ECN Midterm 2

If the reserve ratio is 5 percent, then $500 of new reserves can generate

$10,000 of new money in the economy. -f the reserve ratio is 5 percent, the money multiplier is 1/0.05=20. Therefore, $500 in new reserves can generate 20 X $500 =$10,000 in new money in the economy.

Feds two jobs

1. The first is to regulate banks and ensure the health of the banking system. 2. to control the quantity of money that is made available in the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy.

The manager of the bank where you work tells you that your bank has $10 million in excess reserves. She also tells you that the bank has $200 million in deposits and $165 million in loans. Given this information you find that the reserve requirement must be

25/100 -If a bank has $200 million in deposits, and has loaned out $165 million of those deposits, then it has kept $200 million -$165 million = $35 million as reserves. Of those $35 million in reserves, $10 million are excess reserves. This means that the bank was only required to keep $35 million -$10 million = $25 million in reserves. This means that of $200 million deposited, the bank is only required to keep $25 million in reserves. This equates to a 25/200, or 12.5% reserve requirement.

Suppose that the inflation rate is 2% and the real interest rate is 4%. What is the nominal interest rate?

6% -The nominal interest rate equals the real interest plus the inflation rate: 4% + 2% = 6%.

Bond

A bond is a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond. Put simply, a bond is an IOU. It identifies the time at which the loan will be repaid, called the date of maturity, and the rate of interest that will be paid periodically until the loan matures.

Adverse Selection

A high-risk person is more likely to apply for insurance than a low-risk person because a high-risk person would benefit more from insurance protection.

Which of the following investment options would a risk averse investor of $100,000 prefer?

A risk-free government bond that pays 3% each year for two years.

The markets for insurance suffer from two types of problems that impede their ability to spread risk

Adverse selection and Moral Hazard

Moral Hazard

After people buy insurance, they have less incentive to be careful about their risky behavior because the insurance company will cover much of the resulting losses

Market for Loanable Funds

All savers go to this market to deposit their saving, and all borrowers go to this market to take out their loans. Thus, the term loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption, and to the amount that investors have chosen to borrow to fund new investment projects.

Which of the following does the efficient market hypothesis imply?

An index fund is a mutual fund that buys all the stocks in a given stock index. The performance of these funds can be compared with that of actively managed mutual funds, where a professional portfolio manager picks stocks based on extensive research and alleged expertise. In essence, an index fund buys all stocks, whereas active funds are supposed to buy only the best stocks. -In practice, active managers usually fail to beat index funds

Which of the following explains the effect of an investment tax credit on the market for loanable funds?

An investment tax credit would encourage borrowing at each real interest rate level.The demand curve for loanable funds shifts to the right causing both the equilibrium quantity of loanable funds and the equilibrium interest rate to increase.

Suppose Klara is a risk averse person, which of the following games might she play?

As a risk averse individual, Klara dislikes a loss more than is pleased by a comparable gain. Therefore, she will only play a game when the chance of winning a certain amount is significantly higher than the chance of losing the same amount. Then a game where she has a 60% chance of winning $1 and a 40% chance of losing $1 is the only worthwhile option for Klara.

Which of the following describes the difference between compounding and discounting?

Compounding produces a future value, whereas discounting produces a present value.

Consider an economy with GDP = $8.7 trillion, consumption spending = $6.1 trillion, taxes net of transfers = $1.0 trillion, and government purchases = $0.8 trillion. Which of the following is true for the described economy

Correct. Private saving is GDP net taxes and consumption: Y - T - C = $8.7 trillion - $1.0 trillion - $6.1 trillion = $1.6 trillion. Investment is the source of the demand for loanable funds, which is I = Y - C - G = $8.7 trillion - $6.1 trillion - $0.8 trillion = $1.8 trillion.

If the natural rate of unemployment is 5 percent and the actual rate of unemployment is 5.5 percent, then by definition there is

Cyclical unemployment is the difference between actual unemployment and unemployment at its natural rate. So, cyclical unemployment = .5 percent of the labor force. The natural rate of unemployment includes both frictional and structural unemployment.

reserves

Deposits that banks have received but have not loaned out are called reserves. In this imaginary economy, all deposits are held as reserves, so this system is called 100-percent-reserve banking.

Which of the following is an example of an efficiency wage?

Efficiency wages are above equilibrium wages intended to produce worker productivity. For example, higher wages attract a better pool of applicants.

The term "efficient markets hypothesis" refers to

Efficient markets hypothesis refers to informational efficiency of the stock market. Stock prices reflect all available information about the value of the asset. Stock prices change when information changes.

S=I

For the economy as a whole, saving must be equal to investment.

Inflation Rate

Hence inflation rate can be found as the difference between the nominal interest and the real interest rate: 6.5% - 3% = 3.5%.

Budget Surplus

If T exceeds G, the government runs a budget surplus because it receives more money than it spends. This surplus of T − G represents public saving. -It contributes to national saving as the government saves the difference by retiring some of the outstanding government debt. Thus the amount of loanable funds increases. As a result, the supply curve for loanable funds shifts to the right causing the equilibrium real interest rate to decrease and the equilibrium quantity of loanable funds to increase.

Budget Deficit

If the government spends more than it receives in tax revenue, then G is larger than T. In this case, the government runs a budget deficit, and public saving (T − G) is a negative number. -public saving is negative, and this reduces national saving at each real interest rate level. As a result, the supply curve for loanable funds shifts to the left, the equilibrium quantity of loanable funds available to finance investment by households and firms decreases, whereas the equilibrium real interest rate increases.

fairly valued

If the price and the value are equal, the stock is said to be fairly valued.

Undervalued

If the price is less than the value, the stock is said to be undervalued.

Fundamental analysis shows that the stock of Gold Fish corporation has a present value that is lower than its price. Which of the following is true?

If the price is less than the value, the stock is said to be undervalued. If the price exceeds the value, the stock is said to be overvalued.

Over valued

If the price is more than the value, the stock is said to be overvalued.

In a closed economy, GDP is $12 trillion, consumption is $7 trillion, taxes net of transfers are $3 trillion and the government runs a deficit of $1 trillion. What are private saving and national saving?

In a closed economy, private saving is (Y - T - C) = ($12 trillion - $3 trillion - $7 trillion) = $2 trillion. National saving is a sum of private saving (Y - T - C) and public saving (T - G), which is -$1 trillion. Thus S = $2 trillion + (-$1 trillion) = $1 trillio

A bank which must hold 100 percent reserves opens in an economy that had no banks and a total initial money supply (currency) of $1,000. If customers deposit $87 into the bank, what is the value of the money supply?

Incorrect. Banks in a 100-percent-reserve-banking system accept deposits, but do not loan out the reserves. The deposits are held until the depositor accesses the account with a check or debit card. Each deposit in a bank reduces currency, since the money will no longer be in the hands of the public, and increases the demand deposit portion of M1 by the same amount. Each withdrawal decreases the demand deposits of M1, but increases currency by the same amount. Therefore banks do not influence the money supply in a system of 100-percent-reserve banking. In this case, if a customer deposits $87 into her checking account, currency will decrease by $87 but at the same time demand deposits will increase by $87 leaving M1 unchanged. Therefore, the money supply does not change and remains at $1,000.

fiat money

Money without intrinsic value -think of paper dollar and why we can only use that and not monopoly

In a small closed economy investment is $55 billion and private saving is $50 billion. What are public saving and national saving

National savings is a sum of private saving and public saving. Thus public saving is the difference between national saving and private saving: $55 billion - $50 billion = $5 billion. At the same time, the accounting identity shows that national saving and investment are equal for the economy as a whole, S = I. Thus national saving, S = $55 billion.

In a small closed economy investment is $50 billion and private saving is $45 billion. What are public saving and national saving?

National savings is a sum of private saving and public saving. Thus public saving is the difference between national savings and private saving: $50 billion - $45 billion = $5 billion. At the same time, the accounting identity S = I shows that national saving and investment are equal for the economy as a whole. Thus national saving, S = $50 billion.

Municipal bonds

Owners of municipal bonds issued by state and local governments, are not required to pay federal income tax on the interest income. Because of this tax advantage, such bonds typically pay a lower interest rate than bonds issued by corporations or the federal government.

Consider a closed economy with a government deficit and positive investment. Which of the following is correct?

Private saving is the amount of income that households have left after taxes and paying for consumption. This closed economy has positive investment because households earn more than they consume and pay in taxes, which leads to positive private saving. Public saving is the amount of tax revenue left after government spending. A government deficit implies that the amount of tax revenue falls short of the government spending, which means that public saving is negative.

Which of the following is an example of stock market irrationality?

Speculative bubbles in the stock market occur because the price that people pay for stock depends on what they think someone else will pay for it in the future.

Suppose that Black&White Company announces that its revenue in the last quarter decreased by less than its investors had anticipated. According to the efficient markets hypothesis, the value of the company's stock will decline.

Stock prices change when information changes. When good and unexpected news becomes public, the value and the stock price both should rise. The fact that Black&White Company's revenue declined by less than investors had anticipated, is a good news and the efficient markets hypothesis predicts that the value of the company's stock should increase.

Suppose you have to choose between two bonds. The interest rate on one bond is 5% and the interest rate on the other is 2%. Which of the following is likely to be true about these bonds?

The 2% bond is a municipal bond, and the 5% bond is a U.S. government bond

Money Multiplier

The amount of money the banking system generates with each dollar of reserves i -reciprocal of reserve ratio

The principal (of a bond)

The buyer of a bond gives his money to Intel in exchange for this promise of interest and eventual repayment of the amount borrowed (called the principal). The buyer can hold the bond until maturity, or he can sell the bond at an earlier date to someone else.

National saving (or saving) is the total income in the economy that remains after paying for consumption and government purchases: (Y - C - G).

The fact that national saving is positive, greater than zero, means that (Y - C - G) > 0.

If the reserve ratio is 20 percent, then $150 of new reserves can generate

The formula for the money multiplier is 1/R, where R represents the reserve ratio of all banks in the economy. If the reserve ratio is 20 percent, the money multiplier is 1/0.2=5. Therefore, $150 in new reserves can generate 5 X $150 =$750

reserve ratio

The fraction of total deposits that a bank holds as reserves

Consider a closed economy, in which S = (Y - T - C) + (T - G) holds. What does this identity imply if the government's tax revenue is equal to its expenditures?

The government receives T in tax revenue and spends G on goods and services. If T = G, then S = (Y - T - C), which means that national saving equals private saving.

A shift of the supply curve of loanable funds to the left causes the equilibrium interest rate to increase.

The higher interest rate will discourage investment and decrease the equilibrium quantity of loanable funds.

Standard Deviation

The higher the standard deviation of a portfolio's return, the more volatile its return is likely to be, and the riskier it is that someone holding the portfolio will fail to get the return that she expected.

Natural Rate of Unemployment

The normal rate of unemployment around which the unemployment rate fluctuates

Collective Bargaining

The process by which unions and firms agree on the terms of employment is called

Bank capital

The resources that a bank obtains from issuing equity to its owners are called

Equity Finance

The sale of stock to raise money

Frictional unemployment

The unemployment that results from the process of matching workers and jobs -explains short spells of unemployment -caused by job search and sectoral shifts

Discouraged Workers

These individuals may have tried to find a job and may have given up after an unsuccessful search.

Not in Labor Force

This category includes those who fit neither of the first two categories, such as full-time students, homemakers, and retirees.

Unemployed

This category includes those who were not employed, were available for work, and had tried to find employment during the previous four weeks. It also includes those waiting to be recalled to a job from which they had been laid off.

Employed

This category includes those who worked as paid employees, worked in their own business, or worked as unpaid workers in a family member's business. Both full-time and part-time workers are counted. This category also includes those who were not working but who had jobs from which they were temporarily absent because of, for example, vacation, illness, or bad weather.

Suppose that consumers decide to ride buses more often and own fewer cars. Bus companies hire more drivers, while automobile companies lay off workers. The unemployment this creates is an example of

This is an example of a sectoral shift which creates frictional unemployment.

Structural

This occurs when the quantity of labor supplied exceeds the quantity demanded.. -results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one -wages are kept above equilibrium -contributes to natural rate of unemployment

A higher discount rate discourages banks from borrowing reserves from the Fed.

Thus, an increase in the discount rate reduces the quantity of reserves in the banking system, which in turn reduces the money supply

Suppose that Bertha's wealth is $11,000. Which of the following explains why Bertha is risk averse?

Utility gain from additional $1,000 is less than utility loss from losing $1,000.

Surplus of labor occurs when

When a minimum-wage law forces the wage to remain above the level that balances supply and demand, it raises the quantity of labor supplied and reduces the quantity of labor demanded compared to the equilibrium level.

A national chain of grocery stores with limited internal funds plans to expand by opening several new stores. Which of the following describes how the chain will likely raise the required funds?

When corporations, such as a national chain of grocery stores need to finance a business expansion such as a new store or a factory, they usually borrow from the public by issuing bonds a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond.

Commodity Money

When money takes the form of a commodity with intrinsic value ex:gold, cigs

The efficient markets hypothesis implies that a worse-than-expected news about a company's performance will

When unexpectedly bad news becomes public, the value and the stock price both should decline. The fact that the company has performed worse than investors had anticipated is a bad news and the efficient markets hypothesis predicts that the value of the company's stock will decline.

Which of the following bonds has the highest risk of default (or credit risk)?

Which of the following bonds has the highest risk of default (or credit risk)? -By contrast, The U.S. government bonds have the lowest risk of default and offer low rates of return.

fractional reserve banking

a banking system in which banks hold only a fraction of deposits as reserves

Which of the following includes everyone in the adult population that the Bureau of Labor Statistics counts as "unemployed?"

anyone who is not employed, is available for work, has looked for work in the past four weeks, and anyone who is waiting to be recalled from a job from which they have been laid off.

An argument against the presence of unions is that they

are a cartel

An argument for the presence of unions is that they ____

are a necessary antidote to the market power of firms

stocks and bonds

are examples of stores of value, but not units of account nor medium of exchange.

Financial intermediaries

are financial institutions through which savers can indirectly provide funds to borrowers. The term intermediary reflects the role of these institutions in standing between savers and borrowers ex: banks and mutual funds

Dividends

are the cash payments that a company makes to its shareholders.

REMEMBER

as in the world, most spells of unemployment are short, but most unemployment observed at any given time is long-term.

demand deposits

balances in bank accounts that depositors can access on demand simply by writing a check or swiping a debit card at a stor

if banks hold all deposits in reserve,

banks do not influence supply of money

If the money multiplier is 5 and the Fed wants to increase the money supply by $100,000, it could

buy $20,000 worth of bonds

The Fed can also increase the quantity of reserves in the economy

by lending reserves to banks

who's in charge of monetary policy

by the Federal Open Market Committee (FOMC). The FOMC meets about every six weeks in Washington, D.C., to discuss the condition of the economy and consider changes in monetary policy.

Which of the following most accurately describes what data are included in fundamental analysis of the value of a stock?

capitalization. 2) historical earnings trends. 3) inflation rates.

A shift of the supply of loanable funds to the right

causes the equilibrium interest rate to fall. Lower interest rates stimulate borrowing and investment and increase the equilibrium quantity of loanable funds.

Sectoral shifts

changes in the composition of demand among industries or regions

Stock Index

computed as an average of a group of stock prices.

Efficiency wages

create a surplus of labor and so create structural unemployment.

M1

currency, demand deposits, travelers checks and other checkable deposits

Quantity of loanable funds demanded

declines when interest rate rises

If the minimum wage were currently above the equilibrium wage, then a decrease in the minimum wage that kept it above equilibrium would _____ the _______ of labor.

decrease the surplus

As the term to maturity of a bond increases, the interest rate

decreases because the bond's risk increases. -Long-term bonds are riskier than short-term bonds because holders of long-term bonds have to wait longer for repayment of principal. If a holder of a long-term bond needs his money earlier than the distant date of maturity, he has no choice but to sell the bond to someone else, perhaps at a reduced price. To compensate for this risk, long-term bonds usually pay higher interest rates than short-term bonds.

In a system of fractional-reserve banking, the amount of money in the economy depends on the behavior of ____

depositors and bankers, which prevents the Fed from perfectly controlling the money supply.

liquidity

describe the ease with which an asset can be converted into the economy's medium of exchange. Because money is the economy's medium of exchange, it is the most liquid asset available. Other assets vary widely in their liquidity. Most stocks and bonds can be sold easily with small cost, so they are relatively liquid assets. By contrast, selling a house, a Rembrandt painting, or a 1948 Joe DiMaggio baseball card requires more time and effort, so these assets are less liquid.

Suppose that fundamental analysis indicates a particular company's stock is overvalued. Which of the following is true?

don't add it

Efficiency Wage Theory

emphasizes the link between wages and worker health, wages and worker turnover (Firms with higher turnover, therefore, will tend to have higher production costs. Firms may find it profitable to pay wages above the equilibrium level to reduce worker turnover, 3 worker quality, worker effort

a lower discount rate

encourages banks to borrow from the Fed, increasing the quantity of reserves and the money supply

M2

everything in M1 plus savings deposits, small time deposits, money maker mutual funds, and few minor categories

Since the 1940's U.S. union membership has

fallen. This decline should have reduced the natural rate of unemployment

People who report not being in the labor force but who, in fact, want to work but have given up trying to find a job after an unsuccessful search cause the reported unemployment rate to be higher than otherwise.

false. Discouraged workers do not count in labor system

If the efficient markets hypothesis is correct then some stocks may be better buys than other.

false. If the efficient markets hypothesis is correct, that all stocks are fairly valued all the time and that no stock is a better buy than any other.

In the 1990s, Fed Chairperson Alan Greenspan questioned whether the stock market

fed Chairman Alan Greenspan questioned whether the boom reflected "irrational exuberance."

A wage above equilibrium

helps explain structural unemployment and the natural rate of unemployment

Index Fund

holds all the stocks in a given stock index.

Suppose the money multiplier has increased. Which of the following is the most likely cause?

if the money multiplier gets bigger it must be because the reserve ratio has gotten smaller.

The Efficient Market Hypothesis

implies that all stocks are fairly valued all the time and that no stock is a better buy than any other.

Efficiency Wages

increase productivity and profits.

Efficiency Wages

increase profits and unemployment

An argument for the presence of unions is that they

increase the happiness and productivity of workers.

Suppose that coffehouse employees are not unionized. If they unionize, then the supply of labor in other sectors of the economy will

increase, reducing wages in industries that are not unionized.

If the minimum wage is above the equilibrium wage, then an increase in the minimum wage ______ the quantity of labor supplied and ______ the quantity of labor demanded.

increases, decreases

Union

is a worker association that bargains with employers over wages, benefits, and working conditions

Mutual Fund

is an institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both stocks and bonds.

medium of exchange

is an item that buyers give to sellers when they purchase goods and services. When you go to a store to buy a shirt, the store gives you the shirt and you give the store your money.

store of value

is an item that people can use to transfer purchasing power from the present to the future. When a seller accepts money today in exchange for a good or service, that seller can hold the money and become a buyer of another good or service at another time. Money is not the only store of value in the economy: A person can also transfer purchasing power from the present to the future by holding nonmonetary assets such as stocks and bonds.

cyclical unemployment

is closely associated with the short-run ups and downs of economic activity.

A tax credit repeal

is essentially a tax increase. An increase in the tax on investments would decrease the demand for investment.

The interest earned on bonds issued by the city of Sacramento, California

is not subject to federal income tax and, thus such bonds pay a lower interest rate than comparable bonds issued by the U.S. government. -Owners of municipal bonds issued by state and local governments, are not required to pay federal income tax on the interest income. Because of this tax advantage, such bonds typically pay a lower interest rate than bonds issued by corporations or the federal government.

closed economy

is one that does not interact with other economies. In particular, a closed economy does not engage in international trade in goods and services, nor does it engage in international borrowing and lending.

Private Saving

is the amount of income that households have left after paying their taxes and paying for their consumption.

Public saving

is the amount of tax revenue that the government has left after paying for its spending. The government receives T in tax revenue and spends G on goods and services.

Job Search

is the process of matching workers with appropriate jobs

leverage ratio

is the ratio of the bank's total assets to bank capital.

unit of account

is the yardstick people use to post prices and record debts. When you go shopping, you might observe that a shirt costs $50 and a hamburger costs $5. Even though it would be accurate to say that the price of a shirt is 10 hamburgers and the price of a hamburger is of a shirt, prices are never quoted in this way.

capital requirements

is to ensure that banks will be able to pay off their depositors (without having to resort to government-provided deposit insurance funds)

Term

length of time until bond matures

The worker health version of the efficiency wage theory is

less relevant for explaining unemployment in developed countries than in less developed countries.

If you want to measure and record economic value, you will primarily use which function of money?

money as a unit of account -think of student loans

In a closed economy...

national savings is a sum of private saving and public saving: (-$2 trillion) + $4 trillion = $2 trillion. -At the same time, the accounting identity S = I shows that national saving and investment are equal for the economy as a whole. Thus, investment, I = $2 trillion.

Which of the following decrease when the Fed makes open market purchases?

neither currency nor reserves

Unemployed include:

people without jobs who have looked for work in the past four weeks and the number of people who are on temporary layoff expecting to be recalled. So, the number unemployed = 900 + 100 = 1,000.

when interest rate falls,

people would tend to borrow more causing the quantity demanded of loanable funds to increase. At the same time, lower interest rates make saving less attractive, thus the quantity of loanable funds supplied declines.

Consider a closed economy, in which S = (Y - T - C) + (T - G). In this identity, what does (T - G) represent?

public saving

Efficiency wages

raise structural unemployment.

According to the definitions of private and public saving, if Y, C, and G remained the same, a decrease in taxes would

reduce public saving and raise private saving.

Fundamental Analysis

refers to the detailed analysis of a company to estimate its value.

Stock

represents ownership in a firm and is, therefore, a claim to the profits that the firm makes.

One purpose of government sponsored job training is to reduce

rictional unemployment by giving workers skills to work in growing industries.

Suppose that neither workers in the paper industry nor workers in the furniture industry are unionized. If workers in the paper industry unionize, the supply of workers in the furniture industry will

rise, reducing the wages of workers in the furniture industry.

Suppose that autoworkers are unionized. If autoworkers choose to abolish their union, then the quantity of autoworkers demanded will

rise. The supply of workers in other industries will fall.

Market Risk

risk that affects all companies in the stock market(cannot be eliminated through diversification)

Firm Specific Risk

risk that affects only a single company(can be eliminated through diversification)

The source of the supply of loanable funds is

saving

You are hired by the state to help people find jobs. You meet with each unemployed person for half an hour each week. Over the course of the year most of the persons you work with will be unemployed for a _______ time. Over the course of a day most of your time will be spent working with people who will be unemployed for a ______ time.

short, long

Whenever the price of an asset rises above what appears to be its fundamental value, the market is said to be experiencing a

speculative bubble. Stock market bubbles arise in part because investors are willing to pay more than a stock is worth today if they expect others to pay even more for it tomorrow.

Minimum wage

structural unemployment if they create a shortage in the labor market.

How do bonds differ

term, credit risk, tax treatment

Open

that is, they interact with other economies around the world.

Why should the interest rate matter for your choice?

that the higher the interest rate, the more you can earn by depositing your money in a bank, so the more attractive getting $100 today becomes.

if the FOMC decides to increase the money supply

the Fed creates dollars and uses them to buy government bonds from the public in the nation's bond markets. After the purchase, these dollars are in the hands of the public. Thus, an open-market purchase of bonds by the Fed increases the money supply

compounding

the accumulation of a sum of money in, say, a bank account, where the interest earned remains in the account to earn additional interest in the future

future value

the amount of money in the future that an amount of money today will yield, given prevailing interest rates

present value

the amount of money today that would be needed, using prevailing interest rates, to produce a given future amount of money

federal reserve

the central bank of the United States

What does profitability depend on

the demand for its product, how much competition it faces, how much capital it has in place, whether its workers are unionized, how loyal its customers are, what kinds of government regulations and taxes it faces, and so on.

Informational efficiency

the description of asset prices that rationally reflect all available information. Stock prices change when information changes. When good news about the company's prospects becomes public, the value and the stock price both rise. When the company's prospects deteriorate, the value and price both fall.

Cynical Unemployment

the deviation of unemployment from its natural rate

Which of the following best defines liquidity?

the ease with which an asset is converted to the medium of exchange.

the higher the reserve ratio,

the less of each deposit banks loan out, and the smaller the money multiplier

Credit Risk

the probability that the borrower will fail to pay some of the interest or principal. Such a failure to pay is called a default.

open-market operation—

the purchase and sale of U.S. government bonds

Other things the same, when interest rates increase,

the quantity of loanable funds supplied increases, whereas the quantity of loanable funds demanded decreases. -The interest rate is the price of a loan. It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. Higher interest rates make borrowing less attractive causing the quantity of loanable funds demanded to decrease. At the same time, higher interest rates make saving more attractive causing the quantity of loanable funds supplied to increase.

money stock

the quantity of money circulating in the economy -currency, demand deposits

Diversification

the reduction of risk achieved by replacing a single risk with a large number of smaller, unrelated risks

Debt Finance

the sale of bonds

Suppose that your research shows that the present value of a stock's dividend stream and future price exceeds its price. This should lead you to believe that the stock is

the stock is said to be undervalued. When choosing stocks for your portfolio, you should prefer undervalued stocks. In these cases, you are getting a bargain by paying less than the business is worth.

Efficient Markets hypothesis

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

leverage

the use of borrowed money to supplement existing funds for investment purposes.

The value of a stock is based on the present values of the dividend stream and final price. As a result,

the value of a stock falls when interest rates rise. -here is an inverse relationship between the present value or the price of the stock and the interest rate. Thus, the value of a stock falls when interest rates rises (and the value of a stock rises when interest rates fall).

Two things to consider when doing fundamental analysis

the value of that share of the business and the price at which the shares are being sold. You should choose stocks that are undervalued

Tax Treatment

the way the tax laws treat the interest earned on the bond. The interest on most bonds is taxable income; that is, the bond owner has to pay a portion of the interest he earns in income taxes.

if FOMC wants to decrease money supply

they sell bonds

If stock prices follow a random walk, it means that stock prices are just as likely to rise as to fall at any given time.

true

If the government were to decrease the tax rate on interest income, then the equilibrium amount of loanable funds would increase and the equilibrium interest rate would decrease.

true

As the number of stocks in a person's portfolio increases, the risk of the portfolio decreases, as indicated by the decreasing value of the standard deviation of the portfolio.

true. The standard deviation measures the volatility of a variable-that is, how much the variable is likely to fluctuate. Increasing the number of stocks in a portfolio reduces firm-specific risk through diversification, which will be reflected by a lower standard deviation of the portfolio.

Utility

which is a person's subjective measure of well-being or satisfaction. Every level of wealth provides a certain amount of utility, as shown by the utility function in Figure 1. But the function exhibits the property of diminishing marginal utility: The more wealth a person has, the less utility she gets from an additional dollar. Thus, in the figure, the utility function gets flatter as wealth increases.

In which of the following situations is a firm most likely to see the largest benefits by paying above equilibrium wages?

worker turnover is high, the cost of hiring and training new workers is high.

Advantages of MF

1. The primary advantage of mutual funds is that they allow people with small amounts of money to diversify their holdings. Buyers of stocks and bonds are well advised to heed the adage: Don't put all your eggs in one basket. Because the value of any single stock or bond is tied to the fortunes of one company, holding a single kind of stock or bond is very risky. By contrast, people who hold a diverse portfolio of stocks and bonds face less risk because they have only a small stake in each company. Mutual funds make this diversification easy. With only a few hundred dollars, a person can buy shares in a mutual fund and, indirectly, become the part owner or creditor of hundreds of major companies. 2.give ordinary people access to the skills of professional money managers. The managers of most mutual funds pay close attention to the developments and prospects of the companies in which they buy stock. These managers buy the stock of companies they view as having a profitable future and sell the stock of companies with less promising prospects. This professional management, it is argued, should increase the return that mutual fund depositors earn on their savings.

Discounting

Because the possibility of earning interest reduces the present value below the amount X, the process of finding a present value of a future sum of money is called discounting.