econ 3229

Expected inflation and demand of loanable funds

- inflation reduces the burden of debt. - when inflation is expected to increase, the willingness to incur debt increases.

Cyclical Unemployment

- those out of work due to a weak economy. - disappears in a booming economy. - full employment occurs when there is zero of this, and the unemployment rate is equal to NAIRU.

Computing Inflation Rate

(change in CPI)/(initial CPI) X 100

Treasury Bill yield

(1,000-price)/price X (365 days/days to maturity)

M2

- M1 + other short term highly liquid assets.

Zero-Coupon Bonds

- a bond that makes no annual coupon payments but instead pays a specified amount (face value) at a specified date.

Coupon Bond

- a contract calling for a stream of constant annual payments (C's) over period of n years and a return of face value at maturity.

Consumer Price Index (CPI)

- a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services

Time Preference for Loanable funds

- a positive real interest rates means that by saving, a person can consume more in the future than they can consume today. - the higher the interest rate, the more a person can consume in the future by abstaining from consuming today.

Money

- anything widely or universally acceptable as a means of payments. - money supply: the stock of those items used to make payments. - most common measure: M1

Business Cycle

- as business and consumer confidence increase.. - businesses decide to borrow more to finance additional plant and equipment expenditures.

Supply of Loanable Funds

- as the US interest rate increases, lending funds in the US becomes more attractive compared to other options. - supply curve is upward sloping.

Loanable Funds Model of Interest Rates

- as us interest rates rise, lending funds becomes more attractive. - when you buy bonds you are supplying funds to the market.

Fisher hypothesis- strong version

- asserts that bond yields and interest rates move in a one-for-one level with the level of expected inflation. - financial markets would neutralize the potential redistributive effects of borrowers and lenders. - interest rates would move to the levels such that lenders and borrowers would be unaffected by inflation.

Fisher hypothesis- weak version

- bond yields move with expected inflation but not in a one for one fashion. - the higher levels of inflation would mean that wealth is redistributed from lenders to borrowers. (debtors benefit) - interest rate does not move up enough to compensate lenders for the higher inflation, lenders lose borrowers benefit.

Municipal Bonds

- bonds issued by local governments and other political subdivisions. - issued to finance capital investment projects such as schools, airports, subways. - interest earned is non-taxable. - buyers: banks and wealthy individuals.

Property and casualty insurance companies

- companies that sell protection against loss resulting from fire, theft, accident and natural disasters. - invest the funds received through premiums in municipal bonds, corporate stocks and bonds and us gov securities.

M1

- consists of the value of all of the currency and coins in circulation and the amount of checking accounts in banks.

Corporate Bonds

- debt claims against a corporations assets. - maturities of 10-30 years. - buyers: life insurance companies and private pension funds. - given ratings.

Ex Ante real interset rate

- difference between the actual interest rate and the expected inflation. - occurs at the time of the transaction.

Ex post real interest rate

- difference between the actual interest rate and the rate of inflation that actually occurred.

Factors influencing consumption spending

- disposable income (+) - wealth (+) - interest rates (-) - consumer confidence (+) - household indebtedness (-)

Private pension fund and government retired funds

- employer provided plans that are similar to mutual funds, except that they are limited to employees in certain occupations. - enables economies of scale, expertise and diversification. - income contributed to such funds is typically non-taxable.

Income

- flow of payments received form a job or other sources such as rent, interest, dividends.

Sources of Demand for LF

- household credit purchases - business investment spending - government budget deficit - foreign borrowing in the US

Expected inflation and supply of loanable funds

- if inflation expectations increase, lending becomes less attractive because the real value of the principal loaned out decreases. - lenders will expect to be repaid in less valuable dollars when inflation rises. - demand for bonds decrease, reducing the price, and raising their yield.

Demand for loanable funds

- increase in demand for loans is an increase of supply of bonds. - the demand curve for loans is downward sloping.

Federal Reserve

- influence over short term interest rates. - in a recession, the fed purchases securities in the open market, pumping funds into banks. - in an economic boom, the fed sells securities in the open market. - the supply curve of loans shifts left, driving up interest rates and bond yields.

Commercial Bank

- institution that accept deposits and use the funds to make loans and purchase government securities.

Money Market Mutual Fund

- institution that issues "shares" worth one dollar a piece and uses these funds to purchase treasury bills, negotiable CD's, repo agreements and other safe, liquid assets.

Life insurance companies

- institutions that issue policies, collect payments from policyholders, and invest the funds mainly in corporate bonds and stocks.

Mutual Funds

- institutions that pool the funds of many individuals to purchase a diversified portfolio of stocks or bonds.

interest rates in europe decline, reducing the desire of foreigners to borrow from US

- interest rates go down. - demand shifts left.

profits decline sharply, impairing business confidence

- interest rates go down. - demand shifts left.

Federal reserve increases money supply

- interest rates go down. - supply shifts right.

Household thriftiness increases

- interest rates go down. - supply shifts to the right.

Consumer confidence increases

- interest rates go up. - demand shifts right.

Banks tighten their lending standards

- interest rates go up. - supply shifts left.

Negotiable Certificates of Deposits

- issued by large US banks. - issued in multi million dollar denominations. - they can be sold prior to maturity, relatively liquid. - key source of funds for large banks.

U.S. Treasury Bills

- issued in 90, 180, and 1 year maturities in frequent sealed bid auctions by the U.S treasury. - no default risk. - very little or no market risk. - treasury bills are extremely liquid and popular outlets for banks. - traded in highly competitive secondary market through a network. - sold at a discount rate from face value. - their yield accrues from appreciation in price.

Commercial Paper

- large corporations perceived to be extremely safe can issue short-term debt directly onto the market to fund day to day operations. - firms can borrow at a significantly lower interest rate by issuing commercial paper than borrowing from banks. - Buyers: money market mutual funds

Attributes that are inversely related

- liquidity and yield: illquid assets must compensate the investor for the illiquidity. - longer-term treasury securities normally exhibit higher yields than short-term treasury securities. AND - liquidity and risk: treasury bills are less risky than 30-year treasury bonds because there is more market risk in less liquid long term bonds.

Mortgages

- long term loans that finance real property, secured by a lien on the property. - amortized so the borrower can own the home free at the maturity of the mortgage. - interest paid on mortgages are tax deductible.

Commodity Money

- money which has substantial value as a commodity, as well as being valuable as "money" in using to purchase other goods and services.

Fiat Money

- money whose value as a commodity is far below its value as "money" that is, its value when used in exchange for goods and services. - almost all of our money today is fiat money

Corporate Stocks

- ownership claims against a corporations real capital assets. stocks are equity instruments- ownership claims. - no maturity date. - traded on organized stock exchanges or over the counter. - pay dividends. - corporations are more likely to issue new shares of stock when the price is high.

Frictional Unemployment

- people who may have worked in past couple of weeks, quit last job, and will have another job within a couple of weeks.

Sources of Supply for LF

- personal saving - business saving - government budget surplus - bank loans - foreign lending in the US

Risk

- possibility that owner of an asset may not be able to recover full value of the funds invested.

Credit Unions

- relatively small, consumer-oriented saving and lending institutions. - organized by universities, labor unions, and other organizations to provide loans to working class folks. - typically borrow and lend to the same groups of people.

Attributes that are positively related

- risk and yield: most investors are risk averse, meaning they need to be compensated to get them to take more risk. - BAA bonds have higher yields than AAA bonds. - AAA bonds have higher yield than US treasury bonds.

Market Risk

- risk of fluctuation in market price of the instrument. if you are forced to sell an asset on short notice, you may receive a lower price for the asset. - shares of stock have high market risk. - us treasury bills and money market mutual find shares have extremely low market risk. - passbook savings accounts have zero market risk.

Default Risk

- risk of not recovering the principal and or interest payments that are due because of financial impairment of issuer of the instrument. - corporate bonds are riskier than government bonds, corporate stocks are riskier than corporate bonds.

Repurchase Agreements

- short term loan form a corporation, securities dealer or other large entity with temporarily idle funds. - borrower: commercial bank, securities dealer, other financial institution. - the buyback price is slightly above the original price.

Wealth

- the dollar value of the stock of assets owned minus the dollar value of debts owed.

Yield

- the rate of return on an asset, expressed as percent per year. - corporate bonds --> higher yield than us treasury bonds. - treasury bonds exhibit higher yields than municipal bonds. - stocks have historically returned higher yields than bonds.

Structural Unemployment

- those who lack requisite skills to fill existing job openings. - serious national problem due to a lack of education and poor skills. - Ex: dropped out of high school and can't get a job with degree requirements.

Federal Funds

- unsecured loans between banks in the form of deposits at the federal reserve. - banks with more reserve deposits at the fed than they need, lend these deposits to other banks that have need for them.

Safe-Haven Considerations

- when a nation experiences severe economic or political instability, capital flight takes place.

Federal Budget Deficit

- when this rises, the government issues additional treasury bonds and bills to raise funds. - this tends to boost interest rates and yields. - if the deficit goes up, it means the government is borrowing more and demand curve shifts to the right.

Assets ranked by liquidity

1. passbook savings account 2. money market mutual fund shares 3. us treasury bills 4. negotiable certificates of deposit 5. us treasury notes 6. us treasury bonds 7. corporate bonds 8. shares of corporate stock 9. houses and land

3 forces holding down inflation

1. huge decline in oil prices 2. appreciation of us dollar 3. weak economies among importers of us goods and services

Personal Consumption Expenditures Deflator (PCE)

consists of the actual and imputed expenditures of households and includes data pertaining to durable and non-durable goods and services. It is essentially a measure of goods and services targeted towards individuals and consumed by individuals.

Liquidity

ease and willingness with which an asset can be "cashed in" on short notice

Suppose portugal surprises markets by announcing it is defaulting on its government debt, the effect of this announcement in us financial markets is

supply curve of loans in the US shifts right, interest rates fall, and bond prices rise

To be highly liquid:

the transactions cost of converting to cash must be low and the price of the asset must be relatively stable over time. - us treasury bills are highly liquid - long term corporate bonds and stocks are not.