investment institutions that channel funds from small savers to various borrowers by selling shares in a portfolio of financial assets are called

mutual funds

Under the leadership of Alan Greenspan, the Federal Reserve has pursued a policy of slow gradual disinflation. This indicates the Federal Reserve Officials' views are most likley influenced by

new Keynesians

During the 1980's, critics of intermediate targets argued that indicator variables would be more appropriate than the intermediate targets that were being used. Which of the following was considered as a possible indicator variable

nominal GDP

Open market operations have their greatest immediate impact on

non borrowed reserves

Options

on financial contracts, as the name suggest, confer on the trader the right )or option) to buy or sell a particular asset (shares of stock, bonds, or units of foreign currency, for example) within a specified time at s specified price

The federal funds rate and reserve agreements are examples of

operating targets

Free Riders

people who benefit from an interest group without making any contributions

Garn-St. Germain Act of 1982

permitted depository institutions to offer money market deposit accounts

The phrase printing money refers to the

physical creation of note, coins, and bills by the U.S. Mint

Financial System

plays a crucial role in the economy by channeling funds to their most productive uses

credit crunch

potential borrowers either can't get credit at all or must pay very high interest rates

The term premium is an element of the

preferred habitat theory

risk-based premiums

premiums based on the probability that an individual will file a claim

yield to maturity

the rate required in the market on a bond

The money supply is growing at 3% per year, real output is growing at 2% per year, velocity is constant, and the nominal interest rate is 7%. Inflation is

1%

Collateral

A security pledged for the repayment of a loan.

Chapter 18

Changes in the Monetary Base

Chapter 7

Risk Structure of Interest rates

bank net worth

The difference between the two-assets minus liabilities-

Which of the following assets is most liquids

a $10 Bill

An increase in wealth should cause the price of financial securities to

rise

Sb17.3During the postwar period which of the following goals has been emphasized by the Fed?(A)stabilizing economic growth(B)stabilizing short-term nominal interest rates(C)stabilizing the value of the dollar versus the yen(D)stabilizing share prices on the New York Stock Exchange

(A)stabilizing economic growth

During 1997, Ortega suffered several "black eyes" when junk bonds that he recommended subsequently defaulted. What will happen to bonds that he previously recommended?

(B&C) Market Participants will view the bonds as now being more risky and the secondary price will decline

SB6.6If you are comparing a corporate bond yield of 12% with a Treasury bond yield of 6%, then the default risk premium is(A)12%(B)6%(C)18%(D)24%

(B) 6%

SB10.3Private pension funds hold the highest percentage of assets in:(A)corporate bonds(B)corporate equities and mutual fund shares(C)government securities(D)mortgages

(B) corporate equities and mutual fund shares

SB13.3 An order to pay a specified amount of money to the holder of this document on a specified date is called a(A)euroloan (B)banker's acceptance(C)check(D)currency swap

(B)A banker's acceptance is a time draft. It is an order to pay a specified amount of money to the holder on a specific date.

SB8.2One advantage of buying an option contract is that(A)an options contract provides less opportunity for gain than a futures contract(B)the maximum loss is the option premium(C)an option contract provides fewer insurance benefits than a futures contract(D)an options contract involves lower cost than a futures contract

(B)the maximum loss is the option premium

SB6.1Which of the following statements best defines the default risk premium?(A)The default-risk premium is also known as the market-risk premium.(B)The default-risk premium is the lower yield an investor requires for higher default risk.(C)The default-risk premium is the higher yield an investor requires for higher default risk.

(C)The default-risk premium is the higher yield an investor requires for higher default risk.

Speedback3.4Calculate the yield to maturity (YTM) for a one-year discount bond with a face value of $1,000 and a purchase price of $850(A)0.15(B)0.015(C)0.176(D)0.0176

(C) Recall YTM = (F-D)/D, so (1000-850)/850=.176

SB6.7If a Treasury yield curve slopes upward to the right, what is the correct interpretation?(A)Higher yields imply higher demand and higher bond prices.(B)Lower yields imply lower demand and lower bond prices.(C)Lower yields imply higher demand and higher bond prices.

(C)Lower yields imply higher demand and higher bond prices.

SB17.5 The Fed uses operating targets as well as intermediate targets because(A)if one set of targets proves ineffective in attaining policy goals, the other set is available(B)the Federal Reserve Act of 1913 requires it to do so(C)the public is much less familiar with the variables used as operating targets, so for policy to be effective intermediate targets must also be announced(D)the Fed controls intermediate targets only indirectly

(D)The decision by the Fed to use both intermediate and operating targets is based on the fact that intermediate targets can be controlled only indirectly, whereas it has much more control over operating targets and can gauge their attainment much more effectively

SB4.4According to the Capital Asset Pricing Model (CAPM), what would be the value of beta if the risk-free rate is 2%, the risk premium on the market portfolio is 8%, and the expected return on the asset is 12%?(A)1(B).5(C)2(D)1.25

(D)The expected return on the asset is 12% minus the risk-free rate of 2%, generating a value of 10% for the risk premium on the asset;therefore, if the risk premium on the market portfolio is 8% then beta has to be 1.25.

Under the expectations theory, if the yield on a one-year, two year, and three year bond are 5%,7%, and 7.5% respectively , we would expect the one year rate in the third year to be

8.5%

floating-rate debt

A type of debt issue that carries interest payments that reset periodically based on movement in a representative interest rate index, such as the London Interbank Offered Rate (LIBOR) or the US Treasury bill.

Unit of account

A unit of account is an asset, the value of which is used to keep track of other values. By using the medium of exchange as a unit of account, a single price can be quoted for each product in terms of the medium of exchange. This reduces information costs and facilitates trade.

hyperinflation

A very rapid rise in the price level; an extremely high rate of inflation.

Which of the following bonds should offer the lowest yield, all other things equal?

AA

An unanticipated increase in the money supply shifts

AD to the right and leaves AS unchanged

Suppose that the President is thinking of imposing regulations in futures markets. Why is this a bad idea?

Speculators increase market liquidity

Electronic Money

Money in the form of a computer entry at a bank or other financial institution

Policymakers at the Federal reserve are concerned about monetary theory because:

a. it helps them to understand the relationships between the money supply and other economic variables

You develop an economic theory that states that an increase in the growth rate of the money supply will result in higher inflation. What should be your next step?

b. Apply the three criteria for determining the usefulness of a theory

Which of the following is NOT an example of a financial intermediary?

b. The bond market

The principal liability of the Federal Reserve is

currency outstanding

Risk Structure of interest rates

the relationship among interest rates on bonds that have different characteristics but the same maturity

Term Structure of Interest Rates

the relationship between yields to maturity and terms to maturity across bonds

Shoe leather costs

the resources wasted when inflation encourages people to reduce their money holdings

credit rationing

the restriction of credit by lenders such that borrowers cannot obtain the funds they desire at the given interest rate

multiple deposit contraction

the result of an open market sale

exchange rate risk

the risk related to having international operations in a world where relative currency values vary

Default Risk

the risk that the borrower will not pay the face value of a bond on the maturity date

The new Keynesian approach argues that

the short-run aggregate supply curve has a positive slope

Monetary base

the sum of coins, Federal Reserve notes, and banks' reserves at the Fed

Efficient Markets Hypothesis

the theory that asset prices reflect all publicly available information about the value of an asset

matched sale-purchase transactions

the trading desk often engages in

According to the Humphrey-Hawkins Act, how many times each year must the Fed chairman testify concerning the Fed's conduct of monetary policy

twice

Most open market operations are

defensive

The disadvantages of commodity money include

difficulty of assessing purity

Price controls were last used in the United States during the

early 1970's

Some large banks in the United States and other countries suffered substantial losses when a number of developing countries failed to meet their debt obligations. This debt crisis in international banking began in the

early 1980's

Debt financing reduces information costs by

eliminating the need to audit except in deafult

Banker's acceptances reduce_______ risk to the exporter

exchange rate

Alan Greenspan is currently in his term as Chairman of the Board of Governors

four

A disadvantage of government allocation as an option for the conduct of trade and exchange is that it

ignores market forces in allocating goods

Simple Loan

in a simple loan the borrower receives from the lender and amount of funds called the principal and agrees to repay the lender the principal plus an additional amount called interest (as a fee for using the fund) at a given dater (maturity)

Foreign exchange markets

markets dealing in buying and selling foreign currency for businesses that want to import goods from other countries

Euromarkets

money and capital markets in which transactions are denominated in a currency other than that of the place of the transaction; not confined to Europe

The principal-agent problem is an example of

moral hazard

an increase in the monetary base will most likely result in

more rapid inflation

Stock A has a beta value of 0.5 and a return of 8%. Stock B has a beta value of 1. Because of systematic risk, the most likely return for stock B would be

more than 8%

load funds

mutual funds that charge a commission every time shares are bought or sold

The type of market that is characterized by no centralized place for auction trading is a(n)

over-the-counter market

Federal (Fed) funds

overnight loans made by banks to one-another out of their deposits at the Federal Reserve.

Monica's insurace policy requires her to pay 30% of the costs of her medical care. This is an example of

coinsurance

Federal Reserve float arises because

the Fed clears deferred availability cash items before clearing the corresponding cash item in the process of collection

open market operations

the buying and selling of government securities to alter the supply of money

The opportunity cost of holding excess reserves equals

the interest income that the banks could have received by lending out the excess reserves

Financial Institutions Reform, recovery and Enforcement Act of 1989

the most comprehensive legislation for the S&L industry since the 1930's

To reduce the rate of inflation

the new classicists advocate a cold turkey approach, whereas the new Keynesians advocate a policy of gradualism

natural rate of unemployment

the normal rate of unemployment around which the unemployment rate fluctuates

put option

the option to sell shares of stock at a specified time in the future

monetary neutrality

the proposition that changes in the money supply do not affect real variables

expectations theory

the proposition that the interest rate on a long-term bond will equal the average of the short-term interest rates that people expect to occur over the life of the long-term bond

Speedback 1.1 An important difference between wealth and income is that (A)Wealth is a medium of exchange, whereas income is a store of value.(B)Wealth measures the value of a stock of accumulated assets at a given moment in time, but income measures a flow of earnings over a period of time, such as a year.(C)Wealth is more easily spent than is income.(D)Wealth constitutes a flow of earnings over time, while income represents a stock at a given moment in time

(B) Wealth measures the value of a stock of accumulated assets at a given moment in time, but income measures a flow of earnings over a period of time, such as a year

Speedback 1.4 Which of the following statements best illustrates the role of economic analysis in the study of money and banking?(A)Economic analysis helps us understand an idealized version of how the financial system should operate, but we must depend on facts to solve current problems.(B)Economic analysis provides a theoretical approach to money and banking so that we can solve problems without depending on facts.(C)Economic analysis provides a means of linking changes in interest rates and the money supply to changes in economic activity throughout the economy.(D)The main value of economic analysis is to provide a better understanding of events that happened in the past.

(C) Economic analysis provides a means of linking changes in interest rates and the money supply to changes in economic activity throughout the economy.

Speedback 1.3 One problem that money as a store of value and money as a standard of deferred payment have in common is that(A)People prefer to hold physical assets such as land rather than cash.(B)Lenders would be better off if borrowers paid them in goods rather than in cash.(C)Money can lose purchasing power through inflation and thus reduce the value of cash held as wealth and reduce the value of money repaid by borrowers to lenders.

(C) Money can lose purchasing power through inflation and thus reduce the value of cash held as wealth and reduce the value of money repaid by borrowers to lenders.

Speedback 1.8 The main difference between money aggregates M1 and M2 is that(A)M1 is larger in quantity than is M2.(B)Short-term Treasury securities make up a big part of M2 and are not included in M1(C)M2 excludes liquid currency and checks that are part of M1 and, thus, is a less liquid category of money(D)The savings deposits, time deposits, money market accounts, overnight Eurodollars and overnight repurchase agreements contained in M2 are less liquid than the components of M1.

(D) The savings deposits, time deposits, money market accounts, overnight Eurodollars and overnight repurchase agreements contained in M2 are less liquid than the components of M1.

Inflation

A decline in purchasing power of money, a condition in which rising prices cause a given amount of money to purchase fewer goods and services

Asset

Anything of value owned by a person or a firm

Financial Intermediaries

Are institutions such as commercial banks, credit unions, savings and loan associations, mutual funds, finance companies, insurance companies, and pension funds that borrow and pool funds from savers and lend them to borrowers.

U.S. monetary policy is set by

B. The federal Reserve System

Which of the following is an advantage of check?

Checks may be written in any amount up to the total amount on deposit

Federal Reserve System (Fed)

Collects data on various measures of money supply, and it is the central bank in the United States

Electronic Funds Transfer Systems

Computerized payment-clearing devices

The modern U.S. payment system is a fiat money system, what does that mean?

Fiat money issued by the Fed is definitive money

Central Bank

In modern economies, paper currency is generally issued by a central bank, which is a special governmental or quasi-governmental institution in the financial system that regulates the medium of exchange

Explain how inflation affects the value of money and how price indexes are used to measure inflation.

Inflation is defined as a rise in the general price level. We calculate price indexes to measure such price changes (see the appendix to chapter 2 of the textbook). To calculate a price index, multiply the price of goods and services included in the index in a base year by the quantities consumed in that year to get the total cost in the base year. Then multiply prices in a given year (other than the base year) by the same quantities of goods and services used in the base year to get the total cost in the given year. Divide the cost in the base year into the cost in the given year and multiply by 100. You will get a number such as 130, which means that prices have increased 1.3 times, or 30 percent during the two periods. (Note: for some indexes, the quantities are allowed to change in the given year; for the Consumer Price Index, the quantities are fixed.) The main price index we will use in this course is the Consumer Price Index, or CPI. The CPI compares prices for a fixed market basket of goods and services in a base year to prices for that same fixed market basket in a given year. The CPI is often linked to changes in cost of living for workers (through so-called COLA, [cost of living allowance] clauses in wage contracts) and to changes in social security payments. The CPI, however, doesn't measure all prices in the economy, only prices of consumer goods and services. A second price index is the Producer Price Index, or PPI, which compares prices of productive inputs such as raw materials at two different times. The PPI is called a leading indicator because rises in the PPI will often eventually translate into higher costs of manufactured goods and, ultimately, into higher consumer prices. A third price index is the GDP deflator, which is the broadest of all price indexes because it compares price changes for all goods and services produced in the entire economy (the GDP) for two time periods. The three price indexes often move together minimizing the importance of using a specific index. News releases often include statements like "the CPI for April rose by 0.2 percent." A CPI hike of 0.2 percent for one month is roughly equal to an annual price hike of 2.4 percent (multiply the monthly rate of 0.2 × 12 = 2.4). Price indexes are used to deflate nominal values and to obtain real values. Nominal values are values of output, interest rates, incomes, and other economic variables measured in terms of current dollars. Real values have been deflated so that the nominal values have had price level changes removed. For example, if gross domestic product (the value of all output) is $2 trillion in one year, and prices double the next year but no new increase in output occurs, nominal GDP will be $4 trillion next year. Real GDP, however, is still $2 trillion because no increased quantities of goods and services have been produced. You can look at real values as numbers from which we have "wrung out" all of the inflation effects. In particular, we will focus later on real interest rates, or interest rates that are adjusted to remove effects of inflation. Economists always focus on real measures, as opposed to nominal measures, because they measure what is actually happening without any artificial enhancements. To convert a nominal figure to a real figure (that is, to "deflate" a nominal figure) simply divide the price index into the nominal figure. For example, if a nominal figure is $1 million, and the price index is 150, then divide $1 million by 150, which equals a "real" value of _________.

Information Services

Information Services: The financial system reduces information costs by exploiting economies of scale in the collection, management and communication of information

Liquidity

Is a measure of how readily on asset can be converted to cash

Definitive Money

Is money that does not have to be converted into a more basic medium of exchange, such as gold, silver, or Federal Reserve Notes

M3

M2+ Large-denomination time deposits, Institutional money market fund balances, term repurchase agreements, term Eurodollars

Define money; identify the four key features of money.

Money has historically served as a medium of exchange for societies. What physically serves as money varies with a society's technology, law, or culture. Using money reduces transaction costs of a barter society. Money has four standard functions, which make it ideal for trade. These functions are: (1) a medium of exchange, (2) a unit of account, (3) a store of value, and (4) a standard of deferred payment.

Define financial markets and financial institutions, and identify how each has evolved.

Most consumers are aware in a general way of the financial system that surrounds us. Some of us have savings and checking accounts at commercial banks; others keep deposits at credit unions or savings and loan associations (S&Ls). We hear each day about the closing of the stock market and the announcing of the day's change in the Dow Jones Industrial Average (DJIA). (The DJIA is an average of stock-market prices for 30 major U.S. companies and is the most widely quoted of the many daily market indexes and averages). Similarly, many consumers are aware of the importance of government debt and of the existence of a market for government bonds. Almost everyone has heard of the Federal Reserve Board (known as the "Fed"), but few know how it works. We frequently hear news about how the economy is doing, including updates about the gross domestic product (GDP, or the total output of all goods and services), inflation (changes in the general price level), and unemployment (the number of people who are trying to but cannot find work). What consumers typically do not understand, however, is how all of these topics fit together. The financial system, which includes financial institutions (banks, credit unions, and others), financial markets (stock and bond markets), the Fed, and the economy all work together. The financial system is like an umbrella that encompasses a variety of different kinds of financial markets and financial institutions. Financial markets are markets for different kinds of financial instruments, but especially the markets for stocks and bonds. Stocks are pieces of paper that give you an ownership share (called equity) in a company. Bonds are IOUs that governments and companies sell to people who are willing to loan them money for either short or long periods. Financial institutions include banks, credit unions, and S&Ls. Why do we have financial systems, markets, and institutions? Borrowers wish to borrow; lenders wish to lend; savers wish to save. These, financial intermediaries (which act as a go-between to serve both savers and borrowers) come into focus to help achieve the objectives of all parties to financial transactions. We need to have such systems as organizing devices to facilitate the operation of business and economic activity. A note on the bond market: Much of the focus in this course will be on the government bond market, especially markets for short-term instruments with maturities of one year or less (Treasury bills, or T-Bills), intermediate-term instruments due in one to ten years (Treasury notes), and longer-term instruments that may go from eleven to thirty years (Treasury bonds). The reason for this focus is that the quantity of government bonds affects interest rates. And interest rates affect economic activity. So, the bond market becomes a proxy or mirror for what is happening to the money supply and the economy. The bond market will be discussed in more detail in later chapters.

Specialization

Producing the goods or services for which they have relatively the best ability

Monetary Theory

The investigation of the effect of the money supply on economic activity, interest rates, and prices is called monetary theory

Deflation

The opposite condition, in which the value of money increases, indicating falling, prices is called deflation

Explain how economic analysis is used to interpret and predict what we think will happen to the financial system in the future.

The text emphasizes that this course is an economics course that applies an economic approach. By applying an economic approach, students are taught to use data and information to test theories. The outcome of these tests can serve as the base for predictions and explanations of both the present and future. This analytical approach is in contrast to a wholly descriptive approach, which is based on learning facts and data, which are soon out of date.

Fred says: "Economic theories are so simplistic that they are useless." How would an economist respond to this criticism?

a. Economic models are useful to the extent they explain current events and predict future events

The international capital market:

a. a higher interest rate might induce households to save more, but businesses to borrow less

Specialization improves economic efficiency by

allowing each individual to produce the goods and services for which he or she is relatively skilled

A well-functioning financial system is essential because:

b. those who have excess funds are often not those who have productive investment opportunities

Which of the following is NOT a criterion for determining the usefulness of a theory?

c. Is the theory easy to understand?

The financial system is:

c. useful for transferring funds from lenders to borrowers

Understanding monetary theory can help you by allowing you to:

d. Perform all of the above (Predict the actions of the federal reserve, understand how changes in the monetary policy will affect interest rates and economic output, make financial decisions more efficiently)

If the reserves of the banking system increase by $500,000 as a result of an open market operation, by how much will the M1 money supply increase?

$1,718,750

A put option for 100 shares with a strike price of$45 and a premium of $What is the profit to the issuer of the option 10 is issued. The current market price is $50. What is the profit to the issuer of the option?

$10

In the simple deposit multiplier model, id the required reserve ratio on checkable deposits is 10% then a deposit of $10,000 into a savings account at First National Bank will allow that bank to make a loan equal to a maximum of

$10,000

Using the info above, if the price falls to $40 a share, what is the profit to the holder of the option

$490

You buy a four-year $5000 certificate of deposit from a bank. The interest rate promised on the deposit is 6% compounded annually. At the end of four years, you should receive from the bank?

$6312.38

In the previous question, the real exchange rate would be 1 if the price of the watch in New York City were

$650

The discount price of a one-year bond is $7000, and the interest rate is 6%. The face value of the bond would be

$7420

The wealth elasticity of demand equals

(% change in quantity demanded of an asset)/ (%change in wealth)

After the October 1987 stock market crash, the New York Stock Exchange adopted circuit breakers, which required a halt in trading when stock prices fluctuated too much. Implementation of this policy would likely cause the risk premium to increase because of

(A &B) Higher Liquidity risk, and higher information cost

SB10.4Merchant banking refers to(A)investment banks investing their own funds in companies(B)banking services available to businesses but not to the general public(C)banking services available only to retail merchants(D)banking activities carried out by companies that are not banks

(A)investment banks investing their own funds in companies

SB5.8If there is an excess supply of loanable funds at a given interest rate, then the(A)price of bonds will rise(B)interest rate will rise(C)price of bonds may rise or fall depending upon the reasons for the excess supply of loanable funds(D)price of bonds will fall

(A)price of bonds will rise

SB12.3 Geographic restrictions on banks(A)reduce their ability to take advantage of economies of scale(B)reduce the amount of local lending they undertake(C)reduce their exposure to credit risk(D)raise the costs of their providing risk-sharing, liquidity, and information services

(A)reduce their ability to take advantage of economies of scale

SB6.8If market participants believe that the default risk is increasing, the likely result will be a(A)rise in demand for default risk-free bonds, a fall in demand for high-default-risk bonds, and a larger risk premium(B)fall in demand for default risk-free bonds, a rise in demand for high default-risk bonds, and a smaller risk premium(C)fall in default risk-free bond prices

(A)rise in demand for default risk-free bonds, a fall in demand for high-default-risk bonds, and a larger risk premium

Speedback3.2The real interest rate can be obtained by(A)subtracting the expected rate of inflation from the nominal interest rate(B)changes in supply and demand in the bond market(C)using the Fisher equation, adjusting the real interest rate on a point-for-point basis with increases in the expected rate of inflation(D)adding the expected rate of inflation to the nominal interest rate

(A)subtracting the expected rate of inflation from the nominal interest rate

SB9.10When market participants have rational expectations, the deviation of the expected price from the actual future price is(A)not predictable(B)zero(C)predictable, provided all relevant information is made use of(D) predictable under certain circumstances, but not under others

(A)the deviation of expected price from the actual future price under conditions of rational expectations is unpredictable

The Benedicts are corn farmers whose crop will be harvested in August. Between now and then, they are worried about a fall in price. What strategy could they adopt to limit their risk

(B&C) Purchase a call option & Enters into the futures contracts

SB11.2 Which of the following statements correctly identifies the principal problem of using floating-rate debt to reduce interest-rate risk?(A)Floating-rate debt will eliminate interest-rate risk.(B)Borrowers may default on floating-rate debt if interest rates rise.(C)Bank profits may fluctuate more than they would if interest rates were fixed.(D)Floating-rate debt increases interest-rate risk for banks but reduces interest risk for borrowers

(B) Borrowers may default on floating-rate debt if interest rates rise.

Speedback 2.3 Which of the following financial assets would be purchased in a money market?(A) shares of AT&T stock(B)a 60-day Treasury bill(C)a 10-year Treasury note(D)a 30-year Treasury bond

(B) Capital markets are markets in which all financial assets with maturities of more than one year are traded, in addition to stocks(equities) which do not have a fixed maturity. All assets with maturities of less than one year are traded in money markets.

SB7.4If the price of a pair of Levi's jeans is $30 in the U.S. and 5,000 Yen in Japan, and the nominal exchange rate is 100 Yen to the dollar, the real exchange rate is(A)6 pairs of jeans in Japan per American pair of jeans(B)0.6 pair of jeans in Japan per American pair of jeans(C)1.66 pairs of jeans in Japan per American pair of jeans

(B) If the exchange rate is 100 yen to the dollar, then 5000 Yen equal 50 dollars. Therefore the Japanese are paying $50 for the same jeans that cost $30 in the U.S. Thirty is 60 percent of 50 or .6 pair of jeans in Japan per American pair of jeans.

SB11.7If a bank anticipates a fall in interest rates, it should(A)lengthen the average duration of its liabilities relative to the average duration of its assets(B)arrange to have a positive duration gap(C)arrange to have a negative duration gap

(B) arrange to have a positive duration gap

Speedback 1.6 Financial institutions are important because they(A)provide a means of cashing checks(B)create a link between savers and borrowers by creating IOUs(C)are profit-seeking businesses(D)are a major source of jobs in the U.S. economy

(B) create a link between savers and borrowers by creating IOUs

Speedback 2.7The largest group in the financial system in terms of the quantity of funds moved between savers and borrowers is(A)financial markets(B)financial intermediaries(C)the corporate bond market(D)commercial banks

(B) financial intermediaries

SB7.9The currency premium in foreign-exchange markets(A)helps to offset anticipated declines in exchange rates(B)indicates investors' collective preference for financial instruments(C)rises as domestic interest rates fall(D)helps to offset anticipated increases in exchange rates

(B) indicates investors' collective preference for financial instruments

SB7.8If the U.S. imposes higher import quotas on Japanese autos, then the(A)quantity of U.S. made autos sold in the U.S. will fall(B)long-run exchange rate for the dollar will rise(C)long-run exchange rate for the dollar will fall(D)exports of U.S. autos to Japan will rise

(B) long-run exchange rate for the dollar will rise

Speedback 1.9 The main problem in making transactions in a barter economy is(A)exchanging cash for a fair amount of goods and services(B)solving the problem of double coincidence of wants(C)the loss of value in goods that are exchanged(D)using different items such as seashells and livestock for money

(B) solving the problem of double coincidence of wants

Speedback 2.10 Which of the following represents the sale of securities in asecondary market?(A)the purchase of $1 million in 30-year corporate bonds from an investment banker(B)the purchase of 100 shares of IBM stock from a private investor(C)the purchase of a new issue of government Treasury bills directly from the Treasury(D)the sale of $1 million in 10-year Treasury notes by the Treasury to Zion's Bank

(B) the purchase of 100 shares of IBM stock from a private investor

SB6.10 A schedule of one-year interest rates for bonds maturing in 1, 2, 3,and 4 years, successively, is 8%, 9%, 10%, and 11%. According to the expectations theory, the expected one year rate two years ahead is(A)17%(B)12%(C)8.5%(D)10%

(B)12%

Speedback 1.5 The three most important functions of the financial system are(A)eliminating financial fraud, eliminating risk, and eliminating liquidity(B)selling stocks, bonds, and mutual funds(C)providing risk-sharing, liquidity, and information services(D)setting interest rates on bonds, loans, and savings accounts

(C) providing risk-sharing, liquidity, and information services

Sb16.4 Which of the following statements best explains why the U.S. was without a central bank between 1836 and 1913?(A)Major U.S. private bankers like J. P. Morgan had enough resources to maintain liquidity in the banking system.(B)The commercial banking system worked well enough, so little concern existed over financial system stability.(C)Conflicts among various business, government, geographic, and financial interests prevented agreement on how to organize and establish a central bank.(D)Little need for a check-clearing system existed until 1913

(C)Conflicts among various business, government, geographic, and financial interests prevented agreement on how to organize and establish a central bank.

SB6.3The preferred-habitat theory(A)shows the same pattern of future short-term rates as shown by the expectations theory(B)can explain the upward shift of the yield curve, but cannot explain the parallel shifts in the curve as in the case of the expectations theory(C)shows a more significant expected decline in short-term rates than the expectation theory shows

(C)shows a more significant expected decline in short-term rates than the expectation theory shows

SB15.6 Changes in the money supply over extended time periods are primarily due to(A)changes in the money multiplier rather than changes in the monetary base(B)increases in Treasury issuance of currency(C)increases in the percentage of deposits held in currency and excess reserves(D)changes in the monetary base rather than changes in the money multiplier

(D)changes in the monetary base rather than changes in the money multiplier

If the interest rate remains a constant 6% , approximately how many years will it take until your initial investment doubles in value?

12 years

Suppose that you pay $2000 for a bond that has a coupon payment of $100. After one year, you sell it for $2150. What is your total rate of return on this bond.

12.5%

Suppose the Woodland Bank's net after-tax profit is $100 million and it has $750 million in assets. This bank's return on assets (ROA) is

13.3%

Suppose Kyle and Scott want to start a business. Their bank offers to loan them $10,000 today if they agree to repay a lump sum of $15,000 in three years' time. What is the yield to maturity on this loan?

14.47%

Congress created the Federal Reserve System in

1913

The federal reserve system because law with the passage of the federal reserve act in

1913

Open market operations were first used as a monetary tool in the

1920's

price stability

1970's policymakers in most industrial economies set a

The year in which discount lending was made available to all depository instructions was

1980

the reserve requirements for city and rural banks is the same as a result of banking legislation passed

1980

A market basket of goods in year 1 costs $88. In year 2, the exact same market basket costs $147, between year one and 2 the prices rose

67%

The board of Governors holds____________ seats on the Federal Open Market Committee

7 out of the 12

What would be the rate of growth of the money supply if the money multiplier grew at a 3% rate and the monetary base grew at an average annual rate of 4%

7%

Bank net worth over the past three decades has remained relatively stable at about ___________ of total funds raised

7% to 9%

real business cycle

A cycle that results from fluctuations in the pace of growth of labor productivity and potential GDP.

Balance Sheet

A financial statement that reports assets, liabilities, and owner's equity on a specific date.

Regulation Q

A historical Federal Reserve regulation that set a maximum interest rate that banks could pay on deposits. All interest rate ceilings on time and savings were phased out on April 1, 1986, by federal law.

Taylor rule

A rule developed by John Taylor that links the Fed's target for the federal funds rate to economic variables

Government Allocation

A way of distributing goods nd services, in this system a centralized authority collects the specialized output of each individual producer and distributes it to others according to some plan

Unit of Account

A way of measuring value in the economy in terms of money

SB8.6Which of the following statements best expresses the role of speculators in financial markets(A)speculators disrupt markets by raising prices to higher levels than would exist in their absence(B)speculators make high profits by assuming the same market positions that hedgers assume(C)speculators increase liquidity for hedgers in markets(D)speculators reduce liquidity for hedgers in markets

(C)speculators increase liquidity for hedgers in markets

Speedback 3.7The yield to maturity gives us an interest rate that equates which of the following two sets of data?(A)the present value of an asset and its yield to maturity(B)the interest rate used to discount future income streams and the current yield(C)the current price of an asset and the discounted value of the future income stream from that asset(D)the yield on a discount basis and the bid price of a bond

(C)the current price of an asset and the discounted value of the future income stream from that asset

SB15.1 The government budget constraints best explain(A)that countries in which the government has a high level of control over their central banks tend to monetize government budget deficits at higher levels than countries in which central banks have a higher level of independence(B)that the Fed can increase the budget deficit by conducting open market operations(C)the relationship between federal budget deficits, changes in Treasury security holdings by banks and the nonbank public, and changes in the monetary base(D)that an increase in government deficits leads to an increase in the monetary base

(C)the relationship between federal budget deficits, changes in Treasury security holdings by banks and the nonbank public, and changes in the monetary base

SB11.8If a bank has deposits of $10 million, reserves of $1 million (the required reserve ratio is 10%), and a bank customer writes a check for$1 million, which of the following statements best explains the condition of the bank?(A)The bank has experienced liquidity risk which it could manage by buying $1 million worth of T-bills.(B)The bank has experienced liability risk which it could manage by not renewing large CDs (time deposit certificates).(C)The bank has experienced credit risk which it could manage through raising the amount it spends on information costs.(D)The bank has experienced liquidity risk which it could manage by borrowing $1 million in the fed funds market.—(D)

(D) The bank has experienced liquidity risk which it could manage by borrowing $1 million in the fed funds market.—(D)

SB8.10If a futures contract for U.S. Treasury bonds increases by "18" in the financial quotes, the value of the contract increased by(A)$56,250(B)$5,625(C)$56.25(D)$562.50

(D)The values are reported in thirty-seconds of a percent. So, an increase of 18 indicates eighteen thirty seconds or 18/32. These are sold in increments of 1000,so the increase is 18/32 * $1000 or $562.50 (page 189 of the textbook).

interest rate swap

An exchange of one loan for another (typically one is a floating rate, the other is a fixed rate); Total loan amount isn't exchanged, just the difference between the liabilities at the end of the period

Chapter 14

The Banking Industry

Chapter 13

The Business of Banking

Which of the following regulate options on securities

The Commodity Futures Trading Commission

Chapter 21

The Conduct of Monetary Policy

Which currency is currently considered the international transaction currency

The Euro

Which of the following is NOT a factor in determining the risk Premium?

expected Inflation

which of the following is NOT a market anomaly

exploited profits

Suppose that a large commercial banks has failed. As a consequence, many large foreign depositors are panicking and withdrawing's funds from U.S. banks. Which of the following would be the best response by the Fed to this event?

extend discount loans to banks sufferings deposit losses

Just before its takeover by FDIC in 1984, what kind of discount loan did Continental Illinois receive

extended credit

Money Market deposit accounts

account that pays relatively high rates of interest, requires a minimum balance, and allows immediate access to funds

By screening potential borrowers, banks reduce

adverse selection

Insurance companies screen clients prior to selling insurance because they want to reduce the costs associated with

adverse selection

In managing credit risk, banks must be concerned a

adverse selection, moral hazard, and diversification

Which of the following accounts for long-term trends in exchange rates

all of the above (price level differences, barriers to trade, productivity differences)

The Gramm-leach-Bliley Financial Services Modernization Act of 1999

allowed ownership of banks by securities and insurance firms and allowed banks to participate in securities, insurance and real estate activities

Gramm-Leach-Bliley Act of 1999

allows business combinations (e.g. mergers) between commercial banks, investment banks, and insurance companies, and thus permits these institutions to compete in markets that prior regulations prohibited them from entering.

Futures Contract

an agreement to buy or sell at a specific date in the future at a predetermined price

discount window

an arrangement in which the Federal Reserve stands ready to lend money to banks in trouble

underwriting

an arrangement under which an investment banker agrees to purchase all shares of a public offering at an agreed-upon price

large open economy

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

Closed Economy

an economy that does not interact with other economies in the world

Barter

an exchange of a good or goods in a trade

Bankers acceptance

an order to a bank by a customer to pay a sum of money at a future date

Bankers' Acceptance

an order to a bank by a customer to pay a sum of money at a future date

Bubble

an unsustainable increase in the price of a class of assets

Checkable deposits

any deposit in a commercial bank or thrift institution against which a check may be written

If U.S. productivity Growth in the 1990's outpaced that of other industrial countries, then the dollar would

appreciate relative to other currencies

The definitions of the monetary aggregate currently published by the Federal Reserve System

are changed periodically as financial innovation occurs

Borrowers

are demanders of funds for consumer durables, houses, or business plant, and equipment, promising to repay borrowed funds based on their expectation of having higher incomes in the future

Identify and explain the major factors that will influence a financial asset's expected market price.

What kinds of information do market participants use when applying rational expectations in making market decisions? The basis for making an investment decision is the expectation that a given decision will produce higher total returns than other decisions for assets with similar risk, liquidity, and information characteristics (page 206). Thus, shifts in risk, liquidity, and information costs will clearly affect relative returns on two or more assets. When the expected interest return is adjusted for higher risk, for example, the present value of the asset will be affected (equation 10.2, page 210 of the textbook). Thus, the higher the default risk of a security, the lower will be the present value of that security. Other factors that can affect expected future returns include interest rate shifts, exchange rate shifts, and changes in economic conditions. Consider whether large fluctuations in stock prices can be consistent with the efficient markets hypothesis. The reason for such fluctuations is that whenever current market prices for stock are above or below the present value of future streams of returns, traders will buy or sell shares, thus reestablishing the price equivalent to the present value of the stock. Another key point is the question of whether a change in dividends for one time period will have much of an effect on share price.

Do different monetary aggregates move together

Yes, they move broadly together, but there are significant differences at certain times

Bond Rating

a measure of how much faith the financial community has in the issuers financial stability

money market mutual funds

a mutual fund that pools funds from many investors and uses these funds to purchase very safe, highly liquid securities

Price Index

a number that compares prices in one year with prices in some earlier base year

principal agent view

a theory of central bank decision making that holds that officials maximize their personal well-being rather than that of the general public

loans

a thing that is borrowed, especially a sum of money that is expected to be paid back with interest.

T-account

a tool for analyzing a business's financial position by showing, in a single table, the business's assets (on the left) and liabilities (on the right)

Economic analysis involves

a. Developing theories to predict future events

Fearing that the failure of Franklin National Bank would undermine investors' confidence in negotiable certificates of deposit, the Fed responded to the crisis by

extending discounts loans to good banks

All of the following are mentioned as goals of monetary policy except

balance of trade surplus

Negotiable Certificates of Deposit

bank issued time deposits that specify an interest rate and maturity date and are negotiable

The monitoring of banks is necessary because

bankers have private information about their loan portfolio

off-balance-sheet lending

banks do not hold as assets the loans they make

As the U.S. Treasury shifts funds from tax and loan accounts into the General Account, the monetary base will fall because

banks lose reserves as the Treasury withdraws funds

Credit rationing occurs when

banks restrict lending rather than raising interest rates

state banks

banks that received their charter to operate from a state government

Medium of exchange

because money serves as a medium of exchange, money eliminates the need for a double coincidence of wants and hence reduces tractions costs arising from the search for trading partners

new classical view

business cycle fluctuations are the efficient responses of a well-functioning market economy that is bombarded by shocks that arise from the uneven pace of technological change

Insurance Companies

businesses that protect their clients against financial losses from certain specified risks (death, accident, and theft, for example)

If financial markets are efficient, a reasonable investment strategy would be to

buy and hold a diversified portfolio

When U.s interest rates are high compared to Eurozone interest rates, people will_______ securities causing the dollar to _______

buy, appreciate

The cycle of crisis and response follows a sequence of

financial crisis, regulation, financial innovation, and regulatory response

savings institutions

financial institutions that accept deposits and provide mortgage and personal loans to individuals

Nonbank banks

firms that undertake many of the activities of a commercial bank without meeting the legal definition of a bank

An increase in investment sensitivity to changes in the interest rate would result in a

flatter aggregate demand curve

rules strategy

for monetary policy suggests that the central bank follow specific and publicly announced guidelines for policy

The natural rate of unemployment is equal to the

frictional plus the structural rate of unemployment

Nontransaction deposits

funds that cannot be used for payment directly but must be converted into currency for general use

open-end mutual funds

funds that sell shares directly to investors and repurchase those shares whenever investors wish to sell them

closed-end mutual funds

funds that sell shares to investors but do not repurchase them; instead fund shares are purchased and sold on stock exchanges

Branching Restrictions

geographic limitations on banks' ability to open more than one office or branch

program trading

giving instructions to computers to automatically sell if the price of a stock dips to a certain point to avoid potential losses

Prefered habitat theory

investors care about both expected returns and maturity; they view instruments having different maturities as substitutes- but not perfect substitutes

Foreign bank branch

is a full-service institution, accepting deposits, making loans, and bearing the name of the foreign bank

Money Supply

is important because changes in the money supply growth are associated with changes in other economic variables, such as the prices you pay and the interest you earn on your savings.

the long-run aggregate supply curve

is vertical at full employment output

Risk-neutral savers

judge assets only on their expected returns: variability of returns is not a concern

quotas

limitations on the amount of specific products that may be imported from certain countries during a given time period

Dealers

link buyers and sellers by buying and selling securities at stated prices

Which of the following is the least liquid bank asset

loans

discount loans

loans the federal reserve makes to banks

State and local Government Bonds

long-term bonds issued by state and local governments

Corporate Bonds

long-term debt issued by private corporations typically paying semiannual coupons and returning the face value of the bond at maturity

Over-the-counter (OTC) markets

markets that do not operate in a specific fixed location - rather, transactions occur via telephones, wire transfers, and computer trading

Stocks that are traded in the Lilliputian stock exchange tend to revert to a long-term trend value over time. This would indicate that the Lilliputian stock exchange is characterized by

mean revision

discretion strategy

means that the central banks should adjust monetary policy as it sees fit to achieve goals for economic growth, inflation, and other economic and financial variables

Suppose output in the economy increases from $5000 billion to 5200 billion while real interest rate rise form 3% to 4%. Everything else being equal, yo would expect

money demand to either increase or decrease

demand deposit

money in a checking account that can be paid out "on demand" or at any time

By monitoring the operations of borrowers, banks reduce

moral hazard

Julie Seagall is the owner-operator of a small beauty salon. She told the bank that she would use her loan to finance the purchase of new equipment but she used the funds instead to build a pool in her backyard. This is an example of

moral hazard

Your friend Harry refuses to install a sprinkler system in his hotel. "I am covered by insurance, after all." he says. This is an example of

moral hjazard

no-load funds

mutual funds that do not charge loads

Banking Panics

occurred when customers believe one or more banks might be bankrupt

bank failure

occurs when banks are unable to meet depositors' demands for their money

out-right purchases and sales

of treasury securities of various maturities by the trading desk

Banks are subject to runs because they

offer deposits that are liquid, allowing panic to be easily acted on

The failure of Penn Central was significant because it undermined investors' confidence in

other issuers of commercial paper

full employment output

out put produced by the full employment of existing factors of production

Saucerization of a financial instrument refers to

packaging similar loans or mortgages, into a negotiable security

Indexed bonds

payments of principal an interest are adjusted for changes in the price level

defined benefit plan

pension plan that guarantees a specified level of retirement income

According to the preferred habitat theory, the fact that the yield curve normally slopes upward indicated that

people prefer shorter-term securities

You want to buy a refrigerator at EZ Appliance. Because you do not have $1200 cash, you fill out a loan application with Glaser Financial that allows you to pay off the refrigerator in 24 monthly installments. Glaser is an example of a

consumer finance company

Which of the following is not a benefit of open market operations over other monetary policy tools

cost

The primary type of loans made by credit unions is

customer loans

Which of the following is NOT an asset or liability of the Federal Reserve

demand deposits

Stocks that are traded in the Frutopian stock exchange have prices that reflect the underlying fundamental value of the stock. This would indicate that the Frutopian stock change is characterized by

price anomalies

Suppose the economy is originally at its full employment level. if the federal government increase its spending on military goods, then in the long run

prices rise, but output remains at the full employment level

national banks

privately owned banks that received their operating charters from the federal government

Financial Intermediation

process by which individual savings are accumulated in depository institutions and, in turn, lent or invested (indirect form of finance)

monetizing the debt

process of creating enough additional money to offset federal borrowing so that interest rates remain unchanged

Noise Traders

pursue trading strategies based on an inflated view of their ability to understand the significance of a piece of news.

Expected Real Interest Rates

r equals the nominal interest rate i minus the expected rate of inflation pie to the E or R-I-pie^E

Stocks that are traded in the Ecotopian stock exchange tend to appreciate in price each Wednesday. This would indicate that the Ecotopian stock exchange is characterized by

rational expectations

The assumption that participants use all available information in the pricing of financial assets is known as the

rational expectations hypothesis

LWS and WS borrow $150,000 from Polar Bank to purchase a new home. As part of the loan contract, Polar Bank requires that LWS and WS put up their new house as collateral. The use of collateral by Polar Bank

reduces the asymmetric information advantage of LWS and WS

financial market and institution stability

stability of financial market and institutions based on the policies implemented

All of the following are listed as determinates of portfolio choice by the author except

state of the economy

The Fisher Hypothesis

states that the nominal interest rate rise or falls point-for-point with expected inflation

The more interest elastic is the money demand, the

steeper the aggregate demand curve

The Federal Reserve-treasury According of 1951 allowed the Fed to

stop pegging interest rates

The passage of a balanced budget amendment to the U.S. Constitution requiring the federal budget to be balanced each year would likely result in the bond_______ ________ shifting to the ___________

supply curve, left

Marketable securities

temporary investment of "extra" cash by organizations for up to one year in U.S. Treasury bills, certificates of deposit, commercial paper, or Eurodollar loans

Open Market Operations

the buying and selling of government securities to alter the supply of money

The total rate of return on a coupon bond consists of

the current yield and the rate of capital gain earned during the holding period

Disintermediation

the cutting out of marketing channel intermediaries by product or service producers or the displacement of traditional resellers by radical new types of intermediaries

expiration date

the date at which the option of a call or put option end

Net Worth

the difference between assets and liabilities

Duration gap refers to

the difference in the percentage change in the value of assets and liabilities resulting from a change in interest rates

Which of the following was NOT a financial innovation in response to restrictions on bank competition

the expansion of the U.S. government bond market

in which of the following areas have international financial regulators met to achieve a consensus

deposit insurance, minimum capital requirements, central bank intervention in an international banking crisis

A high domestic inflation rate will cause a(n)

deprecation of the domestic currency against foreign currencies

Financial Futures would be most accurately classified as a

derivative claim

Wealth elasticity of Demand

describes how responsive the percentage change in the quantity of an asset chosen is to a percentage change in wealth

The oldest of the Federal Reserve policy tools is

discount lending

Which of the following is NOT a liability of the Fed

discount loans

secondary credit

discount loans to banks that are not eligible for primary credit

seasonal credit

discount loans to smaller banks in areas where agriculture or tourism is important

The interest rate that the Fed charges depository institutions for loans is called the

discount rate

According to the new classical view, aggregate output will be at full employment in the short-run when

the expected and actual price level are the same

A call option contract involves asymmetric rights and obligations because

the option seller is obligated to sell the underlying asset

discount policy

the policy tool of setting the discount rate and the terms of discount lending

Compensating balance

the portion of an unsecured loan that is kept on deposit at a lending institution to protect the lender and increase the lender's return

Fundamental Value

the present value of expected earnings of a company or of all companies in the stock market as a whole

spot price

the price at which a commodity or financial asset can be sold at the current date

open market purchase

the purchase of government bonds from the public by the Fed for the purpose of increasing the supply of bank reserves and the money supply

Nominal Exchange Rate

the rate at which a person can trade the currency of one country for the currency of another

Real exchange rate

the rate at which a person can trade the goods and services of one country for the goods and services of another

simple deposit multiplier

the ratio of the amount of deposits created by banks to the amount of new reserves

The U.S. government participants in financial intermediation

through government sponsored financial institutions such as the Federal Home Loan Mortgage Company, through guaranteeing loans made by private institutions

Federal Reserve Bank

divided into 12 federal reserve districts

Which of the following is NOT a crietion of an effective intermediate target

divisibility

Nonbank offices

do not take demand deposits but make loans

A credit-scoring system is a mechanism for

evaluating the likelihood of default

Stock that are traded in Utopian stock exchange vary considerably relative to changes in their underlying fundamental value. This would indicate that the Utopian stock exchange is characterized by

excess volatility

An expansion of the monetary base causes multiple

expansion of the money supply

The actual open market operations, the buying and selling of securities in financial markets, is done by the

trades at the New York Federal Reserve bank

The M1 aggregate includes those assets that are

traditionally considered to be money

Businesses raise external funds both from financial intermediaries and directly from financial markets. If we compare the amount raised from each source, the amount raised form financial intermediaries is

twice as great

After the Fed obtains a check for clearing, it has_______ business days to credit the payee's bank account

two

Excess reserves as a percentage of total reserves are

under 5%

A defined benefit plan for which contributions together with projected future earnings are insufficient to pay the projected defined benefits is said to be

underfunded

Speculators are important for smoothly functioning derivative markets because they

undertake risk and provide liquidity

supply shocks

unexpected events that affect aggregate supply, sometimes only temporarily

Commercial Paper

unsecured promissory notes of $100,000 and up that mature (come due) in 270 days or less

Intrinsic value

value independent of any benefit to humans

The reserve requirement on checkable deposits as of 2003

variable between 0%, depending on the amount of deposits held.

Federal Deposit Insurance Corporation Improvement Act of 1991

which established risk groups according to how well capitalized the bank is.

risk-loving savers

who actually prefer to gamble by holding a risky asset with the possibility of maximizing returns

The market niche that is served by most international banks is that of

wholesale banking

bank run

widespread panic in which great numbers of people try to redeem their paper money

Which of the following is NOT a government agency involved in the mortgage market?

Fannie Mae is not (Ginnie Mae, FHA, and Farmers Home Administration is)

Discuss the five factors that affect portfolio choice.

Financial analysts spend much time attempting to forecast investor demand for different types of financial assets. The five determinants of portfolio choice discussed in the textbook provide a basis for predicting shifts in savers' behavior in allocating their savings funds among different kinds of assets. As you read through this material, categorize yourself in terms of where you fit in terms of each of these criteria. How will you change your savings pattern as your income and wealth increase? How good are you at estimating future inflation so you can estimate expected future returns? How risk-averse are you? What do you know about the liquidity of different kinds of assets? How willing are you to spend time and incur costs of finding adequate information on which to base investment decisions?

Identify and explain the differences among the three theories of the term structure of interest rates; the segmented markets theory, the expectations theory, and the preferred habitat theory. Then assess each of these three theories in terms of how well each of them explains (1) why the yield curve slopes upward and to the right and (2) why the yield curve shifts up or down in parallel fashion rather than in a twisting direction.

Frequently, financial instruments with common characteristics of risk, liquidity, information, and taxes (RLIT) have different yields for different maturities. Why do yields vary as maturity varies (and we hold constant all other variables)? This analysis is referred to as "Term Structure". Term Structure looks at yield differences for financial assets with different maturities. Our tool for analyzing term structure is the Treasury yield curve. Refer to the yield curve in the box labeled "Using the News" on page 143. Notice that the curve slopes upward to the right. The next thing you will notice is that when the curves shift, they tend to shift (almost) parallel to one another. We can reach these obvious conclusions about the yield curve: (1) short-term yields are lower than long-term yields, so (2) the mirror-image securities prices (inferred from the diagram, not shown directly by it) are higher for short-term securities than for long-securities, and (3) if short-term yields are lower than long-term yields and if short-term securities prices are higher than long-term securities prices, then it must follow that the demand for short-term securities is higher than the demand for long-term securities. Following along this line of thought, these observations must mean that we can reach a general conclusion that short-term is preferred to long-term. If short term is preferred to long term, then, of necessity, the yield curve will slope upward to the right. Check the WSJ or the Bloomberg site on the Internet to see what the Treasury yield curve looks like now. Then check the yield curve each day when you review the paper. What shifts do you see occurring? Why do you think these shifts are occurring? The "Credit Markets Report" section of the paper provides insight into why the yield curve is shifting. Now the task is to crank through the three theories of the term structure of interest rates and see how well each of them explains the following two questions: Does the theory explain why the yield curve slopes upward to the right? Does the theory explain why the two curves shift parallel to one another rather than "twisting"? The segmented markets theory: This theory posits that the market for securities of each specific maturity is a separate market with separate supply and demand characteristics. People generally want to hold securities of specific maturities to meet personal financial objectives. Thus, investors do not want to move among markets and so cannot substitute securities with different maturities. Since the yield curve slopes upward, short term is preferred to long, so the segmented markets theory does explain the upward slope of the yield curve. However, since each maturity represents a different market, the yield curve could shift in a parallel fashion only by coincidence, only if circumstances in all markets shifted in the same direction at the same time. Hence, the segmented-markets theory answers question 1 but not question 2. The expectations theory: There is a trick to understanding the expectations theory. First, recognize that the slope of the yield curve is determined by the sequence of future short-term rates. Second, take into account the fact that any given long-term rate is determined by taking the average of a series of short-term one-year rates. Consider this example: Assume that a series of one year rates for 1, 2, 3, and 4 years in the future is 6% for the first year, 7% for the second year, 8% for the third year, and 9% for the fourth year. We already know what the first year short-term rate is: 6%. We also know what the second year rate is: 7%. What we do not know is what the expected future one-year rate is one year from now. So we infer it from what we do know. If the second year rate is 7%, and if it is determined by the average of the first-year rate (6%) and the (unknown until we figure it out) one-year expected rate one year ahead, then 7% is the average of two numbers: 6% and x%. To find x, multiply 7 x 2, which equals 14, subtract the known first year rate of 6, and the estimate of the expected one-year rate in one year is 8% (6% + 8% = 14%/2 = 7%). The textbook continues this example to illustrate calculations for two and three years into the future, and for down-sloping yield curves. Note the emphasis on the pattern of expected one-year rates. If future short-term rates are expected to fall, the yield curve will slope downward to the right. If future short-term rates are expected to rise, the yield curve will slope upward to the right. The expectations theory has one other important implication. If, as the theory posits, long-term rates are simply the averages of a series of short-term rates for the same period, then investors don't care whether they buy long-term bonds or short-term bonds. Their return is the same for the entire holding period from a single long-term bond or from a series of short-term bonds. Look at the example of the comparison between a "buy-and-hold" strategy and a "roll-over" strategy for buying bonds on page 146 of the textbook. If one accepts the basic assumption of the expectations theory that long-term rates are the averages of a succession of expected future short-term rates, then the expectations theory provides an explanation of parallel shifts in the yield curve. If a succession of increases occurs in short-term rates, then long-term rates will rise, and a parallel shift occurs in the yield curve. But how could this theory explain the upward slope of the curve? Unless we accept the absurdity of a perpetually rising yield curve, the expectations theory fails in explaining the upward slope of the yield curve. Finally, we come to the preferred-habitat theory (P-H), which promises to fix the shortcoming of the segmented markets theory and explain shifts as well as slope, and remedy the defect in the expectations theory and explain slope as well as shifts. How does the P-H theory accomplish this goal of answering both questions (slope and shifts) about the yield curve? Again, short term is preferred to long term. And investors will substitute securities with different maturities, but, investors require a term premium to switch from their preferred habitat. According to the P-H theory, the yield level on the yield curve is the sum of two figures: the market interest rate and the term premium. Moreover, the term premium gets bigger as the maturity increases because the market must reward investors an increasingly larger amount to switch from their preferred (shorter) habitat to a longer (less-preferred) habitat. If you have digested the previous two sentences, you can figure out the P-H theory. Think about the graph of an up-sloping yield curve. Because the term premium rises as maturity increases, the market interest rate graph will fall below the yield curve and the gap between the yield curve and the market rate curve (unobserved) will widen as maturities rise. The P-H theory explains the upward slope of the yield curve because short is preferred to long and a term premium must be offered to switch habitats from short to long. The assumption that long-term rates depend on a succession of short-term rates means that a shift in short-term rates will also shift long-term rates.

The primary source of financial capital in the U.S economy is

Intermediaries

Chapter 1

Introducing Money and the Financial System

Discuss the advantages of portfolio diversification.

If there is one concept concerning investment that should be permanently imprinted on your financial future, it is the concept of diversification. Some people can hardly stand the idea of giving up possible huge gains by raising the probability of a lower but safer return. Obviously, if the risks of all assets in a portfolio moved up or down simultaneously, diversification would accomplish little in terms of reducing risk. Also, investors and savers must recognize at the outset that they cannot eliminate all risk because so-called market or systematic risk (widespread market fluctuations that affect all assets) cannot be eliminated. On the other hand, so-called idiosyncratic risk (risks associated with changes in unique conditions affecting an individual financial instrument) can be reduced.

Explain the basic characteristics of futures markets, including the obligations of buyers and sellers, the way that futures prices are set, and the way that daily settlement of positions occurs in futures markets.

If you agree to buy $1 million in Treasury bills six months from now at a price agreed upon today, you have entered into a futures contract. A futures contract is called a derivative financial instrument because the value of the futures contract is derived from the underlying commodity or financial instrument. By entering into this contract, you have assumed the long position. The seller has assumed the short position. Agricultural commodities used to comprise about 70% of total futures transactions, but now account for only about one-third of such transactions. Financial futures such as contracts to buy or sell futures in currencies, stock indexes, Treasury securities, and other financial instruments make up most futures transactions today. Note in the WSJ Guide to Understanding Money and Investing that all futures and options contracts expire on the third Saturday each month (page 127 of the book) and that the cost of a futures contract ranges between 2% and 10% of the total contract. By using debt to purchase futures contracts, we say that investors have leveraged their investment by using a fraction of the money required to pay the total cost of the contract. Note also that both the buyers and sellers of futures contracts have symmetric rights ; that is, the buyer has the right and obligation to receive the underlying financial asset, and the seller has the right and obligation to sell the underlying financial asset. The price of the underlying asset can change continuously. Hence, the securities exchange through which the futures contract was negotiated conducts a daily settlement of positions, called marking to market. Most contracts never reach delivery date but are offset by opposite contracts before that time is reached. If the market price of an underlying asset rises by delivery or settlement date, the buyers (longs) who bought the contract at a lower market price will receive the increased price. Similarly, sellers (shorts) who sold the futures contract at a higher price than market price on delivery or settlement date will receive the higher price. But what about the buyers (longs) who agree to buy at a price that ultimately is below market price, or the sellers (shorts) who agree to sell at a price that ultimately is below market price? In these two cases, either the buyer or the seller must stand the shortage. What the buyer has accomplished, however, is locking in a certain price. Perhaps the buyer would have been better off to have taken a chance on market price and then to have paid a lower price than the futures contract would have required. However, he or she was willing to give up the possibility of a lower price in order to lock in a price ceiling to minimize supply cost risk.

Diversification

Involves allocating wealth among different types of assets and reduces the overall risk faced by savers, as long as asset returns do not move perfectly together

Equity

Is an ownership claim to a share in the profits and assets of a frim

Money Supply

Is the total quantity of money in the economy

The Humphrey Hawkins Act addresses

a price level stability and employment

principal-agent problem

a problem caused by an agent pursuing his own interests rather than the interests of the principal who hired him

Standby letter of credit

a promise by a bank to lend funds, if necessary, to a seller of commercial paper at the time that the commercial paper matures

A yield curve will slope downward when

a short-term rates are above the long term rates

Asymmetric information

a situation in which one party to an economic transaction has less information than the other party

If the supply curve for reserves is flat, then an increase in demand for reserves would cause

a small increase in the federal funds rate and a relatively large increase in banks reserves

Which of the following statements is true

a spot transaction is settled immediately

What is the risk premium on a 10-year corporate bond that pays 11% interest if a 10-year U.S. treasury bond is yielding 7.2%

3.8%

Mswift stock is currently paying a dividend of $4 per share. The growth rate of its dividend is revised upward from 3% to 4% on the basis of its latest earnings report. For a discount rate of 7%, the value of the stock should increase by

35%

The federal reserve chairman serves for years as chairman

4

If the bank borrowed form the fed, how much would the bank need to borrow

5

Chapter 8

The Foreign-Exchange Market and Exchange Rates

Purchasing Power

The ability of money to be used to acquire goods and services

The expansion of international banking based in Japan can be explained by the

liberation of Japanese banking regulation

Changes in the money supply are commonly associated with changes in which of the following?

D. All of the above (Interest rates, Inflation rates, Economic Output)

During the 1980's U.S saving was inadequate to finance U.S. investments, yet the economy continued to grow how?

Increasing globalization of financial markets allowed foreign funds to fill the gap

Chapter 4

Interest Rates and Rates of Return

Understand the relationship between nominal interest rates and expected currency appreciation or depreciation.

Interest rate parity must mean that nominal returns of foreign and domestic assets must be equal, assuming that risk, liquidity, information, and other factors affecting nominal returns also remain constant. If the interest rates for both foreign and domestic assets are constant, then, as we demonstrated in our analysis of figure 8.3 any difference in returns on foreign and domestic assets must logically be due to changes in relative exchange rates. The real interest rate parity condition is stated in equation (8.6) on page 173 of the textbook. Real interest rate parity is measured in equal quantities of goods traded, not in terms of nominal interest rate equality.

If the inflation rate is 6%. approximately how long will it take for prices to double

12 years

Current Yield

CY=C/P

Transaction Cost

Effort must be spent searching for trading partners-a type of transaction cost, or cost of trade or exchange

Legal Tender

Federal Reserve Currency is legal tender in the United States

Which of the following is NOT a means by which the bank could raise funds to meet its reserve requirement

Increase lending

Who was the first chairperson of the European Central Bank's executive board

Wim Duisenberg

Which of the following is NOT an explanation for the 1987 stock market crash

bubbles

You buy a one-year discount bond with a face value of $3000 issued by a local travel agency that is trying to raise money for expansion. If the yield to maturity is 8%, how much would you have to pay for this bond?

$2777.78

As a result of this action, the level of excess reserves in the economy will increase by

$31,250

SB7.3Suppose that during the next year you expect the dollar will appreciate against the pound from 0.5 pound to the dollar to 0.75 pound to the dollar. How much will you expect to make on an investment of$10,000 in British government securities that will mature in one year and pay interest of 8%?

(A) 28%(B)-28%(C)8%(D)-59.5%—( B)Since the dollar appreciated, the investment in pounds, including interest, could be exchanged for fewer dollars at the end of the year. The exchange rate increased from .5 to .75 or generated a loss of 33%. However, the investment earned 8%. A net loss of 28% resulted from the transaction.

SB7.6Under conditions of exchange rate market equilibrium, if the nominal interest rates on U.S. assets and Australian assets differ, the rate difference is most likely attributable to expected(A)fluctuations in the exchange rate between the two countries(B)changes in risk between the two countries(C)changes in liquidity between the two countries(D)changes in information costs between the two countries

(A) Assets are assumed to have identical risk, liquidity, and information costs in considering the interest rate parity condition.

Speedback 2.4 How does diversification reduce risk?(A) Diversification provides a means of investing in a variety of different assets so that the overall returns will average out.(B) Diversification provides a way to invest in a variety of high-return assets without incurring any offsetting risk.(C)Diversification enables savers to invest in a single safe asset which is just one of many assets offered by a financial institution.(D)Diversification enables the risks incurred by large investors to reduce the risks of small investors.

(A) Diversification provides a means of investing in a variety of different assets so that the overall returns will average out.

SB11.6 In what sense can a reserve requirement be said to be a tax on bank intermediation?(A)Banks are unable to lend out all their deposits.(B)Banks must pay tax on any funds removed from a reserve account at a rate equal to the applicable corporate income tax rate.(C)Banks must pay taxes on the amount by which they fail to meet their reserve requirements.(D)Banks must pay tax on any funds deposited in a reserve account at a rate equal to the applicable corporate income tax rate.

(A) The effect of reserve requirements is to impose an implicit tax, not an explicit tax.

SB8.4If, as a lender, you are concerned that interest rates might rise during the term for which you wish to make a loan, you can hedge against this possible rise by(A)selling futures contracts on Treasury bills(B)buying futures contracts on Treasury bills(C)buying call options on Treasury bills(D)increasing the size of your loan

(A) This locks them in at a given prices, so if the price of bonds drops (as rising interest rates indicates), the lender can sell them for a premium and hedge against the risk of losing money on the loan you made.

Speedback 2.8 Which of the following describes a repurchase agreement (also called a"repo" or RP)?(A)a bank selling $1 million in Treasury securities today and agreeing to buy them back tomorrow at a slightly higher price(B)buying back 1,000 shares of stock today that you sold for ahigher price yesterday(C)a securities firm agreeing to buy back all stock purchases that cause an investor to lose money

(A) a bank selling $1 million in Treasury securities today and agreeing to buy them back tomorrow at a slightly higher price

Speedback 2.5Which of the following would be considered a derivative financial asset?(A)a futures contract to deliver corn in 60 days(B)any asset purchased in the cash securities market(C) bonds purchased in the secondary bond market(D)stock purchased from the New York Stock Exchange

(A) a futures contract to deliver corn in 60 days

SB11.9 If you deposit a $50 check in the bank, before the check has cleared the change in your bank's balance sheet there will be a $50 increase in(A)cash items in the process of collection and a $50 increase in checkable deposits(B)cash items in the process of collection and a $50 increase in reserves(C)cash and a $50 increase in checkable deposits(D)reserves and a $50 increase in checkable deposits

(A) cash items in the process of collection and a $50 increase in checkable deposits

SB8.3An important difference between futures and options contracts is that(A)futures contracts have symmetric rights while options contracts have asymmetric rights(B)the buyer of a futures contract assumes the long position, while the buyer of an options contract assumes the short position(C)futures contracts are traded primarily in commodity markets, while options contracts are traded primarily in financial markets(D)futures contracts have asymmetric rights while options contracts have symmetric rights

(A) futures contracts have symmetric rights while options contracts have asymmetric rights

SB11.4 Securitization refers to(A)selling directly to investors' loans or securities that were formerly held by financial intermediaries(B)banks insisting that collateral be supplied on previously unsecured loans(C)changing the mix in an investment portfolio away from stocks and toward bonds(D)reducing the exposure of a bank's portfolio to interest rate risk

(A) selling directly to investors' loans or securities that were formerly held by financial intermediaries

SB8.5The intrinsic value of an option is(A)the amount the option is actually worth if it is immediately exercised(B)impossible to determine in the absence of information on the future prices of the underlying asset(C)the amount the option is expected to be worth on its expiration date(D)equal to the option premium

(A) the amount the option is actually worth if it is immediately exercised

Speedback 2.1The largest percentage change in quantity of financial assets held by financial intermediaries between 1978 and 2003 occurred in(A)the growth in mutual fund shares (B)the growth in pension fund reserves (C)the growth in home mortgages(D)the growth in bank deposits

(A) the growth in mutual fund shares

SB4.9Which of the following statements best describes the behavior of a risk-neutral saver?(A)A risk-neutral saver judges assets only on their expected returns and is not concerned with the variability of returns.(B)A risk-neutral saver is willing to hold risky assets because of the possibility of making a high return.(C)A risk-neutral saver evaluates both variability of expected returns and their size.

(A)A risk-neutral saver judges assets only on their expected returns and is not concerned with the variability of returns

Speedback 3.9Which of the following statements best expresses the relationship between bond prices and bond yields?(A)Bond prices and bond yields are inversely related.(B)The greater the time to maturity for a given asset, the lower will be the price change caused by a given shift in the yield to maturity.(C)Bond prices and bond yields are positively related.

(A)Bond prices and bond yields are inversely related

Sb14.9 If a wave of counterfeit currency hit the United States, what would happen to the currency-deposit ratio?(A)C/D falls(B)C/D stays the same(C)cannot tell from the data provided.(D)C/D rises

(A)Increased risk of currency reduces demand for currency so C/D falls. See discussion on page 401 of the textbook.

Speedback 3.5Which of the following is an incentive for buying a Treasury STRIP?(A)Investors can gain the certainty of a known return if they hold the STRIP instruments until maturity.(B)Investors can buy the rights to a variable interest rate return if they hold the STRIP instrument until maturity.(C)Investors can potentially earn a higher interest rate from STRIPS than they expected when they bought the instrument if they hold it until maturity.

(A)Investors can gain the certainty of a known return if they hold the STRIP instruments until maturity

SB14.10If a bank customer writes a check on the bank for $10,000, and the bank's reserve ratio is 10%, what is the reserve status of the bank?(A)The bank must make up $9,000 in deficient reserves.(B)The bank must make up $100,000 in deficient reserves.(C)The bank must make up $90,000 in deficient reserves.(D) The bank must make up $10,000 in deficient reserves

(A)The bank must make up $9,000 in deficient reserves.

SB15.8If the federal government raises taxes by $1 billion and then spends the money to pay government bills, the effect on the monetary base will be(A)zero(B)a net decline in bank reserves(C)a rise in the monetary base of $1 billion(D)a fall in the monetary base of $1 billion

(A)The funds paid in taxes flow back into bank reserves when the government pays its bills, so the monetary base doesn't change.

SB4.6One of the tradeoffs to consider in choosing a more liquid asset over a less liquid asset is that(A)The more liquid asset is likely to have a higher price and earn a lower return than the less liquid asset.(B)The more liquid asset is likely to have a lower price and earn a higher return than the less liquid asset.(C)The more liquid asset is likely to be riskier than the less liquid asset.(D)Risk-loving savers will always prefer more liquid assets over less liquid assets.

(A)The more liquid asset is likely to have a higher price and earn a lower return than the less liquid asset.

SB16.3 The issue of Fed independence typically rises over(A)Negative reaction by the public to Fed policy(B)Academic disagreement regarding monetary policy(C)Role of the Fed in managing monetary policy(D)Expansion of the money supply

(A)The public's negative reaction to Fed Policy creates political pressures regarding Fed Independence.

SB16.8 To conduct open market operations, the FOMC issues a directive to(A)The trading desk at the Federal Reserve Bank of New York(B)The Board of Governors in Washington, D. C.(C)The presidents of the district banks(D)Chairman of the New York Stock Exchange

(A)The trading desk at the Federal Reserve Bank of New York

Sb13.8 Deposits of U.S. Dollars in European banks (maintained in dollars)are called(A)Eurodollar(B)banker's acceptance(C)currency swap(D)global dollars

(A)U.S. dollar deposited in European banks and maintained in dollars as known as Eurodollars

SB5.2Now looking at the bond supply curve, an increase in expected inflation will result in which of the following(A)a lower value of existing bond portfolios and an increase in the supply of bonds(B)a lower value of existing bond portfolios and a decrease in the supply of bonds(C)the bond supply curve will shift left, raising the price of bonds and lowering the interest rate

(A)a lower value of existing bond portfolios and an increase in the supply of bonds

Speedback 3.6The concept of present value is important because it(A)allows us to compare returns on different financial instruments with different maturities earning different interest rates(B)insures that a fall in interest rates will result in lower measures of present value(C)enables us to calculate present value of money market instruments but not capital market instruments

(A)allows us to compare returns on different financial instruments with different maturities earning different interest rates

Sb17.10In a Federal Reserve repurchase agreement, the Fed(A)buys securities from a dealer in the government securities market, and the dealer agrees to buy them back at a given price at a specified future date(B)does not require collateral if it agrees to buy securities from a dealer overnight, since the dealer may just buy them back tomorrow(C)does not consider such transactions as open market operations(D)sells securities to a dealer in the government securities market and agrees to buy them back the next day

(A)buys securities from a dealer in the government securities market, and the dealer agrees to buy them back at a given price at a specified future date

SB8.1The seller of a futures contract(A)has the obligation to deliver the underlying financial instrument at the specified date(B)has the obligation to receive the underlying financial instrument at the specified future date(C)may, at his or her option, deliver or receive the underlying financial instrument at the specified date(D)assumes the long position

(A)has the obligation to deliver the underlying financial instrument at the specified date

SB15.4 If Treasury currency outstanding increases, the monetary base will(A)increase whether the increase in currency is held by banks or by the public(B)increase, provided the increase in currency is held by banks(C)decrease(D)increase, provided the increase in currency is held by the public

(A)increase whether the increase in currency is held by banks or by the public

SB5.4Which of the following reasons best explains why the bond demand curve is equivalent to the loanable funds supply curve?(A)A rise in bond prices in the bond demand curve diagram is equivalent to a rise in loanable funds interest rates in the loanable funds supply curve diagram.(B)A rise in bond prices in the bond demand curve diagram is equivalent to a fall in loanable funds interest rates in the loanable funds supply curve diagram.(C)The bond demand curve cannot be equivalent to the loanable funds supply curve.(D)A fall in bond prices is equivalent to a drop in the loanable funds interest rate.

(B)A rise in bond prices in the bond demand curve diagram is equivalent to a fall in loanable funds interest rates in the loanable funds supply curve diagram.

SB4.3Which of the following criteria best expresses a saver's portfolio allocation decision with respect to expected returns on assets?(A)A saver will generally ignore inflation and choose the asset with the highest stated interest rate of return.(B)A saver will seek to choose the asset with the highest real rate of return after taking taxes and inflation into account.(C)A saver will seek to invest when inflation is at its peak to ensure the maximum nominal return on investment.(D)A saver will generally ignore tax differentials on alternative investments.

(B)A saver will seek to choose the asset with the highest real rate of return after taking taxes and inflation into account.

SB4.7The amount of gain in reducing idiosyncratic risk by adding additional stocks to a portfolio is sharply reduced after reaching which of the following numbers of stock in a portfolio?(A)1,000(B)20(C)8(D)500

(B)According to the textbook, adding 20 stocks to a portfolio of New York Stock Exchange-listed stocks will reduce idiosyncratic risk by about 21.7%; further reductions from additions of more stock result in minimal reductions in such risk.

SB12.5 Which of the following is not true of membership in the FDIC?(A)All national banks are members of the FDIC.(B)All commercial banks are members of the FDIC.(C)Most large state banks are members of the FDIC.(D)Some state banks are not members of the FDIC

(B)All national banks, MOST large state banks, and some small state banks are members of the FDIC (page 309 of the textbook)

SB13.5An Edge Act Corporation may(A)engage only in domestic banking services(B)engage only in international banking services(C)engage in domestic and international banking services

(B)An edge Act Corporation may only perform international banking services.

Speedback3.3A discount bond differs from a coupon bond in that(A)Market fluctuations may result in capital gains and losses for coupon bonds but not for discount bonds if the bonds are sold before their maturity date.(B)Buyers of discount bonds receive only the face value of the bond at maturity while buyers of coupon bonds receive periodic interest payments representing the coupon rate during the life of the bond in addition to receiving the face value of the bond at its maturity.(C)Buyers of discount bonds receive coupon interest payments during the life of the bond while buyers of coupon bonds receive only the face value at the maturity of the bond.

(B)Buyers of discount bonds receive only the face value of the bond at maturity while buyers of coupon bonds receive periodic interest payments representing the coupon rate during the life of the bond in addition to receiving the face value of the bond at its maturity

SB13.1 Fluctuations in a bank's net worth that accompanies increases or decreases in exchange rates are called:(A)liquidity risk(B)exchange rate risk(C)interest rate risk(D)global risk

(B)By definition, exchange rate risk is the risk of fluctuations in banks' net worth that accompany increases or decreases in exchange rates.

SB16.6Who among the following components of the Federal Reserve System has the greatest power in influencing monetary policy?(A)The member banks(B)The chairman of the Board of Governors(C)The district Federal Reserve banks(D)The governors (other than the chairman) of the Board of Governors

(B)Historically, member banks, district Federal Reserve banks, and governors other than the chairman have been dominated by the power of the chairman.

SB6.9If the fluctuations in expected real interest rates are small, then which of the following statements provides an explanation of how the upward-sloping yield curve can be used for economic forecasting?(A)If real interest rates are constant, then an upward sloping yield curve suggests that lower inflation is expected.(B)If real interest rates are constant, then an upward sloping yield curve means higher inflation is expected.(C)An upward sloping yield curve provides a signal that a recession is likely.

(B)If real interest rates are constant, then an upward sloping yield curve means higher inflation is expected

SB5.9If the bond market is initially in equilibrium, and bond prices temporarily drop below equilibrium, the result will be(A)an excess supply of bonds and an excess supply of loanable funds(B)an excess demand for bonds and an excess supply of loanable funds(C)an excess demand for bonds and an excess demand for loanable funds(D) an excess supply of bonds and an excess demand for loanable funds

(B)If the price of bonds falls below equilibrium, an excess demand for bonds results; however, lower bond prices mean higher loanable funds interest rates, resulting in an excess supply of loanable funds.

SB5.10 What will most likely happen to interest rates during a recession?(A)Interest rates will rise because the bond demand curve shifts to the left.(B)Interest rates will fall because a fall in bond supply and a fall in demand results in a higher equilibrium bond price and a lower interest rate in the loanable funds market.(C)Interest rates will rise because the loanable funds supply curve shifts to the right.

(B)Interest rates will fall because a fall in bond supply and a fall in demand results in a higher equilibrium bond price and a lower interest rate in the loanable funds market.

Sb13.7 Banking markets that have little or no regulation and low taxation on profits are called(A)Euromarkets(B)offshore markets(C)international banking markets(D)Edge Act corporations

(B)Offshore markets have little or no regulation and tax bank profits at a very low rate.

SB5.1In an open economy, if the domestic interest rate is below the world interest rate, then(A)The real world interest rate is likely to fall.(B)That economy will become a net lender abroad.(C)That economy will become a net borrower abroad.

(B)That economy will become a net lender abroad.

SB12.8 Compared to the banking systems in other major industrial countries, the banking system in the United States has(A)more banks and is more concentrated(B)more banks and is less concentrated(C)fewer banks and is less concentrated(D)fewer banks and is more concentrated

(B)more banks and is less concentrated(

SB17.8 In the 1970s, the Federal Reserve Open Market Committee instructed the Open Market Trading Desk to implement policies that would achieve both interest rate stability and monetary aggregate growth stability. What was wrong with this policy directive?(A)Monetary aggregates are much more difficult to measure than are changes in interest rates.(B)The Fed cannot attain both interest rate stability and monetary aggregate growth stability simultaneously.(C)Fiscal policy was highly effective in stabilizing the economy, so monetary policy was considered unnecessary.(D)Using the fed funds rate as an operating target may result in countercyclical monetary policy; that is, in shrinking the money supply during an economic upturn

(B)The Fed cannot attain both interest rate stability and monetary aggregate growth stability simultaneously.

SB16.7 The main source of power in the Federal Reserve System rests on the Fed's(A)Ability to eliminate business cycles(B)Control of monetary policy(C)Control of fiscal policy(D)Independence from the legislative and executive branches of the federal government

(B)The Fed's independence may help in its control of monetary policy, but independence is not the main basis for the Fed's power.

SB13.2Which two countries have the longest history of international banking?(A)U.S. and Italy(B)U.K. and Switzerland(C)France and Germany(D)U.S. and Japan

(B)The United Kingdom and Switzerland have the longest history of International banking

SB17.4Which of the following types of information does the manager of the Open Market Trading Desk not take into account when implementing open market directives from the Fed?(A)the level of reserves in the banking system(B)the level of inflation in the overall economy(C)bids and offers from Treasury security dealers(D)the desired level of reserves recommended by the open market directive

(B)The manager of the Open Market Trading Desk takes reserves, desired level of reserves and bids and offers from Treasury security dealers into account in implementing open market directives.

SB10.10Finance companies(A)take in deposits from savers and purchase assets with funds(B)sell commercial paper and securities and make loans to borrowers with the funds(C)bring together small savers and large borrowers(D)take in deposits from savers and make loans to borrowers

(B)The role of finance companies is to sell commercial paper and make loans to borrowers with the funds.

SB 17.1Which of the following open market operations is considered to be a dynamic transaction?(A)an open market operation that compensates for increased currency demand during the Christmas season(B)an open market operation that is intended to influence interest rates and the money supply(C)an open market operation that compensates for fluctuations in Treasury deposits from tax and loan accounts to the Fed's accounts(D)an open market operation that offsets a sharp rise in the Fed float

(B)These three transactions describe defensive Federal open market operations designed to offset fluctuations in the factors that either decrease or increase the monetary base.

SB9.6Which of the following statements correctly characterizes the 'lemons' problem?(A)Adverse selection weeds out poor lending risks and only borrowers with good credit ratings will be able to get loans.(B)When interest rates are high, adverse selection will eliminate many strong borrowers and leave mainly risky borrowers.(C)Owners who sell high-quality cars are likely to get a better price than are sellers of 'lemons.'(D)Credit rationing will be reduced as strong borrowers take out more loans.

(B)When interest rates are high, adverse selection will eliminate many strong borrowers and leave mainly risky borrowers.

SB4.8An older saver would choose which of the following portfolios(A)a portfolio with assets likely to increase nominal returns to reduce the risk of living on a fixed income(B)a portfolio with safe assets and an expected real rate of return near zero(C)a portfolio based on maximizing expected real returns to ensure having money for retirement

(B)a portfolio with safe assets and an expected real rate of return near zero

SB14.1.Which of the following changes in variables affecting the complete money multiplier will cause the money supply to fall?(A)a fall in the currency/deposit (C/D) ratio(B)a rise in the required reserve ratio(C)a fall in the excess reserves/deposit (ER/D) ratio(D)a fall in the required reserve ratio

(B)a rise in the required reserve ratio

SB6.2If you believed strongly in the expectations theory, you would likely(A)change your relative demand for instruments of different maturities to take advantage of different yields(B)believe that expected returns would be about equal for bonds of different maturities(C)agree with the conclusion that the expectations theory explains the upward slope of the yield curve, but not parallel shifts in the curve(D)be unable to infer expectations of future short-term rates from current long-term rates

(B)believe that expected returns would be about equal for bonds of different maturities

Sb12.10Attempts by the federal government to maintain banking stability resulted in(A)an increase in loans granted by banks to high-quality borrowers(B)decreased stability in banks because unregulated financial institutions began offering close substitutes for bank deposits and loans(C)limits on sources of funds for large borrowers(D)giving banks a competitive advantage in the market for loans

(B)decreased stability in banks because unregulated financial institutions began offering close substitutes for bank deposits and loans

SB9.5If financial market participants base their decisions on rational expectations, then market prices of financial assets will provide a best estimate of(A)the prediction of upturns and downturns in financial markets(B)fundamental value of financial assets(C)the reduction in risk from investing in financial markets

(B)fundamental value of financial assets

SB9.7Investors are better off when financial asset prices are determined in an efficient market because(A)risky assets are not allowed to be traded in an efficient market(B)funds will flow from savers to investors offering the most profitable investment opportunities(C)returns on assets will be higher(D)returns from assets traded in an efficient market are not subject to state or local taxes

(B)funds will flow from savers to investors offering the most profitable investment opportunities

SB4.2Stocks with higher betas will generally result in(A)lower expected returns because of their increased liquidity(B)higher expected returns because of their higher risk(C)lower systematic risk, but higher idiosyncratic risk(D)lower expected returns because of their lower risk

(B)higher expected returns because of their higher risk

SB6.4The segmented markets theory(A)provides a logical explanation of why parallel shifts occur in the Treasury yield curve(B)provides an explanation of the upward slope of the Treasury yield curve, but cannot explain parallel shifts in the curve(C)explains why bonds of different maturities are perfect substitutes(D)cannot explain the upward slope of the Treasury yield curve

(B)provides an explanation of the upward slope of the Treasury yield curve, but cannot explain parallel shifts in the curve

SB10.5Mutual funds(A)take in deposits from savers and purchase assets with the funds(B)sell shares to savers and purchase assets with the funds(C)bring together small savers and small borrowers(D)take in deposits from savers and make loans to borrowers

(B)sell shares to savers and purchase assets with the funds

SB17.9 A major problem in relying on discount loan policy as a monetary policy tool is that(A)the Fed has a tighter rein over discount policy than it has over open market operations(B)the spread between the fed funds rate and the discount rate set by the Fed can cause unintended increases or decreases in the monetary base and the money supply(C)increases in the discount rate may provide erroneous signals of Fed monetary policy intentions(D)discount policy is ineffective in addressing the illiquidity problems of individual banks

(B)the spread between the fed funds rate and the discount rate set by the Fed can cause unintended increases or decreases in the monetary base and the money supply

SB6.5The term structure of interest rates explains why(A)yields are held constant along a given Treasury yield curve(B)yields differ for financial instruments with differing maturities(C)the Treasury yield curve always slopes upward(D)yields differ for financial instruments with the same maturities

(B)yields differ for financial instruments with differing maturities

Speedback 2.9The problem of asymmetric information occurs in financial markets when(A)Lenders monitor securities market information more carefully than do borrowers.(B)Market prices of stocks and bonds do not reflect all of the information available to company insiders.(C)Borrowers may withhold vital information from lenders.

(C) Borrowers may withhold vital information from lenders.

Speedback 2.2 Which of the following statements best explains the role of financial markets? (A) Financial markets issue claims (IOUs) on savers directly to borrowers.(B)Financial markets create assets for borrowers that become liabilities for lenders.(C)Financial markets issue claims (IOUs) on borrowers directly to savers.(D) Financial markets eliminate risk.

(C) Financial markets issue claims (IOUs) on borrowers directly to savers.

SB7.7Which of the following statements about purchasing power parity is correct?(A)Purchasing power parity assumes that inflation rates between two countries are constant.(B)Purchasing power parity assumes that nominal exchange rates remain constant.(C)Purchasing power parity assumes that real exchange rates are constant, so fluctuations in nominal exchange rates are due to changes in inflation rates between two countries.(D)Purchasing power parity assumes that if the U.S. price level rises 5% more than the French price level, the U.S. exchange rate will rise.

(C) Purchasing power parity assumes that real exchange rates are constant, so fluctuations in nominal exchange rates are due to changes in inflation rates between two countries

Speedback 2.6 Which of the following best defines the term "Eurodollar"?(A)any dollar deposited by a European central bank in a New York bank(B)dollars spent by European tourists in the U.S.(C)any U.S. dollar deposited in a bank outside the U.S. anywhere in the world(D)any European currency borrowed by American banks

(C) any U.S. dollar deposited in a bank outside the U.S. anywhere in the world

SB8.8Derivative financial instruments are(A)loans made by banks at an interest rate derived from the market interest rate(B)financial assets whose value is derived from prices set in the stock market(C)assets that derive their value from underlying assets(D)assets whose values are derived from primary financial markets

(C) assets that derive their value from underlying assets

SB10.2In examining data on financial intermediaries in the United States, which type of institution holds the lowest percentage of assets?(A)mutual funds(B)commercial banks(C)credit unions(D)life insurers

(C) credit unions

SB7.2If the dollar can be exchanged for fewer pesos today than yesterday, we say the dollar has(A) appreciated(B)become more valuable relative to the peso(C)depreciated(D)remained constant in value

(C) depreciated

SB11.5The largest source of funds for commercial banks is(A)discount loans from the Fed(B) checkable deposits(C)nontransaction deposits(D)borrowings from the fed funds market

(C) nontransaction deposits

SB11.10Banks use credit rationing rather than simply raising the interest rate charged borrowers with higher default risks because(A)of interest rate ceilings in many states(B)of fear of offending the loan applicants(C)of fear of adverse selection problems(D)use of credit rationing is encouraged by the Federal Reserve

(C) of fear of adverse selection problems

SB12.4 Which of the following statements does not describe Fed actions during the Great Depression of the 1930s?(A)The Fed raised the interest rate it charged on loans to member banks in 1931.(B)The Fed thought the economy would work itself out of the Depression by itself.(C)Fed actions lowered the value of the dollar against other currencies.(D)The Fed failed to act decisively as a lender of last resort

(C)Fed actions lowered the value of the dollar against other currencies

Sb16.9Which of the following statements is correct?(A)The boards of directors of the district banks are all local bankers.(B)Member banks receive no return on the stock they own in Federal district banks.(C)Federal Reserve district banks pay dividends on their earnings to member banks.(D)Federal Reserve district banks are owned by the government

(C)Member banks receive dividends on stock they own in Federal district banks.

Speedback 3.1If a Fed watcher expects the fed funds rate to fall, he or she knows that the Fed will most likely(A)seek a slowdown in overall economic activity(B)sell government bonds(C)buy government bonds(D)decrease the supply of fed funds

(C)Selling government bonds would shrink excess reserves and raise the fed funds rate. Buying government bonds would expand excess reserves and lower the fed funds rate. 'Buy government bonds' is the correct answer.

Sb17.6 Which of the following statements is true?(A)The Secretary of the Treasury sets both the discount rate and the conditions for the availability of discount loans.(B)The Fed sets the discount rate, but the Secretary of the Treasury sets the conditions for the availability of discount loans.(C)The Fed sets both the discount rate and the conditions for the availability of discount loans.(D)The Fed sets the discount rate, but Congress sets the conditions for the availability of discount loans

(C)The Fed sets both the discount rate and the conditions for the availability of discount loans.

SB5.7How does the government budget deficit affect the bond market?(A)The increased supply of bonds will increase the price of bonds and lower the interest rates on government bonds.(B)The government budget deficit will have no effect on the bond demand and supply curves.(C)The bond supply curve will shift to the right, but households will likely keep savings constant, so bond prices fall and interest rates rise.

(C)The bond supply curve will shift to the right, but households will likely keep savings constant, so bond prices fall and interest rates rise.

SB4.10 If the wealth elasticity of demand for financial assets is less than 1.0, a 1% increase in wealth would lead to(A)a more than proportionate increase in demand for financial assets(B)no change in the percentage of a given asset in an investment portfolio(C)a reduction in the percentage of a given asset in an investment portfolio(D)an equal percentage change in the demand for investment assets

(C)a reduction in the percentage of a given asset in an investment portfolio

SB9.8Moral hazard problems arise when(A)lenders have difficulty in distinguishing between good and lemon firms(B)borrowers default on loans(C)borrowers have an incentive to conceal information(D)when a downturn in economic activity makes repaying loans difficult for borrowers

(C)borrowers have an incentive to conceal information

SB12.6 By saying that the U.S. has a dual banking system, we mean that(A)both commercial banks and savings & loan intermediaries exist in the U.S.(B)both the U.S. Treasury and the Federal Reserve are involved in regulating banks(C)both state and federal governments may charter, regulate and examine banks in the U.S.(D)the U.S. has both a central bank and a system of commercial banks

(C)both state and federal governments may charter, regulate and examine banks in the U.S.

SB14.5If the Fed buys $1 million in securities from a local Bank, the local bank's balance sheet would reflect a $1 million(A)increase in liabilities(B)increase in securities and a $1 million decrease in reserves(C)decrease in securities and a $1 million increase in reserves(D)decrease in liabilities

(C)decrease in securities and a $1 million increase in reserves

SB9.4In the context of the evaluation of the efficient markets hypothesis, pricing anomalies refer to the(A)gap between actual and expected prices(B)spread between the price at which a broker will purchase stock from an investor and the price at which the broker will sell stock to an investor(C)existence of trading strategies that appear to have offered above-normal returns(D)difficulty in practice of computing stock prices on the basis of expectations of future

(C)existence of trading strategies that appear to have offered above-normal returns

SB15.7 If the Treasury sells $2 million in gold, the Fed's gold and SDR certificate account will(A) rise by $2 million, whereas the monetary base will fall by $2 million(B)rise by $2 million, as will the monetary base(C)fall by $2 million, as will the monetary base(D)fall by $2 million, whereas the monetary base will rise by $2 million

(C)fall by $2 million, as will the monetary base

Sb14.2 Although open market operations and discount loans both change the monetary base, the Fed has(A)complete control over both discount loans and open market operations(B)very little control over either discount loans or open market operations(C)greater control over open market operations than over discount loans(D)greater control over discount loans than over open market operations

(C)greater control over open market operations than over discount loans

SB12.9 The major reason why U.S. banks are regulated so heavily is that(A)banks cannot make a profit without federal subsidies(B)the FDIC lacks sufficient funds to bail out failing banks(C)liquidity risk and information problems are closely associated with bank runs(D)banks are subject to substantial interest rate risk

(C)liquidity risk and information problems are closely associated with bank runs

SB10.8The use of deductibles and coinsurance are examples of attempts by insurance companies to deal with the problem of(A)adverse selection(B)excessive government regulation(C)moral hazard(D)failure of policyholders to keep paying their premiums

(C)moral hazard

SB9.9When the market price of a financial instrument equals its present value, savers and borrowers can be sure that the(A)inflation rate equals the interest rate(B)inflation rate will be zero in the future(C)price communicates information about market participants' expectations of value(D)interest rate will be zero in the future

(C)price communicates information about market participants' expectations of value

SB11.3The main purpose of increasing the focus on liability management by commercial banks is to(A) reduce the amount of required reserves(B)make sure the bank's balance sheet balances(C)reduce bank debt(D)borrow additional funds so they can make more loans

(D) borrow additional funds so they can make more loans

SB7.1An increase in the expected inflation rate in the U.S. will(A)increase the budget deficit in the U.S. relative to the budget deficits of foreign governments(B)cause the U.S. exchange rate to appreciate(C)reduce the nominal interest rate in the U.S.(D)cause the U.S. exchange rate to depreciate

(D) cause the U.S. exchange rate to depreciate

SB8.9Basis risk is a problem in hedging when(A)hedgers fail to fulfill their futures contracts(B)financial markets are highly liquid(C)perfect correlation exists between the rate on the hedged instrument and on the instrument actually traded in the futures market(D)imperfect correlation exists between the rate on the hedged instrument and on the instrument actually traded in the futures market

(D) imperfect correlation exists between the rate on the hedged instrument and on the instrument actually traded in the futures market

SB5.6A change in bond demand occurs when(A)bond prices fall(B)changes in loanable funds interest rates occur(C)bond prices rise(D)changes in wealth occur

(D)A change in bond demand (a shift in the bond demand curve) can occur only when some factor other than a change in bond prices occurs, since a change in bond prices can only cause a movement along a bond demand curve.

SB14.7 Which of the following situations affecting the nonbank public would cause the currency-to-deposit ratio (C/D) to rise?(A)The size of the underground economy decreases.(B)Wealth increases for the economy as a whole.(C)An increase occurs in the interest paid on checkable deposits.(D)A period of bank panics occurs

(D)A period of bank panics occurs

SB9.2Which of the following statements about the effects of efficient markets is incorrect?(A)Higher stock prices signal higher future profit expectations.(B)Higher bond prices mean risk premiums and borrowing costs are falling.(C)"Churning" portfolios is not a profitable strategy.(D)Above-normal profit opportunities still exist in the trading process.

(D)Above-normal profit opportunities still exist in the trading process.

SB16.2The Depository Institutions Deregulation and Monetary Control Act of 1980(A)Eliminated the requirement that banks hold reserve deposits with the Fed(B)Required all state banks to join the Federal Reserve System(C)Prohibited nonmember banks from receiving discount loans(D)Required all banks to maintain reserve deposits with the Fed

(D)Required all banks to maintain reserve deposits with the Fed

SB16.5 Members of the Board of Governors(A)May serve no more than three consecutive four-year terms(B)Must resign when the President who has appointed them leaves office(C)Serve for life or good behavior(D)Serve one nonrenewable 14-year term

(D)Serve one nonrenewable 14-year term

Sb17.2The Fed often issues its policy statements in vague language that is difficult to understand. Why doesn't the Fed come right out and tell the public what it is going to do?(A)The Fed does not want to be accountable for its errors.(B)The Fed does not want to tell the public what it knows about what is going to happen in the economy.(C)The Fed's intentions are obvious if one watches its trading activity on any given day.(D)The Fed does not want to influence financial markets

(D)The Fed does not want to influence financial markets

Sb14.6 Which of the following Fed actions would not increase the monetary base?(A)The Fed buys U.S. Treasury securities.(B)All Fed actions result in an increase in currency in circulation.(C)The Fed increases the amount of discount loans.(D)The Fed sells U.S. Treasury securities

(D)The Fed sells U.S. Treasury securities

SB16.10Which of the following conditions may limit the Fed's independence from external pressure?(A)The Fed's profits have exceeded $15 billion per year.(B)The Fed is exempt from the congressional appropriations process.(C)Board members are appointed for long, nonrenewable terms of office.(D)The President can appoint a new Board chairman every four years

(D)The President can appoint a new Board chairman every four years

SB5.3If investors are more optimistic about stocks than they are about bonds, which of the following results is likely to occur?(A)The bond demand curve will shift right, and the loanable funds curve will shift left.(B)Investors will move to the left along an existing bond demand curve, thus raising bond prices and lowering interest rates.(C)Investors will prefer bonds to stocks because bonds have lower risk.(D)The bond demand curve will shift to the left, lowering bond prices, resulting in a shift to the left in the loanable funds market and higher interest rates.

(D)The bond demand curve will shift to the left, lowering bond prices, resulting in a shift to the left in the loanable funds market and higher interest rates.

SB16.1 Which of the following appears to be evidence against the public interest view of the Fed's motivation?(A)The unwillingness of the Fed to turn over its excess profits to the Treasury(B)The conflict with the Treasury over interest rate fixing during World War II(C)The independence of Fed chairmen from the authority of the President(D)The failure of the Fed to emphasize the goal of price stability

(D)The failure of the Fed to emphasize the goal of price stability

Sb15.5 Suppose the Fed buys $150 million of Japanese yen with Federal Reserve notes. What is the net effect on the monetary base?(A)The monetary base stays the same since Japanese yen would not count in the Fed's balance sheet.(B)The net effect cannot be determined without knowing the dollar/yen exchange rate.(C)The monetary base falls by $150 million.(D)The monetary base rises by $150 million

(D)The monetary base rises by $150 million

SB9.1One reason that the principal-agent problem is a general one in equity contracts is that(A)since top management usually also owns the bulk of the firm's stock, it has little incentive to respond to the wishes of the remaining shareholders(B)most uses of corporate funds are highly visible(C)the Securities and Exchange Commission does a poor job of detecting fraud by top management(D)many uses of corporate funds are hidden from view

(D)many uses of corporate funds are hidden from view

SB10.6A defined benefits plan(A)is always fully funded(B)may be under funded but cannot be over funded(C)may be over funded but cannot be under funded(D)may be either under funded or over funded

(D)may be either under funded or over funded

SB8.7Index arbitrage refers to(A)buying futures contracts and selling options contracts on the same stock(B)selling futures contracts on stocks and buying equivalent futures contracts on bonds.(C)selling futures contracts and buying options contracts on the same stock(D)simultaneous trading in stock index futures and the underlying stock

(D)simultaneous trading in stock index futures and the underlying stock

SB4.5Diversification cannot reduce the risk of investing in a portfolio of assets if(A)the assets in the portfolio are highly liquid(B)investors choose a mix of short-term and long-term investments(C)the risks are idiosyncratic risks(D)the returns on the assets in the portfolio move together perfectly

(D)the returns on the assets in the portfolio move together perfectly

SB9.3In an efficient financial market(A)investors often attain unexploited profits(B)prices of financial assets remain constant(C)adaptive expectations ensure that asset prices are at least equal to their fundamental value(D)the self-interested actions of informed traders cause available information to be incorporated in market prices

(D)the self-interested actions of informed traders cause available information to be incorporated in market prices

Federal Deposit Insurance

(FDI) A United States government corporation created by the Glass-Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank

Using the info above, if the price falls to $40 a share, what is the profit to the issuer of the option

-$490

A U.S security yields 4% and a comparable British security yields 3%. If the U.S dollar is expected to depreciate 1% against the pound, the currency premium would be

0%

An individual is in a 30% tac bracket and purchases a corporate security that is returning 10%. If the expected inflation rate is 4%, the after-tax real rate of return on the asset is?

3%

Describe the assets and liabilities that are found on a typical commercial bank balance sheet.

A balance sheet contains a list of assets (what the company owns) and a list of liabilities (what the company owes) and net worth. The asset total should equal the sum of liabilities plus net worth (called equity capital in table 13.1). Net worth, therefore, is the difference between assets and liabilities. Banks make money by acquiring liabilities so they can create assets. Banks use cash inflows to create excess reserves so they can either loan the money or invest it in securities. As discussed in previous lessons, as a deposit is made into a bank, the bank must maintain a percentage of this deposit as "reserves", the balance may be loaned out to other customers who then deposit the money and the cycle continues. These reserves are shown on the balance sheet along with other assets such as loans, security investments and deposits at other banks. Study the balance sheet of U.S. commercial banks for 2003 in table 13.1 carefully (page 277 of the textbook). Look up any terms you do not know. You may refer to the glossary or conduct an Internet search for additional clarification. You may also check the St. Louis Federal Reserve site for additional examples of balance sheets for commercial banks.

Explain the inverse relationship between bond prices and interest rates. Calculate the total rate of return, including both current yield and capital gain or loss.

A key concept in understanding the mastering interest rates and bond prices is to understand the inverse relationship between bond prices and interest rates. Suppose a bond with a coupon rate of 10% and a face value of $1,000 is offered for sale in the market. The market interest rate jumps to 20%. No one would want to buy the bond because it pays less interest than could be earned on other investments in the market. Thus, the price of the bond would have to be lowered to entice investors to buy this bond rather than invest in alternate instruments. This lowered price or "discount": means that this bond would sell for less than the face value in the market. Thus, as the interest rate increased, the bond price decreased. The inverse is true when interest rates decline. Suppose this bond is again offered in the market with a face value of $1000 and coupon interest rate of 10%. The market interest rate drops to 5% on items of similar risk. The demand for this bond increases because it pays significantly higher interest, with similar risk. The price of this bond will increase, or the bond will be sold at "a premium". The higher the demand for a bond, the higher its price and the lower its yield. T-bills have low yields and high prices because they are more liquid and have less risk than long-term bonds. Twenty or thirty-year Treasury bonds have higher yields and lower prices because they have higher risk (their returns must be discounted for more years into the future, reducing their present value) and lower liquidity. To review these concepts, look up some bond prices and interest rate data in the financial pages of The Wall Street Journal. Be sure to study the material on how bond yields and prices are related in the textbook. Note the impact of changes in interest rates on fifty-year bonds in the story of Tennessee Valley Authority (TVA, a government agency set up to build dams on some of the tributaries of the Mississippi River to generate electricity, sell fertilizer, etc.) in the box "Consider This" in the textbook. Figuring the Total Rate of Return on an Investment The total rate of return on an asset consists of two components: The current yield, or the coupon rate divided by the current price of the bond (C/P). The current yield tells you how much you will receive on a bond assuming the price of the bond stays the same throughout your holding period. Since the price of the bond in question is likely to be sold at a premium or a discount, you must consider, in addition to the current yield, the change in market value, or the capital gain or loss on the bond. If there is a capital gain, the total return is greater than the current yield. If there is a capital loss, the total return is less than the current yield.

procyclical monetary policy

A monetary policy which unintentionally destabilizes the economy by following an expansionary monetary policy in the expansion phase of the business cycle and a contractionary monetary policy in the recession phase of the business cycle.

Financial Institutions

A network of markets and institutions to bring savers and borrowers together

An increase in oil prices will shift the _______ curve to the left causing prices to _________

AD; Rise

If there is an excess supply of bonds in the market, then the price of bonds is__________ the equilibrium price and the interest rate is_________ the equilibrium interest rate

Above; Below

asymmetric information

An asymmetric information problem exists when one party to a transaction is in a position to use information that is know to them. but not others, to their advantage. The minimization of the asymmetric information problem explains much of the structure of the financial system

Explain the investment choices presented in this chapter (mutual funds, money market funds, finance companies, insurance companies, pension funds commercial banks, credit unions and saving and loan institutions).

After reading the text and the information presented in the "WSJ Guide to Understanding Money and Investing," you should have a greater understanding of the investment choices available to you. One of the newest types of investment opportunities is the mutual fund. Although mutual funds date back to the 1920s, this type of investment gained popularity in the late 1970s and early 1980s. As time has progressed, the popularity of such investments has increased steadily. Again refer to the table on page 247 in your text. Notice the dramatic shift in mutual funds between 1980 and 1990. Continue reviewing the chapter and evaluate the investment opportunities available for you.

The U.S. treasury Secretary who tried to establish a nationwide banking system in 1791 was

Alexander Hamilton

small open economy

An economy that trades goods and services with other economies and, by itself, has a negligible effect on world prices and interest rates

Explain how the banking industry is regulated/monitored.

All financial depository institutions, including commercial banks, savings institutions, and credit unions, are monitored by a network of state and federal regulators. The goal of these regulators is to ensure a sound financial system and to reduce the risk of possible financial crises such as bank runs. The Federal Deposit Insurance Corporation (FDIC) has played a significant role in ensuring bank financial stability. If a bank fails, the deposits are insured. In other attempts to maintain stability of the banking system and to protect the position of small banks, Congress passed the McFadden Act, which prohibited interstate branching by national banks and required them to be subject to intrastate branching requirements in states in which they are located. The restrictions themselves however, have created their own problems. Limiting national banks' ability to expand into other states creates many small banking situations. Small local banks may not be able to meet the financial needs of their customers. Larger banks may be more equipped to make jumbo loans or service the needs of corporate clients. The current legislation is moving to change these regulations and allow more interstate expansion.

List and explain the costs of reducing inflation.

Although general agreement exists on the causes of inflation, general disagreement flares when analysts and policymakers debate about how best to bring inflation down. The debates primarily center around the time frame of reducing inflation—quickly or "cold turkey" or gradually reducing the growth rate. Come to your own conclusion. Which method do you favor and why?

Pension Funds

Amounts of money put aside by corporations, nonprofit organizations, or unions to cover part of the financial needs of members when they retire

Explain the basic characteristics of options contracts, including the rights of buyers and sellers and the way options are priced.

An option is a financial derivative instrument that conveys rights to buyers and obligations to sellers. An option buyer pays a price for the right to buy or sell a financial instrument or a commodity at some set time in the future at an agreed-upon price. Options possess a convenient insurance feature. If it is to the buyer's advantage to exercise the option on the expiration date, the buyer may do so. If not, the most an option buyer can lose is the price of the option. The size of the option premium depends on the probability that the option will be exercised, on price volatility of the underlying asset, on the time remaining until the exercise date, on the role of credit in the options transaction, and on the comparative default-risk free interest rate. An option to sell an underlying asset is known as a put option, or a put. An option to buy an underlying asset is known as a call option, or a call. The strike price, or exercise price, is the option contract price at which the underlying asset is bought or sold. The intrinsic value is the amount an option is worth when it is exercised. Can you make money on an option? If the strike price of a put option (an option to sell) is higher than the market price, then the put option is said to be in the money. Similarly, if the strike price is below the market price, then the put option is said to be out of the money (a term not used in the textbook).

Use graphic analysis to predict the effects of changes in Fed policy on the level of bank reserves and the federal funds rate.

Analyze the graphs carefully on pages 467 through 470 of the textbook. These diagrams show the effects of changes in the three major Fed policy tools (open market operations, discount loans, and reserve ratio changes) on the supply of and demand for total reserves, including both borrowed and non-borrowed reserves. You could likely predict the effects of alternative policy shifts on the supply and demand curves for reserves and on the change in the equilibrium fed funds rate without even looking at the diagrams. However, spend a few minutes on the graphs to make sure you have them clearly in mind. Analysts use shifts in the fed funds rate as a summary measure for gauging Fed changes in monetary policy. In the course, we put you to work monitoring the fed funds rate without knowing much about why it was important other than the fact that it serves as a signal of either expansionary monetary policy (expanding reserves and the monetary base) or contractionary monetary policy (shrinking reserves and the monetary base. 17.5: The Prin

Primary Markets

Are those in which newly issued claims are sold to initial buyers by the borrowers

Total Rate of Return

As a result, the total rate of return, which is the sum of current yield and the actual capital gain or loss, can differ from the yield to maturity

Compare the U.S. banking industry with the banking industry in Japan and Germany.

As cultures differ among countries, so do the nature and functions of financial institutions (pages 326 through 330 of the textbook). In the Japanese banking industry, for example, the cooperative structure of Japanese industry influences the banking industry as well. The government regulations of Japan made it easier for small local firms to access credit. Review the special features of Japanese and German banking in the textbook and contrast these features with the activities of and restrictions on U.S. banking activities. Which country has the better system? Where would you deposit your money if you had access to all three systems?

Identify the similarities between domestic and international banking.

As discussed in previous lessons, domestic banks earn a profit by "selling" money at a higher rate than they "buy" the money. This is accomplished via the banks providing risk-sharing, liquidity and information services at low cost. International banks operate in much the same way. These banks provide services to consumers by accepting deposits from savers and lending money to borrowers. International banks also incur financial regulations. Foreign activities of domestic banks, for example, are regulated by the Federal Reserve System. Similarly, foreign bank operations within the U.S. are also regulated by the Fed.

Explain what causes the aggregate supply curve to shift.

As discussed in the text, most economists generally agree on the difference between the slopes of short-run and long-run AS curves, but they differ over the reasons that seek to explain short-run and long-run AS curves (pages 591-598 in the textbook). Thus, the so-called new classical school of thought believes that an up-sloping AS curve can be explained by the positive supply response that occurs when the actual price level is greater than the expected price level (page 591 of the textbook). This theory is called the misperception theory because it is based on the idea that producers may misinterpret the difference between changes in the general price level and changes in the relative price of the good they are producing. In other words, producers will increase output only if they perceive that the relative price (the price of their good relative to the prices of other goods) of the good they are producing is increasing. If they misperceive a general price level increase as an increase in the price of their own good, then they respond by increasing output. That is why the new classical theory of the upward sloping AS curve is called the misperception theory. Only when the expected price level exceeds the actual price level will the AS curve slope upward. The new Keynesians, on the other hand, believe that prices in the short run are sticky. That is, they believe that because of labor contracts, supplier contracts, implied agreements not to raise prices, and other factors discussed on pages 593 through 598 of the textbook, prices in the short run will remain rather flat. The long-run AS curve is a more basic concept. To derive the long run AS curve, just draw a vertical line at a given (full-employment) level of output (page 597 of the textbook). Note: you do not have to know the algebra for the sticky price model on page 595 of the textbook (not on the exam). But you should know how the idea of sticky prices can affect the slope of the AS curve. Why might the short-run AS curve (SRAS) shift? In other words, what reasons other than a shift in the aggregate price level (P) (which causes a movement along an existing AS curve, not a shift in the curve) can lead to a rightward or leftward shift in the SRAS curve? You can review several reasons for such shifts on pages 596 and 597 of the textbook and then test yourself on what you know by studying table 25.2 on page 599. Finally, why might the LRAS curve shift? In the long-long-run, everything can shift. Factors that may cause the LRAS curve to shift either right or left are discussed on pages 597 through 598 of the textbook.

Select at least three Treasury securities of varying maturities, including at least one T-bill, one Treasury note, and one Treasury bond, then decide how much you want to invest in each security and record these transactions on a spreadsheet.

As indicated in the general guidelines to your portfolio project assignment in Appendix A of this course manual, you are to "invest" a fictitious allotment of $5 million in a series of financial instruments. The purpose of this exercise is to learn how to read the financial pages, how to record basic transactions, and how to follow the markets. You can allocate as much or as little of your $5 million as you wish to any given investment. Since we will not add other types of financial instruments until later lessons, you can spend all of your $5 million now or hold some of it. The idea is to make as many buy-sell transactions as possible so that you can get the feel of watching the markets and of monitoring market conditions that influence daily, weekly, and monthly shifts in bond yields and prices and stock prices. Do not worry about what bond you should select. Just pick something. Jump into the market. You are not graded on whether you lose or make money. As indicated in the guidelines handout, buy at least one T-bill, one Treasury note (indicated by the small letter n following the bond listing) and one Treasury bond. The reason for selecting one of each of these three securities is so you can start monitoring variations in short-term, intermediate-term, and long-term interest rates so that you can get a feel for interpreting the Treasury yield curve as it changes from day to day. So make your bond choices, record your transactions on a worksheet, and begin watching them daily. Not all bonds are recorded in the WSJ financial pages each day if no activity has occurred in the market for that particular security on a given day, so you will not always find a given security listed. If you have a computer, you can search one of the bond quote information resources on the Internet to get the latest quotation for your security. Above all, do not worry if you don't have everything figured out right at the start. Just keep working at it and the project will become clearer as you go along.

Explain how to compare expected returns on foreign and domestic investments

As we discussed in the introduction to this lesson, comparing returns on comparable investments in foreign and domestic assets is more complicated than just comparing foreign and domestic interest rates because exchange rates may fluctuate during the life of the investment. Thus, the comparative returns on foreign and domestic assets are summarized by the equation on page 169 of the textbook: Value of $1 investment after one year = 1 + i f − EX e /EX.This equation states that $1 earned in a foreign investment will be $1 plus the earnings on foreign interest, a positive amount (assuming no capital gains or losses). But a second adjustment must be made for the change in the expected exchange rate. In other words, the total interest rate return, say, for investing in a British asset must be adjusted for the expected appreciation or depreciation of the dollar. If the dollar is expected to appreciate, then a given sum in terms of British pounds can be exchanged for fewer dollars, and the second term in the above equation will be negative. A more promising alternative in terms of expected returns would be if the dollar was expected to depreciate because then the returns earned in pounds can be exchanged for more (cheaper) dollars. Suppose we have an equilibrium exchange rate of 100 yen to the dollar and an equilibrium return of 5%. If the exchange rate rises to 105 yen/dollar, then this exchange rate is expected to fall because it is artificially high. Specifically, this higher exchange rate is expected to fall back to the initial equilibrium exchange rate of 100 yen/dollar, which equals a 4.8% drop (100 is 95.2% of 105) or depreciation in the dollar. When the initial equilibrium interest rate of 5% is added to the 4.8% expected depreciation in the dollar, the expected total return is 9.8%. Now take time to reason through the comparative returns on foreign and domestic investments if the exchange rate falls from 100 to 97 (figure 8.3, page 171 of the textbook). In this case, since the exchange rate falls below equilibrium, it is expected to appreciate. And a higher dollar means that the exchange rate term in our equation is negative, so the return on the yen-denominated investment drops to 1.9%.

List and explain the principal costs of inflation.

As you review the costs of inflation (pages 661 through 663 of the textbook), you will become more aware of possible reasons why the Fed is considered to be such a powerful inflation fighter. You will also see why it makes a difference whether inflation is expected or unexpected and why inflation uncertainty causes distortions of prices, including the prices of financial assets.

Universal banking allows

Banks and other types of businesses to be combined in one firm, with no geographic restrictions

Standard of deferred payment

Because individuals are willing to sell on credit today in exchange for money in the future, money can also serve as a standard of deferred payment. This facilitates trade over time.

Explain the importance of moral hazard and adverse selection on financial intermediaries and on debt and equity financing.

Because not all parties in a financial transaction typically have access to the same information, the problem of asymmetric information arises. Borrowers may withhold information about their credit history. People buying insurance may misrepresent their health status. Companies selling securities may withhold information about the financial condition of their businesses. Because of these two problems, two kinds of costs arise: (1) adverse selection costs and (2) moral hazard costs. Banks and other lenders spend a lot of money screening credit risks. The volume of personal credit data available to lenders has accelerated in recent years. While all of this information is valuable in screening risks, it is not inexpensive. Adverse selection occurs because of the difficulties in separating applicants on the basis of risk. Then, once loans are made, how can a lender be sure the borrower will spend the borrowed funds for the purpose for which they were intended? The monitoring problems associated with appropriate uses of borrowed funds are called moral hazard problems. Most of the remainder of chapter 11 is concerned with various issues concerning adverse selection and moral hazard and with alternative methods of attempting to reduce the costs of these two problems.

Coupon Bonds

Bonds with interest coupons attached to their certificates; bondholders detach coupons when they mature and present them to a bank or broker for collection.

Discuss the role of rational expectations in determining market prices of financial assets.

Buyers and sellers in financial markets are continuously trying to predict future asset prices before making market decisions. What people think will happen ultimately determines market prices of financial assets. If buyers and sellers make use of all available information in making financial market decisions, they are basing decisions on rational expectations. When market decisions are based mainly on past history, market participants are basing decisions on adaptive expectations. Rational expectations go beyond adaptive expectations because such expectations not only make use of information based on the past but also incorporate expectations about the future (pages 206 through 208 of the textbook). If, in fact, asset market prices are based on rational expectations, then such prices will equal fundamental value, which is defined as the value that equates market prices with the present value of the future stream of returns for particular assets. Of course, no one can predict the future with perfect accuracy. However, financial market participants must use their best judgment based on all available information to make buy-sell decisions. As indicated in the textbook, deviations between expected and actual prices will produce a random error, and it is not possible to forecast the errors of other forecasters. Even though no one can predict the future with perfect accuracy, some kind of benchmark is needed against which market performance can be evaluated. The deviations from that benchmark that occur in financial market activity can be assessed on a more objective basis. The benchmark we use is one called the efficient market hypothesis.

Use risk, liquidity, information costs (RLI), and taxes to explain the risk structure of interest rates, that is, to explain why yields of financial instruments with the same maturity vary.

By holding the maturities of different financial instruments constant, analysts can focus on reasons other than maturity to see why yields vary. First, consider the element of default risk, or the odds that a borrower will not repay a loan or redeem a bond. Market analysts measure default risk by comparing the size of the risk premium; that is, by measuring the extra premium an investor requires on a risky instrument compared with the yields on a default risk-free instrument such as a Treasury bond. When default risk for a bond increases, the demand for such bonds decreases (the demand curve shifts left as in figure 7.1(b), page 134 of the textbook) while the demand for low default-risk bonds rises (the demand curve shifts right, figure 7.1(a), page 134), thus resulting in a higher bond price. Since the difference in bond prices between the high default-risk market and the low default-risk market has risen, the difference between bond prices in the two markets results in a rise in the default risk premium. (Study the graph of long-term and short-term yields on page 138 of the textbook.) Similar analyses are shown for demonstrating the effects of decreased liquidity (figure 7.3) and increased information costs (figure 7.4) on bond prices and the size of premiums these changes have on yield premiums. Since investors are ultimately concerned with the real returns after taxes (inflation-adjusted), any rise in taxes or any shift to less favorable tax laws results in similar effects on bond demand, bond prices, and the size of the differential in the yield premium as compared with bonds that feature more favorable tax treatment (figure 7.5 of the textbook). By reasoning through the effects of changes or differences among financial instruments in terms of risk, liquidity, information costs, and taxes, we can get a clearer idea of why interest rates vary for securities with identical maturity. For instance look at the WSJ and find the comparative yields for so-called high-yield bonds (better known as junk bonds) and the yields on 60-day T-bills.

An important offshore international financial center is the

Caribbean

Explain off balance sheet activities.

Changes in bank regulation has lead to a variety of new debt instruments, reduced bank reliance on checking deposits and savings accounts as sources of funds, increased loans, and placed additional emphasis on management of bank balance sheets. These changes have also allowed banks to develop off-balance sheet lending. Through off-balance sheet activities, banks do not hold as assets the loans they make. This is accomplished by a variety of activities such as standby letters of credit, loan commitments and loan sales. Many banks now sell the loans they have issued to third parties

Information

Communicates information about borrowers' circumstances so that individual savers do not have to search out perspective borrowers

Property and casualty insurance companies

Companies that sell protection against loss resulting from fire, theft, accident, natural disasters, and other events. They invest the funds received through premiums in municipal bonds, corporate stocks and bonds and U.S. govt securities.

Financial Options

Confer on the buyer the right to buy or sell within a specified time at a specified price

Discuss the characteristics of the four basic debt instruments: simple loans, discount bonds, coupon bonds, and fixed-payment loans.

Debt instruments (also called IOUs or credit market instruments) divide into four basic categories: simple loans, discount bonds, coupon bonds, and fixed-payment loans. Note the differences among these instruments in the way in which principal and interest are paid. As you look at discount bonds, note that we refer to U.S. savings bonds, T-bills, and zero-coupon bonds as discount bonds. Coupon bonds include long-term Treasury and corporate bonds. Study the material in the "Consider This" box in the textbook that explains how STRIPS (Separate Trading of Registered Interest and Principal of Securities) work and why they are important. Basically, STRIPS provide a way to give investors some of the benefits of longer-term discount bonds in short-term financial instruments.

Explain the functions and advantages of money in a specialized economy.

Discussion of the role of money in an economy based on specialization and exchange begins with the contrast between a barter economy (in which participants must depend on the double coincidence of wants to effect exchanges) and a money-based economy, in which money eliminates the problems of barter and makes fluid exchanges possible. Review of the meanings of the terms definitive money, commodity money, legal tender, and fiat money.

Differentiate between cost-push and demand-pull inflation.

Economists have long distinguished between inflation caused by rising production costs, mainly higher wages, and inflation caused by sustained demand increases that push the economy to an artificial (temporary) output level above the level of full-employment output.

Explain recent macroeconomic fluctuations in the U.S. by using the AD-AS model.

Economists typically sort out changes in AD or AS into aggregate demand shocks and aggregate supply shocks. Then they look at what happens to fluctuations in the macroeconomy and assign certain outcomes to either or both AD shocks and AS shocks (pages 603 through 605 of the textbook). The price hikes engineered by OPEC (the oil exporting cartel) were clearly supply shocks, shifting the SRAS curve leftward and creating stagflation, stagnation or recessionary pressures along with higher inflation, a result that seemingly contradicted everything economists knew about macroeconomics up to that point.

Explain the concept of the wealth elasticity of demand.

Elasticity simply refers to the percentage change in one variable as a result of a one percent change in another variable. For price elasticity, a good is said to be "price elastic" if the elasticity coefficient is greater than one. That is, a good is price elastic if a one percent change in price resulted in a greater than one percent change in quantity demanded. On the other hand, a good was said to be price inelastic if a one percent change in price generates a smaller percentage change in quantity demanded or the coefficient is less than one. We use the same concept of elasticity to explain the wealth elasticity of demand for financial assets. Think about what kinds of assets would be highly responsive in terms of percentage changes in investment expenditures in response to a one-percentage change in wealth. Would you hold proportionately more cash as your wealth increases? Or would you hold proportionately more bonds as you get wealthier? (Note the differences in response between necessity assets and luxury assets.)

Explain the role of the Eurocurrency.

Eurocurrency plays a very important role in international banking. Eurocurrency deposits are time deposits denominated in a currency other than the issuing bank's domestic currency. The text uses Eurodollars to exemplify this concept. The Eurodollar is a dollar-denominated deposit held outside the U.S. (page 371 of the textbook). According to Hubbard, "A new Eurodollar deposit is created each time a deposit in a U.S. bank account is transferred to a bank outside the U.S. while being kept in dollars." Eurodollars are gaining popularity because they are not subject to the same regulations as domestic U.S. accounts, and much of the international banking is conducted in this market.

Analyze the effectiveness of the Fed in controlling inflation.

Every time the Fed raises or lowers the target rate for the fed funds rate, protests arise from second-guessers and critics, sometimes including Congress and the White House. If the Fed raises rates, the rate increase is either too much or too little; the hike came too soon or too late. The same scenario occurs in reverse if the Fed lowers rates: the rates are lowered too much or too little; the drop in rates came too soon or too late. The Fed's success in controlling inflation depends heavily on its credibility (pages 669 through 674 of the textbook). Some critics think that rules would work better than discretion. In other words, that a rule that said the money supply should increase by 3% a year, for example, would work better than letting bankers and economists sit around a big table and haggle over what they think should be done as far as the economy and the fed funds rate are concerned. Which is best, rules or discretion? Again, you can reach your own conclusion after you read about opposing viewpoints in the textbook. Now, after you finish this assignment, move on quickly to finishing your Fed paper, polishing up your portfolio, and taking the final exam. Do not procrastinate taking the final exam. Students typically perform better on exams when the material is fresh in their minds.

A review in a trade journal gives Sophtwear's new program high marks. Why might the supply of Sophtwear bonds shift to the right?

Expected profits from expanding operations is now greater

Monetary Theory

Explores the relationships linking changes in the money supply to changes in economic activity and prices

Explain the role of government regulation in the financial system.

Government regulation and control of the financial system has been a hotly debated topic since the first Bank of the United States was created in the late 1700s. Just how much control should the government have over banks and other financial intermediaries? You will learn more about specific types of regulatory controls later on, but for now be aware of the complex web of controls that seek to attain various objectives in keeping the financial system and the nation's money supply safe. As you will see later, regulatory controls tend to be imposed only after a major crisis occurs, as happened during the Depression years of the 1930s. But regulation is not only aimed at preventing fraud and at maintaining a sound currency. It is also aimed at monetary policies, which seek to maintain the economy on an even keel by keeping inflation low and minimizing economic fluctuations in output and employment. Current regulatory proposals before Congress could well change the face of the financial system dramatically over the next ten or twenty years. Anticipating these changes and developing strategies for coping with them will provide a continual challenge to financial market participants.

Discuss the difference between nominal and real exchange rates.

If you exchange $100 for French goods today and you know the euro/dollar exchange rate, you can figure out the quantity of French goods you can buy today. But, if the euro/dollar exchange rate (the nominal exchange rate) falls by one half, tomorrow, each dollar only buys half as many euros as it did yesterday. These fluctuations in nominal exchange rates do not tell us what we really want to know, however. What we really want to know is the real exchange rate, or the actual quantity of goods and services that a given quantity of domestic currency will buy in terms of foreign goods (equation 8.1, page 160 of the textbook). We also need to know how the relationship between nominal and real exchange rates is affected by the relative rates of inflation in two countries (equations 8.2 and 8.3 on page 161). Equation 8.3 explains that the change in nominal exchange rates is equal to the change in real exchange rates plus the difference in inflation rates between foreign and domestic economies.

Discuss the problems the Fed faces in achieving monetary policy goals.

Implementing appropriate policies to attain the above mentioned goals is a difficult task. Data are imperfect and often subject to revision; thus, economic indicators may provide an erroneous picture of how the economy is changing. Lags occur in reactions to changes in monetary policy. New business expansion cannot be implemented overnight, and layoffs and contractions typically take some time to materialize. Some monetary policy analysts think that lags anywhere from six months to as long as twelve to eighteen months may elapse before reactions to monetary policy shifts can be reasonably assessed. By the time the effects have worked their way through the system, the economy may be in an entirely different segment of the business cycle, and the policy changes at that point could move the economy in the wrong direction. To assist the Fed in defining goals, it uses what it calls intermediate targets and operating targets (pages 480 and 481 of the textbook). As in all economic decisions, tradeoffs exist because not all goals can be achieved at once: some goals may be achieved at the expense of others. Particularly relevant is the idea that the Fed cannot set monetary growth goals and stable interest rate goals at the same time (pages 481 and 482 of the textbook). If the Fed targets money growth, interest rates will fluctuate; if it targets a given interest rate, the money supply will fluctuate. This conflict is one of the most crucial monetary policy dilemmas confronting the Fed and the financial system.

Discuss how banks manage risks such as: moral hazard, liquidity, credit and interest rate risk.

In a banking situation, moral hazard is the risk that banks take when they must monitor borrower behavior in the uses of borrowed funds. Borrowers may keep information about the use of funds and about their own financial condition to themselves, thus placing banks in the position of dealing with asymmetric information. Moreover, banks may use private information about depositors to their own advantage, creating moral hazard for depositors as well. Banks reduce moral hazard costs to savers by issuing short-term debt contracts to savers and by making loans partly from their own funds. Since banks face the constant possibility of withdrawal of funds by depositors, this concern prevents banks from making unfair use of the private information they have about depositors. Also, banks can place their own capital at risk in making loans to further reduce moral hazard concerns of savers. Liquidity risk is the possibility that depositors may collectively decide to withdraw more funds than the bank has immediately on hand. A small bank for example may not have sufficient cash on hand to cash the local factory's payroll checks on payday. In this situation, the bank would suffer a liquidity crisis. How would this situation arise? Sometimes the required (noninterest-bearing) reserves kept in either vault cash or deposits at the Fed may not be enough to meet cash requirements. Banks do not want to keep any more reserves than absolutely necessary, because they need to earn a return on their assets to make a profit. Banks may prevent this situation by earning extra returns via managing the balance sheet. Banks may gain extra funds by managing the assets side of the balance sheet: lending in the fed funds market (loaning excess reserves to other banks), and making overnight loans to other banks with repurchase agreements. Banks can gain extra funds (liquidity) by managing the liabilities side of their balance sheet through time deposits (CDs or certificates of deposit), borrowing in the Eurodollar market (dollar-denominated deposits held outside the U.S.), or by borrowing in either the fed funds market or through repurchase agreements. Of course, banks could always call in loans or deny loan renewals. Banks now manage the liability side of their balance sheets much more aggressively than they did several decades ago, having recognized that they must stimulate an incoming flow of funds in order to expand bank assets (loans and securities). Another risk that lending institutions including banks incur is credit risk—or the risk of default by the borrower. However, banks have developed ways to manage or reduce this risk. Increased information about the borrower, credit-risk analysis and diversification are ways banks may defer this risk. Note also that banks manage interest rate risk with floating-rate debt, swaps, futures and options (pages 291 - 293 of the textbook).

Fixed-payment Loan

In a fixed-payment loan, the borrower makes regular periodic payments (monthly, quarterly, or annually) to the lender

Discuss how the nonbank public makes decisions that can affect the money multiplier.

In calculating the simple money multiplier, we assumed that individuals and businesses (depositors) held all money as checkable deposits -or zero currency. That is, we have assumed that 90% of all deposits are fully loaned out (assuming a 10% required reserve ratio). In reality, individuals and businesses hold some portion of their deposits (C/D) in currency. The money supply (M) therefore, equals currency in circulation (C) and checkable deposits (D). The equation is: M = C + D Thus, analysts who predict changes in the money supply and interest rates must be able to estimate the C/D ratio. The factors affecting the C/D ratio (wealth, expected returns, risk, liquidity, and information costs) are reviewed on pages 399 and 400 of the textbook.

Explain the components of the monetary base (MB).

In chapter 2, the money supply was classified groups: M1, M2, M3 beginning with the most liquid category (M1). We also introduced the concept of the simple money multiplier, which is used to show how a new deposit leads to a multiple of deposits, thus creating a change in the money supply. We now expand this discussion to illustrate how the Fed can alter the flow of deposits into and out of banks and thereby influence the monetary supply. Note figure 17.1 on page 385. The monetary base multiplied by the money multiplier generates the money supply. Take a look at the Fed balance sheet (page 385 of the textbook). Notice two primary assets (U.S. government securities and discount loans) and two liabilities (currency in circulation and reserves). The total of "currency in circulation" plus reserves is called the monetary base. Currency in circulation is currency in the money supply that is outside the banking system, mainly Federal Reserve notes (the dollar bills in your wallet are Federal Reserve notes). Note: all paper money in circulation is a liability of the Fed because the Fed must stand behind it. Reserves are total reserves, which include deposits with the Fed and vault cash. Note that by including vault cash as a part of reserves and by including currency in circulation as the other component of the monetary base, we have included all currency in circulation, whether held by banks or not.

foreign-exchange market stability

In the global economy, foreign exchange market stability, or limited fluctuations in the foreign exchange value of the dollar, is an important monetary policy goal of the Fed

List and explain the terms found on the Fed's complete balance sheet.

In the previous lesson (lesson 14) we focused on two items on the assets side of the Fed's balance sheet (U.S. government securities and discount loans) and on two items on the liabilities side of the Fed's balance sheet (currency in circulation and reserves and vault cash held by banks and bank deposits at the Fed). The latter two items, currency in circulation and reserves, make up the monetary base (B). Although changes in the Fed's portfolio of U.S. government securities account for most of the changes in the base, sometimes shifts in other components of the balance sheet can lead to changes in the base. If the Fed has set a certain interest rate target for the fed funds rate that reflects a given volume of reserves, and a change in another element of the Fed's balance sheet occurs that shifts the reserves, then the Fed may need to counter by buying or selling more securities in the open market to offset these shifts. Review the Fed's complete balance sheet in table 18.1 (page 418 of the textbook) and the definitions of each of the components of the Fed's complete balance sheet (pages 418 through 419 of the textbook). Several new terms appear here. Cash items in the process of collection (CIPC) are checks presented to the Fed for clearance that have not yet been debited against the bank on which they are drawn, so the total dollar value of these checks is an asset to the Fed. Since checks are always being presented for clearing, the Fed has a continuous positive balance in this account. Gold and SDR certificates are other new terms. Historically, when governments settled their international debts in gold, the U.S. Treasury often engaged in gold purchases. When the Treasury bought gold, it issued a gold certificate to the Fed (an asset) and the Fed credited the Treasury with a deposit balance (a liability). Since 1971, the U.S. government no longer settles international debts in gold. (Question: What function does the gold in Fort Knox serve? Answer: The gold in Fort Knox is an historical artifact.) When the International Monetary Fund (the IMF) was created following World War II to assist nations in borrowing and making international payments, a form of "paper gold" was created to settle international accounts called Special Drawing Rights (SDRs). So think of SDRs as paper gold. When the Treasury acquires SDRs in payment of debt, it issues SDR certificates to the Fed and receives a deposit account in return. The rest of the items on both the assets and liabilities sides of the Fed's complete balance sheet should be self-explanatory from the definitions in the textbook. Note that deferred availability cash items (DACI) are the liabilities side of cash items in the process of collection (CIPC). As we will soon see, the (positive) difference between the two is called the float. For example, consumers may experience float if they write out checks before they have deposited a check (not nice) or if they are given thirty days or so to pay a credit card debt, which is legal.

In less-developed countries, business depend more n intermediation than in developed countries, why?

Less-developed financial markets are more fragmented, making information gathering more difficult

Risk Sharing

Makes it easier to hold a diversified portfolio of assets (hold many varying assets)

Which monetary aggregate do most economists and policymakers currently consider to be the best measure of the medium of exchange

M1

M2

M1+ small-denomination time deposits, saving deposits, money market deposits accounts, noninstitutionalized money market fund shares, overnight repurchase agreements, overnight Eurodollars

Identify and evaluate the principal goals of monetary policy.

Macroeconomic policy goals typically include attaining price stability, high employment, and economic growth. Monetary policy goals added to the three previous macroeconomic goals include: maintaining stability of financial markets and financial institutions, attaining interest rate stability, and monitoring foreign-exchange market stability (476-478 of the textbook). Many analysts argue that the most important goal of monetary policy is inflation control. Certainly the bond markets react spasmodically to changes in any economic indicator that even suggests possible higher or lower inflation. In 1996 and early 1997, the Fed began paying more attention to what has become known as preemptive strikes, or anticipatory raises in interest rates to counter expected future increases in interest rates. These preemptive strikes have caused much controversy because once having raised rates, no one may ever know whether inflation would have occurred.

Make at least one futures transaction and one options transaction for your investment portfolio.

Make at least one futures transaction, one call option transaction, and one put option transaction and record these transactions on your worksheet or your spreadsheet. You may purchase either a financial future or a commodity future. The basic idea is to make a transaction and then watch the market to see what your gain or loss is going to be. Do not worry about whether you have chosen the right option or whether you have recorded the information correctly. Continue watching the market for the option and future you have chosen. Ignore margins and other complications of making futures and options transactions.

Explain the relationship between the bond market and the loanable funds market.

Market equilibrium occurs when the quantity supplied equals the quantity demanded, or at the price and quantity that occur when the supply curve crosses the demand curve. Thus, the equilibrium bond price and quantity occur at the point where the bond demand curve crosses the bond supply curve. At the equilibrium price and quantity, neither an excess quantity of bonds will be supplied, nor an excess quantity of bonds will be demanded (figure 6.3, page 106). Similarly, the loanable funds market will be in equilibrium at the point where the loanable funds supply curve crosses the loanable funds demand curve.

International Capital Market

Market for lending and borrowing across national boundaries (grown rapidly in the past 20 years)

Financial Markets

Markets for buying and selling bonds, stocks, foreign exchange, and other financial instruments

Explain the difference between monetary theory and monetary policy.

Monetary theory is a body of simplified models that seek to explain how changes in monetary variables like the supply of money and interest rates lead to changes in the economy. Monetary policy, on the other hand, involves studying how policy making bodies like the Fed seek to alter the course of economic activity by changing monetary variables like the volume of bank reserves, the money supply, and interest rates.

Store of Value

Money allows value to be stored easily, resulting in a store of value: If you do not use all your accumulate dollars to buy goods and services today, you can hold the rest for future use.

Wealth

Money, like other assets, is a component of wealth, which is the sum of the value of assets less the value of liabilities

Explain the historical circumstances that prompted major regulatory changes within the banking industry.

Most of the major regulations affecting the banking industry were enacted following a major financial crisis. Congress created the FED, for example in response to numerous bank failures in the early 20th Century. The Federal Deposit Insurance Corporation (FDIC) was created as a response to the banking crisis in the 1930s (during the Great Depression). In 1989 Congress passed FIRREA (the S&L bailout) as a response to the failure of many savings and loan associations. These are only a few examples of historical circumstances that led to government regulation of the banking industry. Perhaps the most significant financial crisis in U.S. history is that of the Great Depression. This economic collapse followed the stock market crash of 1929 and continued through the 1930s. During the depression, banks failed, businesses failed and farms collapsed. Review the discussion of the effect of the Great Depression in the text on pages 337 and 338. Did the FED make any mistakes during this period? What did we learn? Did the FED respond differently to later crises? How did the FED respond after the September 11 attacks in New York and Washington? Was this effective?

Risk Sharing

Most people prefer less risk to more risk, all else being constant, so they seek to reduce risk through risk sharing. The financial system provides borrowers and lenders with risk sharing through asset pooling and diversification

Maintenance of Financial Stability

Most regulation of financial system is concerned with the stability of the financial system. Specifically, because most financial assets are held by intermediaries, policymakers are particularly concerned about the financial soundness of intermediaries

Explain the process that occurs when you deposit a check in a bank.

New deposits of money are the sources of cash and reserves for a bank. New deposits generate new required reserves, which lead to new excess reserves that can be used for lending or for investing in U.S. government securities. When you deposit a check in your bank that was drawn on another bank, the bank on which the check was drawn will experience a decline in checkable deposits, required reserves, and excess reserves. Your bank experiences an increase in checkable deposits, required reserves and excess reserves. Your bank may then lend a portion of that money and earn a profit on the interest charged.

Use the models we have developed that show equilibrium in both the bond and loanable funds markets to explain changes in interest rates.

Once you have mastered the concept of why bond and loanable funds supply and demand curves shift, apply that understanding to consider how business cycles and expected inflation affect equilibrium bond prices and interest rates. Review pages 116 through 120 in the text to see how inflation and business cycles work their way through the bond market. After reading this section, can you explain why interest rates generally rise during economic recoveries and generally fall during recessions? Can you identify why a rise in expected inflation leads to lower bond prices and higher nominal interest rates?

Discuss the significance of regulations in preventing bank runs and contagion effect, and the justification for insurance as a prevention of bank panics.

One of the primary reasons for extensive regulation of the banking industry is the need to maintain confidence in the banking system—that is to assure depositors that the underlying assets of the bank are sound and that the bank can maintain liquidity. When consumers start to lose confidence in a bank, a "bank run" can occur. In a bank run, depositors withdraw their funds because of fears that the bank will fail. If all depositors attempt to withdraw all funds, even a sound bank can experience losses or be unable to meet the demands of the depositors. Thus, the fear itself can create bank failure. As depositors at other institutions see one bank failing, they may begin to fear that their own bank will fail. This is called the "contagion effect". The result is that many banks could experience difficulty when one bank is perceived to have difficulty. The government has enacted extensive regulations to prevent such occurrences. Typically, after a bank receives a charter and begins to conduct business, the institution is then monitored by state and federal regulators. If examiners discover issues with low net worth or excessive risk taking, the bank is monitored even closer. If regulators decide to close the bank, depositors are paid off by the federal deposit insurance corporation (FDIC). There are limitations however, on the amount the FDIC will cover per account, so check with your local bank to determine if you are fully covered by the insurance.

dynamic transactions

Open market operations designed to change the level of reserves.

defensive transactions

Open market operations designed to maintain the level of reserves

Business Taxation

Play taxes on business earnings. Corporations must pay property tax on buildings, land and equipment. Must also pay sales tax on goods and services they own and capital gains tax on money earned from the sale of capital assets. Excise tax (if companies sell tobaccos or gasoline) and value added tax, if applicable.

Identify and explain the principal factors that result in shifts in both the demand curve and the supply curve for bonds and loanable funds.

Recall the difference between a change in quantity demanded or supplied and a shift in demand or supply. A single demand curve shows the relationship between price and quantity demanded. Thus, a change in price will cause a change in quantity demanded (a movement along the demand curve). A supply curve shows the relationship between price and quantity supplied. A change in price will cause a change in quantity supplied (a movement along the supply curve). A change in price changes quantity demanded or quantity supplied. Any other factor (except a change in price) generates a change in supply or a change in demand. A change in demand or a change in supply indicates a change or shift in the entire demand or supply curve. An increase in demand means a rightward shift in a demand curve, which indicates that demanders are willing, for some reason, to buy more at each of the existing old prices. A fall or decrease in demand means that demanders are willing to buy less at each of the old prices. The same analysis applies to supply. An increase in supply means suppliers are willing to supply more at each of the old prices; a decrease in supply means suppliers are willing to supply less at each of the old prices. This distinction between changes in quantities supplied or demanded (movements along a supply or demand curve caused only by changes in price) and changes in supply or demand (shifts in an entire demand or supply curve) is a semantic distinction, but an important distinction, necessary to understand why equilibrium prices change. Given this review of introductory information, work your way through the material on explaining changes in equilibrium interest rates beginning on page 107, of the textbook. Note that each movement of a supply or demand curve in the bond market results in a mirror image shift in the loanable funds market, and vice versa. Next, take time to check the WSJ in its bond quotes section to see how bond prices are fluctuating daily. Study the Credit Markets Report in the WSJ.

Record basic bond transactions on a worksheet by referring to quotations in the WSJ.

Refer to the instructions in your investment portfolio assignment. You will want to begin making transactions now if you have not already begun.

Money

Refers to anything that is generally accepted as payment for goods and services or in the settlement of debts

Discuss the causes of price level changes and the causes of inflation, or sustained increases in the general price level.

Review the material on pages 655 through 657 of the textbook that explains how fluctuations in the price level occur. Note particularly the effects of an increase in the nominal money supply on both the AD and AS curves (figure 28.2, page 658). Review also the discussion beginning on page 659, regarding sustained changes in the price level. Note: a one-time price level rise is not inflation. A rise in the price of one good relative to the price of another good is a relative price change, not inflation. Inflation occurs when there is a sustained rise in the general price level (the price level for all goods and services combined). (See pages 659 through 661 of the textbook.)

Identify the difference between risk structure or interest rates and term structure of interest rates.

Risk structure of interest rates explains differences in yields across securities with similar maturity. This analysis of interest rates holds maturity of financial assets constant. The term structure looks at yield differences for financial assets with different maturities, but holds other items (such as risk, liquidity and information-costs) constant. Investors use both types of analysis in forecasting movement of securities.

Risk-adverse savers

Seek to minimize variability in the return on their savings and prefer security in their investments

Which of the following is an example of the lemons problem?

Sellers of good cars withdraw from the market because the average price of cars is too low

Explain why bond sellers sell bonds and why investors purchase bonds.

Selling bonds or issuing debt is a common way for corporations or governments to raise money. The bond seller promises to pay back the money at some future date and may or may not make interest payments to the lender. Basically, bond buyers and sellers loan and borrow money for the same reasons that any borrowers or lenders make these kinds of transactions: bond buyers (lenders) wish to earn a return on their funds, and bond sellers (borrowers) typically wish to make investments in businesses to expand their markets and increase their potential profits.

Money Markets

Short-term instruments, with a maturity of less than one year, are traded in money markets

Explain the issues associated with Fed policy concerning reserve requirements.

Since 1980, shifts in reserve requirements have been limited to those scheduled in the Depository Institutions Deregulation and Monetary Control Act of 1980. While a decrease in reserve requirements, as occurred for some depository institutions when the DICMCA was passed in 1980, can be a windfall for unexpected increases in excess reserves, a serious increase in reserve requirements may be less likely. Raises in required reserve ratios may cause problems. Think about the multiple deposit contraction effects of lower reserves and you can see that a hike in the reserve ratio could handicap the banking system. Review the criticisms of reserve requirement policy on pages 463 through 465 of the textbook.

Describe financial markets for debt and equity in terms of both primary and secondary markets.

Students typically have an inherent fascination for the stock (equity) market. The stock market, through media attention to daily fluctuations in the Dow Jones Industrial Average (DJIA) is highlighted in the headlines of the daily financial news. Economists typically focus less on the stock market than on the bond market, viewing the stock market as a market that registers reactions to changes in market information about companies and to changing expectations about the future. As indicated earlier, we focus primarily on the bond (debt) market in a course in money and banking because the bond market is a key determinant of interest rates, and changes in interest rates lead to changes in economic output, prices, and employment. Nonetheless, we need to learn the basics of the stock market to see how changes in the bond market affect the stock market and vice versa. Sometimes bond and stock markets move together, sometimes in opposite directions. Sometimes the reason

Financial Institutions & Intermediaries

Such as banks, mutual funds, and insurance companies, act as go-betweens by holding a portfolio of assets issuing claims based on that portfolio to savers

Explain how signals from changes in stock and bond prices, risk premiums, term structure of interest rates, and differences between foreign and domestic interest rates affect investment strategies.

Table 10.1 on page 213 of the textbook summarizes major signals for savers and borrowers in efficient markets from changes in stock and bond prices, risk premiums, upward slope of the term structure, and the differences between domestic and foreign real interest rates. When it comes to strategies for portfolio allocation, one implication of the efficient markets hypothesis that perhaps is that the hypothesis insures that all existing information has already been reflected in the market prices of assets. Thus, a single investor has no likely way of exploiting exceptional profit opportunities in the market and should diversify his or her investment portfolio. Review the discussion on the effectiveness of churning, or making frequent transactions to try to stay abreast of market shifts (page 246 of the textbook) and of the likely effectiveness of so-called hot tips. Finally, since all current news and anticipations of future news have already been incorporated in today's security prices, review the importance of unexpected new information on tomorrow's security prices.

Nine of the ten largest banks in this state in 1980 had gone out of business or had been acquired by 1990. The state is

Texas

Differentiate between dynamic and defensive open market operations and explain when each type of operation is used.

The Fed conducts open market operations by coordinating decisions of the Federal Open Market Committee (the FOMC) through the Open Market Trading Desk at the New York Fed. (That is why the president of the New York Fed bank is a permanent member of the FOMC while other Fed regional bank presidents rotate as voting members of the committee.) The Open Market Desk of the New York Fed not only makes outright purchases and sales of Treasury securities, but also may affect bank reserves through repurchase agreements and matched-sale repurchase agreements, or reverse repos. Operating the Open Market Desk is a continuous operation because not only does monetary policy shift over time, but the components of the Fed's balance sheet that lead to changes in the base are continually changing. To counter both predictable and unpredictable changes in the base, the Fed engages in defensive transactions, or operations that are aimed at offsetting shifts in the base that would move the fed funds rate away from the target rate. If the Fed deliberately seeks to bring about changes in monetary policy by targeting a new higher or lower fed funds rate, it engages in so-called dynamic transactions (pages 455 and 456 of the textbook).

Which of the following is NOT an example of a policy rule

The Fed responds to the stock market crash by expanding the money supply

Explain how the Fed measures money using several different definitions. Explain the meaning of M1, M2, M3, and L.

The Federal Reserve has invented four alternative definitions of the money supply, known as monetary aggregates. These aggregates are known as M1, M2, M3, and L. M1 is the most liquid category; its components are most easily converted to cash. M2 contains some components that are less easily converted to cash (are less liquid), while M3 and L are, successively, less liquid Understanding these monetary aggregates is important because they form the basis for determining monetary policy (deliberate changes in interest rates and the money supply to effect changes in the economy). Review the definitions of these aggregates carefully. You may also want to check the glossary at the end of the textbook for further clarification, or search the Internet for further discussions.

Understand GDP and its significance in predicting economic changes.

The GDP is the most dominant of all economic indicators. The GDP or gross domestic product is the market value of final output of all goods and services produced in the economy during a given time period plus net changes in inventories. By including net changes in inventories in the GDP, the GDP measures all output that occurred during the measurement time period, including the value added to raw materials or unfinished goods not yet converted into final products. Including net changes in inventories also avoids double-counting of output. Double counting is further avoided by measuring GDP as "value added," subtracting all intermediate goods (production input costs) used in the production process. If GDP were not measured as value added, then, as in the case of a loaf of bread, the value of the wheat, the value of the flour, the value of the baking process, and the value of the final loaf of bread would all be added together and would distort the value of GDP. By counting only value added, the price of the loaf of bread measures the sum of all value added along the way. Thus, GDP measures the value of final output of all goods and services produced in the economy during a given time period plus the value of net changes in inventories. The GDP estimation process is one of the largest ongoing statistical estimation tasks in the world. The GDP estimate is made quarterly, with the estimate projected on an annual basis. Each new estimate is released on the third Friday of the month following the end of a quarter. For example, 1Q 97 (the GDP estimate for the first quarter of 1997, including January, February, and March) was released at the end of the third week of April. After the initial release, the data may be revised upward or downward as new data continually filter into the estimation process that were not available at the time of the initial estimate. Whether the original estimate is finally revised or not, financial markets treat each new bit of data on GDP growth gingerly, just as the markets treat data on unemployment, inflation and countless other indicators. The GDP estimate is not only significant in its own right, but it also typically provides a mirror image of the other two of the big three economic indicators: inflation and unemployment. Usually, though not always, when GDP rises, inflation can be counted on to rise and the unemployment rate to fall. The assumption that inflation will rise and unemployment fall when GDP rises, rests on the premise of "other things must remain equal. 18.2: Aggregate Demand

Describe the sequence of events in the regulatory process.

The banking industry is a prime example of how legislation follows crisis. Preceding each of the major changes in banking regulation has been a financial crisis that created a need for government interference. Historically speaking, all of the major financial regulatory legislation has followed a major financial crisis. The process typically begins with a financial crisis, followed by government regulation in response to that crisis. The financial system then responds to the government regulation and experts or regulators carefully watch the effect of the new regulation and respond with additional measures if necessary.

Derive the aggregate demand curve and explain what causes the AD curve to shift.

The aggregate demand curve (page 588 of the textbook).represents total demand in the entire economy for all of the goods and services produced during a given time period. In other words, AD means demand for total GDP, which is the sum of expenditures on consumption (C) plus investment (I) plus government spending on goods and services (G) plus expenditures on net exports (NX, or X minus M, a figure that can be negative). Consider the differences between interpreting the AD curve and interpreting the demand curve for an individual good or service. Price is inversely related to quantity in both the AD curve and the demand curve for a single good. But that is where the similarity between the two curves ends. The demand curve for a single good slopes downward and to the right because a rise in the price of that good leads buyers to seek for cheaper substitutes. In the case of the AD curve, the price measurement on the vertical axis is the price level for all goods and services, not just one. So when the aggregate price level rises, the prices of all goods and services rise together. The result? There are no cheaper substitutes when the general price level rises! If there are no cheaper substitutes when the aggregate price level rises along an AD curve, then how do we explain the downward slope of the AD curve? The key is that we must go to the financial markets and the concept of the real money supply (real money balances, or money balances adjusted for inflation so that they have constant purchasing power). Work through the steps for deriving the AD curve listed on page 587 of the textbook. Basically, higher aggregate prices obviously reduce the purchasing power of a given real money supply (M/P, or the money supply deflated by a price index that measures the price level). With lower real money balances, the real interest rate will rise, which means higher real interest rates will deter incentives to invest and consume. Even net exports will shrink because higher interest rates attract foreign investors, thus, raising the exchange rate and making our exports more expensive to foreigners. A rise in the aggregate price level leads to a lower quantity of aggregate output demanded and to a movement upward and to the left along a given AD curve. (Work through the process that occurs when the aggregate price level falls, as outlined in the middle of page 587 of the textbook.) Next, review the reasons why the AD curve will shift to the right (an increase in AD) or shift to the left (a decrease in AD). Remember that only a change in the aggregate price level (P) which causes a subsequent change in interest rates and spending incentives, can cause a movement along an existing AD curve. Thus, the AD curve can shift left or right when some factor other than a shift in the aggregate price level (P) occurs. The text divides these "other factors" into two categories: factors that cause shifts originating in asset markets (markets for financial assets) and factors that cause shifts originating in goods markets (markets for goods and services).

Derive the aggregate supply curve and explain how shifts in the short-run and long-run curves occur.

The aggregate supply curve represents the total quantity of output that producers are willing to sell at various price levels (page 591 of the textbook). The AS curve measures the way that changes in various incentives or disincentives alter the willingness of suppliers to produce goods and supply those goods in the markets. Before we can explain how shifts in the AS curve occur, we must first differentiate between the short-run AS curve and the long-run AS curve (pages 591 through 598 of the textbook). The main distinction between the short-run AS curve and the long-run AS curve is that changes in the price level are expected to affect the quantity that suppliers are willing to supply in the short run but not in the long run. Thus, if prices are expected to influence quantities supplied in the short run, that result can be shown along a short-run AS curve that slopes upward, at least for some part of it. If prices do not affect aggregate quantity supplied in the long run, that result can be shown by a vertical AS curve

Describe the nature of a so-called "swaps" transaction and explain the potential advantages of swaps.

The appendix to chapter 9 outlines an alternative method of risk reduction in financial markets known as swaps, or swaps transactions. The idea behind a swaps transaction is that two parties with different sets of cash flows over a given period might think each is better off with the other party's cash flows than with his or her own. If you would rather have the returns from an asset denominated in French francs as opposed to the returns from an asset denominated in dollars, you could trade dollars for francs at the start, swap the interest payments for an agreed-on period of time, and then swap francs for dollars at the expiration of the agreement. A currency swap may be a cheaper method of borrowing than borrowing directly in the required currency.

Derive the complete money multiplier, beginning with the simple deposit multiplier and incorporating the behavior of the nonbank public and the banks.

The basic money multiplier is now expanded to include the above concepts. This "expanded" money multiplier or the "complete" money multiplier is one of the most important tools you will learn in the study of money and banking, and learning how to derive it and use it to predict the money supply are useful skills to have if you are serious about understanding the money supply process. Again, do not try to memorize these steps. Try to logically work through the set of equations (17.4 through 17.10) on pages 404 and 405 of the textbook. Do not confuse the money supply equation (equation 17.10 on the bottom of page 461 of the textbook) with the equation for checkable deposits (top of page 405 of the textbook). In the money supply equation, the money multiplier is multiplied by the monetary base (B) to determine the money supply. Work through several sets of numbers like those on page 406 of the textbook so that you understand how the equation works and how changes in the nonbank public behavior term [C/D] and the bank behavior term reflecting reserves [R/D] affect the size of the multiplier and the ultimate size of the money supply.) Similarly, study the deposit multiplier shown at the top of page 406 of the textbook so that you can see how bank deposits are affected by changes in the C/D ratio. For additional practice in working with these calculations, work through some of the odd numbered analytical problems in the textbook on pages 413-415. Solutions for these are found in the back of your textbook.

Describe the benefits of derivative markets for the financial system.

The benefits of derivative markets can be evaluated in terms of risk, liquidity, and information costs (RLI). If you buy a put option, or the right to sell at a certain price, you are betting that the price of an underlying asset will rise. Who will sell the put option? Likely, the seller will be someone who thinks prices will fall. Hedgers could not hedge their positions to minimize risk unless speculators are willing to take opposite positions. The benefits of risk sharing, increased liquidity in securities markets, and reduced information costs can be swept aside by derivatives market participants who exercise poor judgment or who take extreme ris

What would be the expected impacts of the elimination of the investment tax credit in the 1980's on the bond market?

The bond supply curve will shift left, and bond prices will rise

Explain the concept of present value and why it is necessary to use present value calculations to compare money sums from different time periods.

The concept of present value is a central financial and economic concept. The basic premise is that resources are worth more now than the same resources later. The reason for increased value of resources now is that interest can be earned on these resources. The textbook states "dollars paid in different periods are not in the same units." By "units" Hubbard means that dollars paid in different periods are worth either more or less than dollars paid in other periods. This time value of money issue precludes direct comparison of financial alternatives. For example, when we purchased our last car, the dealership offered us a choice: we could have zero percent financing on the purchase or a cash allowance toward the purchase price and pay 4.9% interest on the loan. We had to make the choice. Should we rely upon the dealership to advise us on which offer was in our best interest? How do you know which is the better offer? How do we compare cash received today with the value of interest payments over five years? Present value calculation is a way of restating payments into today's dollars to allow comparison of different income streams. To find present value of future income streams from different assets, we make a simple numerical calculation called discounting. By discounting, we reduce the value of future dollars to take into account the foregone interest we could have earned if we had the dollars now. The basic formula for finding present value is the formula (4.1) in the textbook. We used present value calculations to make our decision on the car purchase. The cash allowance dollars were available instantly; therefore this amount was already stated in today's dollars, no adjustment was necessary. But what about the financing charges? How could we compare the value of a cash allowance today with the value of the interest payments we would make over time? We calculated the present value of the interest payments and compared that number with the cash allowance amount being offered. By using present value calculations, we were able to determine that taking the cash allowance and paying the interest rate of 4.9% was a better deal than 0% financing and no cash allowance. Is that the outcome you would have expected? Do you think the dealership knew which offer was better for the consumer? Why do they offer both choices? In this case, the amount we were financing was low enough that the circumstances worked better for us to take the cash allowance and pay 4.9% financing charges. (This will not always be the best alternative. The interest rate, the life of the loan and the amount being financed will all play a part in the calculations and in the decision. If you are faced with similar decisions, make the appropriate calculations before your final choice is selected).

SB15.10See analytical problem 11 on page 431 of the textbook. Using the data from this problem, what are the changes in the monetary base?

The correct answer can be found by adding the sources of the base and subtracting the uses of the base in equation 18.3 (page 420 of the textbook).

Discuss the history of the banking industry in the United States.

The current U.S. banking system is the result of more than two centuries of Congressional action and debate between different sections of the country and between different groups of borrowers and lenders. Special interest groups from the agriculturally dominated western and mid western states and the money-center populous eastern states battling for favorable regulations, and a general distrust of centralized government, were significant factors in delaying the creation of a central bank (the Federal Reserve) until 1913. Major changes in the banking regulations occurred in 1927 and 1933 with the passage of the McFadden Act of 1927 (which restricted branching across state lines by national banks) and the Glass-Steagall Act of 1933 (which separated commercial banking and investment banking). These two acts have significantly affected the shape and development of the U.S. banking industry. Two additional acts are now impacting the banking industry. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (moves toward eliminating the restrictions on interstate expansion) and the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 which repealed the Glass Steagall Act.

Explain the organization and creation of the Federal Reserve System.

The current central bank of the United States, or The Federal Reserve (The FED) was established in 1913, after two previous failed attempts to organize and maintain a central U.S. bank. The Fed itself is a unique creation, largely independent of the other three branches of government with Congressional and Judicial oversight. The original intent of the 1913 Act that created The FED was to give the central bank control over the amount of currency outstanding and serve as a lender of last resort. The FED has evolved into an organization that has assumed the lead role in making monetary policy (Page 436 of the textbook).

Discuss the effects of transactions costs and information costs on financial markets.

The discussion in chapter 11 focuses on the effects of transactions costs and information costs on financial markets and on possible ways of reducing these costs. High transactions costs drive market participants to lower-cost investment alternatives. Inadequate information about lenders and borrowers raises the likelihood of default risk.

Discuss how power to conduct and influence Federal Reserve activities is organized among the Board of Governors, the regional Fed banks, and the banks.

The distribution of power and responsibilities among the Board of Governors, the Federal Open Market Committee, the regional Fed banks, and the member banks is discussed on pages 440 through 442 of the textbook. The power and personality of the Fed chairperson probably dominates all other considerations in discussing how responsibilities and power are distributed within the Federal Reserve System and among the member banks.

duration gap

The duration gap is an accounting term for the difference between the duration of assets and liabilites. The duration gap measures how well cash flows for assets and liabilities are matched. When the duration of assets exceeds the duration of liabilities the duration gap is positive. A positive duration gap means greater exposure to rising interest rates; if interest rates go up then the price of assets fall more than the price of liabilities. Conversely, when the duration of assets is less than the duration of liabilities the duration gap is negative; if interest rates fall then the price of assets goes up less than the price of liabilities. Duration has a double-facet view. While a positive duration gap means greater risk, it also means that, on average, payables became due before receivables.

operating targets

The everyday targets that the central bank seeks to achieve using its policy tools, namely, the federal funds rate and bank reserves

Explain and calculate the yield on a discount basis (YDB) and compare the answer with the yield to maturity (YTM).

The final objective for this lesson asks you to learn a simple calculation for a yield measure called yield on a discount basis (YDB). The reason that we need to know about yield on a discount basis is that yields in the T-bill market are often quoted on a discount basis. The key to understanding the difference between yield on a discount basis and yield to maturity is to note that yield to maturity is calculated by calculating F-D/D x (365/number of days to maturity), while yield on a discount basis is calculated by dividing F-D/F x (360/number of days to maturity) where F is the face value of the security, and D is the discounted price paid for the security. As discussed in the textbook, the yield on a discount basis understates the yield compared with yield to maturity for two reasons: (1) the difference between face value (F) and purchase price (D) is divided by the face value rather than the discount price in the YDB calculation. Since F is larger than D, the resulting quotient is a smaller number; and (2) the YDB calculation uses a factor of 360 days rather than 365 days as in the case of YTM in calculating the fraction of a year left to maturity. Since using 360 days rather than 365 days to find the remaining portion of the year results in a smaller fraction for any given number of days left in the year, YDB will be less than YTM. To clarify your understanding of what you have read in the textbook and what we have just discussed, calculate both YTM and YDB using the following data: F = $10,000; D = $9,600; number of days to maturity = 100. (Answer: YTM =.152; YDB =.144) Thus, we have shown that YDB underestimates the yield.

Provision of liquidity

The financial system creates liquidity services by providing methods for trading existing assets and by creating new, more financial instruments

Risk Sharing

The financial system provides risk sharing by giving savers and borrowers ways to reduce the uncertainty to which they are exposed

Describe how money, interest rates, and prices are related to overall economic activity.

The first two chapters of the textbook is an introduction to the importance of the relationships among money, interest rates, and prices. Interest rates fluctuate in relation to the supply of money just like wheat prices fluctuate as wheat quantities vary. The lower the money supply, the higher the price of money (interest rates), just as wheat prices rise when the wheat crop is short. Higher prices are often linked with higher interest rates as economic policymakers seek to maintain price stability. The bond market will serve as a window through which we will analyze how interest rates, the money supply, and economic indicators, like measures of the price level, interact.

government budget constraint

The limit on government spending and transfers imposed by the fact that every dollar the government spends, transfers, or uses to repay borrowed funds must ultimately be provided by the user charges and taxes it collects.

Payment System

The mechanism for facilitation transactions in an economy

required reserve ratio

The minimum fraction of deposits banks are required by law to keep as reserves

Fiat Money

The modern U.S payment system is a fiat money system, in such a system, money authorized by a central bank or government body is the definitive money and does not have to be exchanged by the central bank of gold or some other commodity money

Explain the alternative approaches the Fed can use to change the monetary base.

The monetary base (B) is the sum of currency (C) plus reserves (R), or B = C + R (equation 17.1, page 387 of the textbook) From this equation, it can be seen that B will increase whenever either C or R, or both, increase. Examine each of the T-accounts on pages 387 through 390 of the textbook, and be sure you understand how each Fed purchase or sale of securities affects the balance sheets of the Fed, the nonbank public, and the banks. Note: Do not try to "memorize" these transactions. Instead, try to rationally analyze who is writing out the check and who is depositing it. If the Fed buys securities directly from a bank (page 387 of the textbook), the bank has $1 million less in securities and $1 million more in reserves. Since the bank owned the securities, it does not have to worry about holding reserves against the check issued to it by the Fed. If the Fed buys securities from the nonbank public (page 387 of the textbook), whoever sells the securities to the Fed will deposit a check, and the bank in which the check is deposited must hold required reserves against the check. Total bank reserves rise by $1 million in both cases (whether the Fed purchases from a bank or from the nonbank public), but required reserves rise only when the purchase is from the nonbank public. Focus on whether a given Fed action affects either currency in circulation or reserves (vault cash plus deposits at the Fed. Now work through the cases in which the Fed sells securities and reduces the base. Again, focus on the flow of money. Who writes the check and who makes the deposit? Check your reasoning by asking yourself whether a given Fed action shrinks either currency in circulation or reserves. If so, the base decreases. Finally, focus on how changes in discount loans (DL, or loans made by the Fed directly to banks) affect the base. Compare the relative importance of discount loans and open market operations. Does the Fed have greater control over open market operations than it does over discount loans?

Discuss the difference between appreciation and depreciation of domestic currency.

The price at which one currency is exchanged for another is the foreign exchange rate. Currency can appreciate or depreciate in value. When using these terms, we are referring to the value of the domestic currency against the foreign currency. For example, if the dollar equals 100 yen and then the dollar equals only 70 yen, the dollar has depreciated by 30 percent. The opposite is true for appreciation. If the dollar could buy 100 yen and suddenly the dollar can buy 130 yen, then the dollar has appreciated. If the dollar appreciates against the yen, then the yen has depreciated against the dollar.

strike price

The price at which the stock or commodity underlying a call option (such as a warrant) or a put option can be purchased (called) or sold (put) during a specified period

Liquidity Risk

The risk that an asset cannot be sold on short notice without incurring a loss

Explain the relationship between the bond market and the loanable funds market.

The textbook suggests that bonds are goods (in much the same way that wheat or corn or any other commodity is a "good"). As in basic supply-demand analysis, one side of the market will supply the good, the other side will demand the good. In the case of bonds, the lender (buyer) is demanding the bond; the seller (borrower) is supplying the bond. Similar to basic supply-demand analysis, where, for example, the market price of wheat is determined by the interaction of wheat suppliers and wheat demanders, the price of bonds is determined by the interaction of bond demanders and bond suppliers. We should also consider loanable funds as a "good." The "seller" of the good (the loanable funds) is the lender who supplies the funds. The buyer of the funds (demander) is the borrower seeking funds. In the case of the loanable funds market, the interaction between buyers and sellers in the loanable funds market determines a price, or the interest rate for loanable funds. Now turn to page 104 of the textbook. In figure 6-1 (a), note that the demand curve for bonds shows bond prices on the vertical axis and quantity of bonds demanded on the horizontal axis. According to the law of demand, the lower the price, the higher the quantity demanded. Now refer to Figure 6-1(b) on the same page. The demand curve for bonds implies the supply curve for loanable funds. The reason is that bond prices are inversely related to bond interest rates. Thus, if bond prices fall, bond interest rates rise. As bond interest rates rise, lenders are willing to supply more loanable funds to the loanable funds market. Thus, the bond demand curve equals the loanable funds supply curve. Next consider figure 6-2 on page 105 of the textbook. Figure 6-2 shows that the bond supply curve is equal to the loanable funds demand curve. In this case, higher bond prices result in a lower quantity of bonds supplied because bond suppliers know they will earn a lower yield as shown in figure 6-2(a). However, if you were borrowing money, wouldn't you be willing to borrow more (demand more loanable funds) if the interest rate falls? Thus, figure 6-2(b) shows that the loanable funds demand curve is the mirror image of the bond supply curve shown in figure 6-2(a).

Explain the role of the financial system in the economy and describe the three key services of the financial system.

There are three key services in the financial system: Risk sharing, liquidity, and information. These three terms describe financial services provided by the financial system through financial markets and financial institutions. To the extent that the financial system can provide risk-sharing opportunities, liquidity (ease of converting assets to cash, the most liquid of all financial assets), and information (about borrowers, lenders, future expectations, market prices, and a variety of other kinds of information), then financial markets succeed in fulfilling their objectives.

Sophtwear's auditor gives the company a qualified opinion for fear that the firm will not be able to finance continued operations should the new software fail. Why might demand for Sophtwear bonds shift to the left?

There is considerable risk of default

Explain the strengths and weaknesses of the "law of one price," or purchasing-power parity (PPP), in predicting long-run changes in exchange rates.

Think about the reasons why a homogeneous good with equal characteristics (also known as a fungible good, like wheat) would ultimately receive the same price in every country in which it is marketed. An entrepreneur with a sharp eye for price differences could scout countries in which a good could be purchased at a low price and then find a country in which the good could be simultaneously sold for a higher price (a process known as arbitrage). Thus, except for costs of transportation, prices for particular goods will tend to even out among countries, other things remaining equal. As the law of one price is extended to the pricing analysis of many good, we apply the theory of purchasing power parity (PPP). The PPP theory assumes that real exchange rates remain constant. If that assumption holds, then we can logically conclude that, if differences among exchange rates exist among countries, then that differential must be due to inflation differences among countries. Study the two equations on page 166. If inflation in a country rises, then its currency will attract fewer purchasers because the purchasing power of that currency has fallen, and the exchange rate for that currency will fall. Although the PPP theory is an attractive theory, analysts find that price differences among countries can be attributable to reasons other than inflation differentials. Sometimes people simply prefer goods from one country, or not all goods can be shipped everywhere, or products may not be alike, thus resulting in varying prices.

Describe each of the major classes of financial institutions, the source of funds for each and the use of funds for each institution.

This chapter introduces five basic financial institutions that comprise the financial system in the United States. These include: securities market institutions, investment institutions, contractual saving institutions, depository institutions, and government financial institutions. These institutions have one primary function—to match borrowers and savers in the financial system. Review the table on page 247. Note that commercial bank have the highest percentage of assets. Take some time to review how the allocation of assets has changed over time. What trends do you see? What governmental, technological or economic changes have influenced this division of assets? This chapter is basically a descriptive summary of each type of financial institution. Review carefully the definition of each institution and the sources and uses of funds for each. Identify the institutions in which you have assets. Have you made wise decisions?

Compounding

This process of earning interest on the interest (as well as on the principal) is known as compounding.

Financial Services

Three key services: Risk Sharing, Liquidity, and Information Services

Discuss how global interest rates and foreign borrowing affect domestic markets for bonds and loanable funds in both small open economies and large open economies.

Thus far in your economic analysis, we have assumed a closed economy (an economy without foreign trade). In reality however, most economies are typically open economies (or economies with foreign trade). To complete an analysis of equilibrium interest rates, we must take into account the fact that domestic bond markets and interest rates are affected by foreign interest rates and by the flows of investment funds among nations. Remember that here we are talking about real interest rates, or the nominal rate adjusted for the expected inflation rate. The general concept is that investors will lend funds where the highest return can be earned. Thus, if domestic lenders can earn higher interest rates abroad, they will lend funds to foreign borrowers. Read the "Checkpoint" discussion on page 123 regarding the effects of changes in Japanese lending patterns. The main point is that world interest rates will adjust so that an equilibrium is reached between desired international borrowing and desired international lending (figure 6.10, page 126 of the textbook).

Identify and explain the major factors responsible for short-run exchange rate fluctuations.

Thus far, we have examined the factors that influence long-run exchange rates. However, the daily or short-run exchange rates can also vary. Changes in domestic real interest rates, changes in domestic expected inflation, changes in foreign interest rates and expectations of (long-run) exchange rates can create immediate fluctuations.

Explain how the Fed conducts open market operations to influence the level of interest rates and the level of economic activity

To understand how the Fed conducts open market operations, you must first understand the way that banks work and the way that the Fed influences interest rates. Note: the Fed does not set interest rates, but influences these rates. The Fed can set in motion a series of steps that will ultimately change interest rates, but the final outcome depends on how the banks and the non-bank public, including businesses, react to the Fed's intent to seek changes in interest rates. The first basic step is to understand that the Fed's main tool in seeking interest rate changes is that of changing bank reserves. Each bank must retain a certain percentage of its demand deposits in reserve. Thus if a bank has $1 million in deposits, and the required reserve percentage is 10%, then it must hold $100,000 in reserves. These reserves cannot be loaned out and earn the bank no interest. For example: If required reserves are $100,000 against a new deposit of $1 million, then excess reserves, or reserves in excess of required reserves, are $900,000. These reserves can be loaned out or invested in interest bearing government bonds. The key is to recognize that each bank can loan out only an amount equal to but not exceeding its excess reserves. Example: If Zion's Bank in Salt Lake City loans $900,000 to me, then I will deposit that check in, another bank, the new bank has a new deposit of $900,000, which means it must have required reserves of $90,000 and it will have $810,000 to loan. In a continued chain reaction, the new bank loans $810,000 to someone else, who deposits the check for the loan in another bank. This third bank now has additional funds to loan out. Subtract 10% for required reserves from $810,000 ($81,000), thus, the third bank can loan ($729,000, or $810,000 minus $81,000). Assuming that each successive bank continues to loan out all of its excess reserves, you can see that each additional loan will get smaller and smaller until the amount of new loans made from excess reserves effectively approaches zero. A short cut to finding the total amount of deposits created by the chain process that started with the initial deposit of $100,000 (an infinite geometric progression) is to take the reciprocal of the required reserve ratio, or 1/.10 in this example. The result is called the simple money multiplier (we will modify the simple money multiplier later on to take account of variations in bank and depositor behavior). In this case, the simple money multiplier is 10 (or 1/.10, so we multiply the initial deposit of $100,000 by 10, and find that $1,000,000 in total new deposits has been created). Since the initial $100,000 deposit was already in the banking system, we subtract that amount from $1,000,000 and find that $900,000 in net new money (bank deposits) has been created. How has this creation of $900,000 in new deposits been possible? The creation of new money has been made possible by the ability of each bank with a new deposit to loan out all of its excess reserves (total reserves minus required reserves) for each new deposit. Now you can begin to see why the Fed would want to be able to control bank reserves so that it can facilitate changes in interest rates and economic activity. The larger the volume of bank deposits, the larger will be the volume of excess reserves. The larger the volume of excess reserves, the lower will be interest rates, the more profitable new loans will be to borrowers, and the more economic activity will take place. If the volume of excess reserves shrinks, the opposite events will take place: interest rates will rise, new loan volume will fall, and economic activity will decline. You can see now that if the Fed can control the volume of bank reserves, it can influence the level of economic activity and interest rates. How does the Fed alter the level of bank reserves throughout the banking system? The answer is that the Fed conducts Open Market Operations, which means that the Fed buys and sells government securities (bills, notes, and bonds) on the open U.S. government securities market. Visualize what happens if the Fed decides to buy bonds, say from a pension fund, or from anyone in the non-bank public. To buy a $1 million Treasury bond, the Fed must write out a check to the bond seller. What does the bond seller do with the check? Most likely, the seller deposits the check in a bank. Now you can complete the sequence. The bank now has $1 million in new deposits and, if the required reserve ratio is 10%, it has $900,000 in excess reserves, which it can loan. And so the money creation process begins. What if the Fed sells bonds? Then, a sequence opposite to that just indicated in the preceding paragraph occurs. Bond buyers must now write a check to the Fed, instead of getting a check from the Fed. When a bond buyer writes a check, bank deposits fall, excess reserves fall, and ultimately the volume of total reserves falls by a multiple of the initial decline in deposits caused by the bond buyer who wrote out a check to pay for the bonds purchased. The volume of excess reserves has a special name. Such reserves are called federal funds, or as they are more commonly known by their abbreviation, fed funds. Don't be misled and think these funds are federal funds that belong to the federal government. The term fed funds is the name for all of the excess reserves held by banks. Since the Federal Reserve influences the volume of excess bank reserves by open market operations in buying and selling government securities, excess bank reserves are called fed funds. Fed funds are owned by banks not the federal government. Just as many different interest rates exist, there is a special interest rate for fed funds known, not surprisingly, as the fed funds rate. The larger the volume of fed funds, the lower will be the fed funds rate (just like the price of corn falls after a bumper crop). Thus, the more bonds the Fed buys, the more checks it writes out and the greater will be the volume of total reserves, required reserves, and excess reserves. The more bonds the Fed sells, the more all bank reserves shrink, including fed funds (the excess reserves). The Fed's Open Market Committee meets approximately every five or six weeks to debate what course the Fed should take in influencing interest rates. Note that we said "influencing" rates; many people mistakenly think the Fed sets rates. The Fed can influence rates by buying and selling bonds. What happens next depends on choices made by banks and depositors. The final step in this preliminary Fed watching exercise is to note that fed funds (excess reserves) can be loaned out. That is, a bank that is short of required reserves can make up the deficiency with a short-term (probably overnight) loan, which it borrows in the fed funds market. If the volume of fed funds (excess reserves) is large, the fed funds rate will be low. Thus, if the Fed wishes to lower the fed funds rate, it will buy bonds and pump more money into the banking system. The fed funds rate is a beacon for other interest rates. If the fed funds rate rises, banks will probably raise the prime rate (the rate that banks charge their best commercial customers); credit card rates and mortgage rates and other rates will also rise. Then businesses will borrow less money, create fewer new projects, and output will fall. Higher mortgage rates mean fewer people can afford housing so fewer houses will be built, fewer loans will be made, and all the businesses tied to the housing industry will shrink. As you begin watching the Fed, you should be tracking the actions that the Open Market Committee takes to influence the fed funds rate. The economy follows the fed funds rate. You can find a wealth of information, including minutes of recent Federal Open Market Committee meetings on the Internet site for the St. Louis Fed. You should check The Wall Street Journal regularly to track the current fed funds rate. The rate is listed under "Money Rates," usually on the same page as the Credit Markets Report. Note that if the Fed seeks a particular fed funds rate, say 5.5%, the actual market rate for fed funds (excess bank reserves loaned by banks to one another) will likely fluctuate by several tenths of a point above or below the 5.5% mark. The Fed staff at the New York Fed's Open Market trading desk constantly watches the prevailing market rates to see if they must take any offsetting actions to try and keep the actual fed funds rate as close to the target rate as possible. Now your assignment is to begin watching the Fed by reading newspaper articles about interest rates and about likely future Fed actions concerning the fed funds rate.

Rally, a U.S. firm, and Fugai, a Japanese firm, are agricultural businesses that sell wheat at the wholesale level. Rally sells wheat in the United States for about 45% less then Fugai sells what in Japan. What might explain this phenomenon?

Trade barriers could prevent the sale of low-cost U.S. wheat in Japan

Derivative Markets

Trades are executed immediately, but the settlement is a later date

Branches

U.S banks operate wholly owned branches around the world to accept deposits and make loans

Which of the following is NOT an asset of the Federal Reserve System

U.S. Treasury Deposits

Calculate the yield to maturity (YTM) for simple loans and discount bonds, and explain the basic procedure for calculating yield to maturity for coupon bonds and fixed-payment loans (you will not be required to make the latter two calculations since they require either bond tables or pre-programmed financial calculators).

Understanding present value is a necessary first step to understanding yield to maturity (YTM). However, when interest rate is unknown, present value cannot be easily calculated. An alternate measure, called "Yield to maturity" can be used under these circumstances. In solving the yield to maturity calculation, find the interest rate that equates the price paid for an asset today with the discounted value of the future stream of returns from that asset. In other words, if you know the price of an asset, and you know the value of all future returns from the asset, then you must find the interest rate that equates the two values. By finding this interest rate, you can compare all types of different credit market instruments with any other instrument, regardless of differences in maturity or payment schedules. For this reason, economists consider the yield to maturity to be the best comparative measure of financial market returns. Follow the examples in the textbook to calculate the yield to maturity for simple loans and discount bonds. Note in the discussion that the same principles apply in calculating yield to maturity on coupon bonds and fixed-payment loans as in the case of simple loans and discount bonds. But also note that the calculations are too complex to do without pre-programmed calculators or special bond tables (which you can find on the Internet, or most finance or accounting textbooks).

Provision Information

Unfortunately, firms may not be willing to truly reveal information that is needed to evaluate the financial securities they issue. to overcome this problem, the government requires issuers of financial instrument to disclose relevant information. The 2002 Sarbanes-Oxley act further addresses the SEC's role in the prosecuting firms that release misleading accounting data

Which of the following countries does not formally target inflation

United States

Identify and explain the major factors that are responsible for long-run fluctuations in exchange rates.

Virtually all businesses and financial institutions are involved in some aspect with foreign currency. Almost every business has some foreign customers and buys some supplies, finished goods, or services from other countries. Thus, many businesses have foreign-exchange departments where specialists try to reduce the financial risk from currency fluctuations. Part of the task of currency-exchange analysts is to predict what will cause currency fluctuations and when these fluctuations are likely to occur. The determination of exchange-rate fluctuations centers on shifts in supply and demand, just like the price of any good or service when incentives affecting supply and demand for each good or service change. In short, when people want more dollars relative to other currencies, we say that the dollar rises (appreciates; that is, the price of the dollar in terms of a given foreign currency rises). When do people want more dollars? The answer is that people want more dollar-denominated assets when they can make more money by investing in U.S. assets than they can make investing in assets of other nations. Thus, after taking taxes, inflation, exchange rate fluctuations, economic stability, preferences for goods and services, and any other factor that could affect the exchange rate of the dollar into account, we can assess why the dollar can be expected to fluctuate. Some additional major factors affecting trends in long-run exchange rates include price level differences, productivity differences preferences and trade barriers. Pay close attention to the effect of trade barriers for exchange rates for the country imposing the barrier.

Explain how changes in default risk affect the default risk premium

We now expand our discussion of default risk. (Understanding default-risk premiums is critical in evaluating yield differentials.) Look at the "Using the News" box on page 143 of the textbook, which provides a good example of how to use bond yields to assess risk. Note that the current yield (C/P) comes closer to the yield to maturity (F-D/D) as the maturity of bonds increases. If everything else (tax, liquidity, and information characteristics) is held constant for long-term bonds, then yield differentials must be identifiable as default-risk premiums.

Use the simple deposit multiplier to show how multiple deposit expansion and multiple deposit contraction occur when bank reserves rise or fall.

We now review the simple deposit multiplier. This multiplier explains how multiple deposit expansion follows an initial increase in deposits and how multiple deposit contraction follows an initial drop in deposits. Remember that each change in deposits leads to a subsequent change in total reserves, excess reserves, and required reserves. If all excess reserves are loaned, a sequence of loans and deposits occurs as each loan is subsequently deposited in the banking system. The effect on the ultimate total change in deposits is summarized in the formula for the simple deposit multiplier, or 1/required reserve ratio. Thus, if the required reserve ratio is .10, the multiplier is 10. A new deposit of $1,000 ultimately leads to a total change in deposits for the banking system as a whole of $10,000. Since the initial deposit of $1,000 was already in the money supply, only $9,000 in new money has actually been created. Note carefully what happens when multiple deposit contraction occurs. First, if the Fed sells a bond directly to a bank, the bank's reserves are short by the amount of the security transaction. If the bank purchasing the security meets its reserve shortage by selling securities to a depositor in another bank, then that bank will find itself short of reserves after the depositor writes out a check to pay the bank selling the security. Follow the sequence of events that occur following the initial decline in deposits as outlined in the textbook. Be sure you see that the simple deposit multiplier (1/required reserve ratio) works exactly the same way as it does for deposit expansion when deposits are withdrawn, only in reverse.

List the pros and cons associated with maintaining the current level of Fed independence from the executive and legislative branches of the federal government.

When Congress or even a President of the United States gets irritated over the actions of the Fed (usually because the Fed won't stimulate the economy sufficiently), lawmakers occasionally propose holding the Fed to stricter accountability and control. Is such a move a good idea in terms of the ability of the Fed to achieve its goals of maintaining a sound financial system and a stable economy? Among factors considered in evaluating Fed independence are the issues of the principal-agent view (in which the Fed is seen as promoting its own power), and the public interest view (page 443 through 445 of the textbook). Probably the overriding concern is that less Fed independence means more politicization and more inflation, and that may be the main reason that the Fed is not likely to lose much independence in the near future.

Explain the efficient markets hypothesis and evaluate the validity of the efficient markets hypothesis.

When rational expectations are used to set equilibrium asset prices in financial markets, then such prices should equal the market forecast of fundamental value. Under these circumstances, the asset's market price is said to convey unbiased signals on which financial market participants can base their decisions (pages 206 and 207 of the textbook). Consider the information embodied in price data. Supply and demand interact to set an equilibrium market price. If markets are efficient; (free to operate without undue exercise of market power of monopolists or oligopolists), or without undue government interference, prices convey correct information to guide market participants. Prices set in efficient markets can be relied upon to reflect all costs, both social and private, in producing a certain good or service. Moreover, equilibrium prices set in efficient markets correctly measure the gain, or marginal benefit, that buyers would receive if they bought the product. Thus, market prices set by the interaction of supply and demand, without undue influence of market power, are said to be efficient in terms of minimizing waste in the economic system. Similarly, the concept of efficient markets can be applied to the analysis of financial markets. The efficient markets hypothesis states that when participants apply rational expectations (that is, when they use all relevant information to make decisions) in financial markets, then the equilibrium price of a financial asset will be equal to the asset's fundamental value, or the price of a financial asset is equal to the present (discounted) value of the future stream of returns from that asset. Think about the kinds of information embodied in the price of a financial asset such as a bond or a share of stock. Buyers and sellers of securities have thought about profitability of a company, default risk, macroeconomic conditions concerning output, employment, inflation, possible changes in Federal Reserve policy affecting interest rates, possible changes in tax and securities laws and regulations, and countless other bits and pieces of information. The interaction of securities sellers and securities buyers results in an equilibrium market price. Is the efficient market hypothesis valid? Do market participants actually make use of all available information? Or is information too costly and does using and understanding such information require more technical expertise than most people have? Yet people who do participate in financial market transactions must base their decisions on the amount of information they have and on the level of understanding they have attained. Market analysts and researchers have developed a number of theories about how sound the efficient markets hypothesis is as a reliable signal of fundamental value. If information flaws exist in providing faulty price signals, then incorrect decisions may occur. Review the discussion of "Actual Efficiency in Financial Markets" beginning on page 214 of the textbook.

Discuss the circumstances under which banks will seek discount loans and identify the pros and cons of Fed discount loan policy.

When the Federal Reserve System was first established in 1913, a principal goal was to help avert financial crises and bank failures by serving as a lender of last resort; that is, when all else failed, the Fed would help eligible banks remain viable. The discount rate is the interest rate that the Fed charges depository institutions for discount loans. The discount rate has fluctuated both above and below the fed funds rate; however, in recent years the discount rate has often been below the fed funds rate. Borrowing at the discount window is not necessarily without drawbacks: the Fed likely will monitor the loan and will frown on applications for repeated borrowings. Changes in the discount rate have been interpreted as signals of Fed intentions with respect to interest rates (page 459 of the textbook).

Discuss how the federal government budget deficit affects the monetary base.

When the U.S. government makes more expenditures (G) than it has in tax revenues (T), the result is a budget deficit. There are only two ways to pay for government expenditures: taxes and borrowing. Borrowing means selling U.S. government securities. Thus, the government deficit is equivalent to the total amount of U.S. Treasury security sales. These securities can be purchased by the banks, by the nonbank public (including foreign purchasers), and by the Fed. The Fed may buy securities directly from the Treasury. Note the impact of such purchases by the Fed on the monetary base. Any Fed purchase of securities from any seller results in an increase in the monetary base because the Fed must write out a check to pay for the securities, and the check is then deposited in the banking system, leading to an increase in bank reserves. Now consider the equation for the government budget constraint (equation 18.6, page 426 of the textbook) which states that the federal budget deficit is the sum of changes in Treasury securities held by banks and the nonbank public plus Fed purchases of Treasury securities. Since Fed purchases of Treasury securities lead to an increase in the monetary base, the federal budget deficit is alternatively the sum of changes in Treasury securities held by banks and the nonbank public plus changes in the base. The equation is called the government budget constraint because it highlights the fact that there are only two ways the federal budget deficit can be financed through Treasury security sales. Treasury securities can be purchased either by banks and the nonbank public or by the Fed. When the Fed helps finance the deficit by buying Treasury securities, this action is called monetizing the debt. This process is sometimes called financing by printing money, but this conclusion is not strictly correct because the Fed is actually buying securities for its own portfolio. Before you leave this objective, review the T-accounts on pages 427 through 429 of the textbook and make sure that you can compare and explain the effects of raising taxes on changes in the monetary base.

Agents

intermediaries that represent either buyers or sellers on a permanent basis

liquidity

Which is the ease with which an asset can be exchanged for money to purchase other assets or exchanged for goods or services

Explain how the capital asset pricing model (CAPM) and the arbitrage pricing theory (APT) are used to model risk premiums.

You will often see the term beta, or ß, mentioned in financial analyses as a measure of risk. The larger the beta for a stock, the relatively greater the (idiosyncratic) risk. The problem of risk in financial markets, is that, the larger the risk, the less willing investors are to hold the asset. Thus, investors are said to pay a risk premium if they seek unusually high returns. Efforts to measure this risk premium have led to the development of two asset-pricing models: (1) the capital asset pricing model (CAPM) and (2) the arbitrage pricing theory. Investors are said to arbitrage if they simultaneously buy something at some price in one market and seek to sell it for a higher price in another market.

Direct disclosure of information is not adequate to overcome adverse selection because

Young companies may not have an adequate track record, and high risk firms will attempt to report information in the best possible manner

negotiable order of withdrawal (NOW) account

a checking account on which the financial institution pays interest; NOWs have no legal minimum balance

Automated Teller Machine (ATM)

a computer terminal that allows a withdrawal of cash from an account

options contract

a contract under which the offeror promises to keep her offer open to the offeree until a specified date

aggregate demand curve

a curve that shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level

Simple Loan

a debt instrument in which the borrower receives from the lender an amount called the principal and agrees to repay the lender the principal plus interest on a specific date when the loan matures

Negotiable bank certificates of deposit

a debt instrument sold by a bank to depositors that pays annual interest of a given amount and at maturity pays back the original purchase price

Fixed Payment Loan

a debt instrument that requires the borrower to make regular periodic payments of principal and interest to the lender

multiple deposit expansion

a function used to describe the amount of money a bank creates in additional money supply through the process of lending the available capital it has in excess of the bank's reserve requirement

Expected Inflation

a future rate of inflation that consumers and firms build into current decision making

inflation

a general increase in prices and fall in the purchasing value of money.

A financial instrument with high information costs also tends to have

a high default risk

Adverse selection

a lender's problem of distinguishing the good-risk applicants form the bad-risk applicants before making an investment

Credit rationing

a lender's refusal to make loans even though borrowers are willing to pay the stated interest rate or even a higher rate or restriction of the size of loans made to less than the full amount sought

Moral Hazard

a lender's verification that borrowers are using their funds as intended

Variations across countries in protection of minority shareholders and creditors and in the efficiency of the judicial system in adjudicating disputes

can lead to less well-developed financial markets

Standby letters of credit make issuing commercial paper easier by

ensuring that the commercial paper issuer will have funds to redeem the paper at maturity

New Keynesian view

holds not only that the money wage rate is sticky but also that prices of goods and services are sticky

agency office

in a foreign country makes loans and transfers, but does not accept deposits, and is therefore not subject to depository regulations in either the domestic or foreign country

Securities market institutions

in particular, investment banks, brokers and dealers, and organized exchanges

the Fed engages in an open market purchase of securities of $800,000 form First National Bank of America. If the required reserve ratio on checkable deposits is 6%, the change in First National's excess reserve position resulting from the open market operation is

increase of $800,000

What was the consequence of the FDIC's decision to guarantee both insured and uninsured deposits of Continental Illinois when it failed in 1984?

increased risk taking by other large banks

demand-pull inflation

increases in the price level (inflation) resulting from an excess of demand over output at the existing price level, caused by an increase in aggregate demand

Brokers

independent firms or individuals whose principal function is to bring buyers and sellers together to make sales

Idiosyncratic risk refers to variations in returns on

individual assets

Loan Syndications

individual banks hold fractions of loans

By agreeing to honor a banker's acceptance, a bank reduces

information costs

By placing their reputations on the line concerning the businesses they underwrite, investment bankers provide which financial service

information services

Swaps are used to protect a bank against

interest rate risk

You read that there has been a rally in the bond market. From this information, you might surmise that

interest rates have fallen

According to the new Keynesians, the cost of reducing the inflation rate is

lost jobs and output

Th effective tax rate on capital gains relative to interest income is

lower because taxes on capital gains are deferred

An anticipated decrease in money supply growth, according to the new classical approach will

lower inflation in the short run but leave real output unchanged in the short run

Jennifer Burger is an investment banker who has been involved in 23 initial public offerings (IPO's) over the last five years. Yesterday, the SEC announced that it was investigating Ms. Burger in regard to potential fraud allocated with several IPO's. Investigations continue. What is the most important reason why the risk premium on IPO's recommended by Ms. Burger would increase?

lower liquidity

An anticipated decrease in the money supply, according to the new Keynesian approach, will

lower the price level and real output in the short run

Federal reserve repurchase agreements

managers use these

The aggregate demand curve has a

negative slope because higher prices cause higher interest rates, which in turn reduce aggregate demand

Marisa believes that monetary policy can be effective in shortening recessions but that expectations are important. She is probably a

new Keynesian

Kenny does not believe that anticipated changes in money growth can affect the economy. He is probably a

new classical

In the 1980's, Paul Volker pursued a policy of rapid disinflation. This indicates that Federal reserve officials views were most likely influenced by

new classicals

The larges source of bank funds is

nontransaction deposits

A treasury security that has a maturity of 7 years is called a

note

currency premium

number that indicates investors' collective preference for financial instruments denominated in one currency relative to those denominated in another

The federal government, in an attempt to prevent a repeat of the 1980 S&L crisis, took a number of actions. Which of the following actions was NOT taken?

reducing the amount of housing-related loans an S&L can make

Financing government spending by raising taxes will ultimately cause the monetary base to

remain unchanged

Which of the following is the most liquid bank asset

reserves

Required Reserves

reserves that a bank is legally required to hold, based on its checking account deposits

Required reserves

reserves that a bank is legally required to hold, based on its checking account deposits

Excess Reserves

reserves that banks hold over and above the legal requirement

excess reserves

reserves that banks hold over and above the legal requirement

A government budget deficit will

result in expansion of the monetary base only if the Treasury sells securities to the Fed

political business cycle

results when politicians use macroeconomic policy to serve political ends

Banks avoid the free-rider problem by

retaining loans so as to profit from information gathered

In a small open economy, the domestic supply of loanable funds equals the domestics demand for loanable funds at the would interest rate of 6%. As a result of an improved economic outlook, we would expect the domestic demand curve for loanable funds to shift___________ and the equilibrium real interest rate to _________

right, not be changed

Stocks

shares of ownership in a company

An increase in the price of raw materials, according to the new Keynesian view will,

shift the short-run supply curve to the left and leave the long-run supply curve unaffected

U.S Treasury Bills

short-term marketable IOUs issued by the U.S. federal government

Collateral

something pledged as security for repayment of a loan, to be forfeited in the event of a default.

Banks are the main source of external funds for business because banks

specialize in gathering information

Diversification reduces risk by

spreading wealth over various assets, reduces the average risk