Macro Ch. 9
What are some things banks do?
-coordinate lenders and minimize information costs -spread default risk across many lenders -play a role in the payments system
financial intermediaries
-institutions that "connect" borrowers and lenders by accepting funds from lenders and loaning funds to borrowers (ex: banks, bond markets, stock markets) -helps to bring about equilibrium -reduce costs of moving savings from savers to borrowers and mobilize savings toward productive uses
Financial intermediation may fail if something causes: -a reduction in the supply of savings -an increase in the supply of savings -an increase in equilibrium interest rates -a decrease in equilibrium interest rates
a reduction in the supply of savings (ex: if property rights become insecure, investors will be reluctant to put their money in banks or invest in bond or stock markets)
Interest Rate Formula
coupon amount/bond price paid
Circular flow of income
economic model that pictures income as flowing continuously between businesses and consumers
The lower the interest rate, the ____________ (greater, lower) the quantity of loanable funds demanded.
greater
Which timeline puts the events leading to the financial crisis of 2007-2008 in proper chronological order? -reduction in the amount of lending in the economy, falling asset prices, high leverage in the shadow banking system -reduction in the amount of lending in the economy, high leverage in the shadow banking system, falling asset prices -high leverage in the shadow banking system, falling asset prices, reduction in the amount of lending in the economy -rising asset prices, reductions in leverage in the shadow banking system, reduction in the amount of lending in the economy
high leverage in the shadow banking system, falling asset prices, reduction in the amount of lending in the economy (the resulting decline in activity demonstrates how important financial intermediaries are to the economy, both when they operate well and when they do not)
Saving
income not used for consumption
If interest rates rise, savings do what ?
increase
The _______ represents the price of a loan. -catch-up effect -loan term -rate of inflation -interest rate
interest rate
Which of the terms acts as the "price" in the market for loanable funds? -demand -interest rate -capital -supply
interest rate
All else equal, lower _____ rates usually result in _____ savings. -exchange; less -exchange; more -interest; more -interest; less
interest; less (the supply curve for savings is positively sloped)
Securitization
loans that are bundled together and sold on the market as financial assets
The _____ the interest rate, the greater the quantity of funds demanded for _____. -higher; investment -lower; saving -higher; saving -lower; investment
lower; investment (the demand curve for borrowing is downward sloping)
Investment
purchase of new capital
smoothing consumption
saving during working years & dissaving during retirement years
Stocks
shares of ownership in a corporation
Withdrawals/leakages
subtract from core consumption: -Saving -Taxes -Imports
The source of the _______ for loanable funds is saving. -demand -interest rate -market -supply
supply
demand for bonds=
supply of loanable funds
Marginal Propensity to Save (MPS)
the amount by which saving changes when disposable income changes; MPS = change in savings/change in disposable (after tax) income
Time Preference
the desire to have goods and services sooner rather than later
market for loanable funds
the market in which those who want to save will supply funds and those who want to borrow to invest will demand funds
When does the stock market increase net investment in the economy?
when a firm first sells shares to the public (not when buying and selling already existing shares)
Five major factors that determine supply of savings
1.) smoothing consumption 2.) impatience 3.) marketing and psychological factors 4.) income 5.) interest rates
bond
A financial security that represents a promise to repay a fixed amount of funds (includes how much is owed/borrowed, when payment is due, and coupon amount/redemption amount)
If the projected rate of return for a project is less than the interest rate for a loan that is necessary to complete the project, how will the borrowing business act? -The business will proceed anyway, knowing that the return is only an estimate. -The business will take out the loan. -The business will demand more funds to cover the shortfall. -The business will not take out the loan.
The business will not take out the loan
Injections
additions to core economy: -Investment -Government Spending -Exports
The ability to borrow greatly ____________ (increases/decreases) the ability to invest.
increases (higher investment = increased standard of living and rate of economic growth)
What kind of relationship do bond prices and interest rate have?
inverse - this means people who buy bonds face interest rate risk
The buyer of a bond is a: -lender. -banker. -borrower. -stockholder.
lender
Equilibrium in the market for loanable funds
quantity of funds supplied = quantity of funds demanded (interest rate adjusts to equalize savings and borrowing)
If interest rate is lower than equilibrium...
quantity of savings demanded > quantity of savings supplied (shortage - demanders bid interest rate up as they compete to borrow)
If interest rate is higher than equilibrium...
quantity of savings supplied > quantity of savings demanded (surplus - suppliers bid interest rate down as they compete to lend)
leverage ratio
the ratio of debt to equity, D/E
Default risk
the risk that the borrower will not pay the face value of a bond on the maturity date
According to modern monetary theory, increased government budget deficits: -will lead to less private consumption -will lead to less investment -will have little or no impact on the economy -will lead to less saving
will have little or no impact on the economy
Lifecycle Theory of Savings
By borrowing (in college years), saving (in working years), and dissaving (in retirement years), workers can smooth their consumption over their lifetime, improving their overall satisfaction
Brian has grown tired of paying rent each month to his landlord and has decided to purchase a condo. Brian has been saving money and has $51.00 that he will use as a down payment on this condo. He will take out a mortgage to pay the remaining price. Brian finds a suitable condo and negotiates a price of $350.00. Assume that there are no extra fees associated with purchasing the condo. Upon moving in, how much equity does Brian have in this condo? What is Brian's leverage ratio associated with this condo when he moves in?
Equity: $51.00 Leverage Ratio: 5.86 (350.00 - 51.00 = 299.00/51.00 = 5.86)
Modern Monetary Theory
Fed will "monetize" the deficit by printing more money
The incorrect fundemental assumption that contributed to the financial crisis in 2008 was: -Bond prices would alway rise -Interest rates would not rise -Housing prices would always rise -Freddie Mac and Fannie Mae would stop buying mortgages
Housing prices would always rise
Classify each of the given events according to the category that best describes how it affects the equilibrium interest rate in the market for loanable funds: -an increase in large investments -an investment tax credit -a decrease in investor optimism -an increase in savings
Increases interest rate: -investment tax credit -increase in large investments Decreases interest rate: -increase in savings -decrease in investor optimism
Which of the situations is an example of the crowding-out effect on investment as it pertains to macroeconomics? -The government of Walla Walla spent $4.3 billion dollars and collected $2.2 billion dollars in tax revenue. -Candex, an eyeglass frame company, decides to cut the price on all of its frames to $10, which successfully drives out all other firms from the market. -The government deficit is at an all-time high in the United States. As such, people begin to save more money in fear that taxes will increase in the future. -Jack wants to borrow money to create a cowboy-themed inflatable bounce house for kids called "Wild Wild West." However, the government is running a deficit which has increased interest rates so much that Jack can no longer afford to borrow the money.
Jack wants to borrow money to create a cowboy-themed inflatable bounce house for kids called "Wild Wild West." However, the government is running a deficit which has increased interest rates so much that Jack can no longer afford to borrow the money.
From where do investment banks get their funds? -Private investors -Quasi-public institutions -Customer deposits -Governments
Private investors
Which statement is TRUE? -The market for mutual funds occurs when suppliers of mutual funds (savers) trade with demanders of mutual funds (borrowers) -If the current interest rate is below the equilibrium interest rate, a surplus will be created, pushing the interest rate up -Trading between savers and borrowers determines the equilibrium interest rate -If the demand for loanable funds increases, the equilibrium interest rate will fall
Trading between savers and borrowers determines the equilibrium interest rate
Crowding out
a decrease in private consumption and investment that results from government borrowing
Which of the following best defines a financial intermediary? -a claim by a buyer to a future payment by a seller -a collection of stocks and bonds issued to investors -a financial institution that transforms investor funds into financial assets -an asset sold by a company which entitles the buyer to partial ownership
a financial institution that transforms investor funds into financial assets
Select the definition of consumption smoothing. -borrowing in periods of high income and saving in periods of low income to make income less variable than consumption -borrowing in periods of high income and saving in periods of low income to make consumption less variable than income -borrowing in periods of low income and saving in periods of high income to make consumption less variable than income -borrowing in periods of low income and saving in periods of high income to make income less variable than consumption
borrowing in periods of low income and saving in periods of high income to make consumption less variable than income
Supply
changes the quantity of loanable funds demanded
Demand
changes the quantity of loanable funds supplied
A ceiling on interest rates can: -create either a shortage or a surplus of savings, depending on whether the ceiling is high or low -not affect the equilibrium level of savings -create a shortage of savings -create a surplus of savings
create a shortage of savings (just like any price ceiling, a ceiling on interest rates, if set too low, will create excess demand for loanable funds)
The source of the _______ for loanable funds is investment. -interest rate -demand -market -supply
demand
All else equal, if consumers decide to borrow less, the: -supply curve in the market for loanable funds will shift to the right -demand curve in the market for loanable funds will shift to the right -demand curve in the market for loanable funds will shift to the left -supply curve in the market for loanable funds will shift to the left
demand curve in the market for loanable funds will shift to the left (this would decrease the demand for loanable funds, and the interest rate would fall)
supply of bonds =
demand for loanable funds
Three important aspects of a bond
face value (amount received when bond matures), coupon amount (amount payable every 6 month), and maturity (number of years to collect interest payments and when principle is due) - Bills do not have these!
leverage
the ratio of the liabilities of a financial institution to its equity capital
rate of return for a zero-coupon bond
((Face Value - Price) / Price) x 100
shadow banking system
-a group of institutions that engage in lending activities, much like traditional banks, but do not accept deposits and therefore are not subject to the same regulations as traditional banks -less heavily regulated -short term debt and long term assets
John has to decide whether to buy a zero-coupon bond with very little risk that costs $950 and will pay $1080 in one year or put his money in a savings account with an annual interest rate of 12%. Compute the difference in the rate of return of the two investments. Round your answer to one decimal place. Which of the two investments will John prefer?
1.7% (1080/950 = 1.1368 -1 = .1368*100 = 13.68 - 12 = 1.7%); zero coupon bond
Suppose the Chief Financial Officer (CFO) of a company is interested in raising funds for a major investment by issuing bonds of varying maturity to investors. One of the longer-term bonds being issued can be purchased for $50,000.00 per bond and pays $3,350.00 annually to the investor. What is the annual interest rate on this bond?
6.7% (3350/50000 = .067*100 = 6.7%)
collateral
A security pledged for the repayment of a loan.
arbitrage principle
-the buying and selling of equally risky asset -ensures that equally risky assets earn equal returns
Which of the following is most accurate? -Now is a good time to buy a bond because interest rates are low and bond prices are high -Now is not a good time to buy a bond because interest rates are high and bond prices are low -Now is a good time to buy a bond because interest rates are high and bond prices are high -Now is not a good time to buy a bond because interest rates are low and bond prices are high
Now is not a good time to buy a bond because interest rates are low and bond prices are high
As interest rate decreases, what happens to the quantity of loanable funds demanded? -Quantity demanded will increase. -Some borrowers will demand more funds whereas others will demand less. -There will be no change in quantity demanded. -Quantity demanded will decrease.
Quantity demanded will increase
What effect will an increase in interest rates have on the quantity of loanable funds supplied? -Quantity supplied will decrease. -Some lenders will offer more whereas others offer less. -There will be no change in quantity supplied. -Quantity supplied will increase.
Quantity supplied will increase
Which statement is TRUE? -A leverage ratio of 10 implies a buyer with $50,000 in cash can borrow $500,000 -A mortgage loan that has been "securitized" is one that has a lot of collateral -Once assets are securitized, the revenue streams from them cannot be divided up or sold in a variety of ways -The buyer of a securitized asset gets up-front cash while the seller gets the right to a stream of future payments
-A leverage ratio of 10 implies a buyer with $50,000 in cash can borrow $500,000
Which statement is TRUE? -If the demand for loanable funds increases, the equilibrium interest rate will fall -If the current interest rate is below the equilibrium interest rate, a surplus will be created, pushing the interest rate up -Trading between savers and consumers determines the equilibrium interest rate -The market for loanable funds occurs when suppliers of loanable funds (savers) trade with demanders of loanable funds (borrowers)
-The market for loanable funds occurs when suppliers of loanable funds (savers) trade with demanders of loanable funds (borrowers)
Investment banks are part of the: -traditional banking system, and those investments are government guaranteed -shadow banking system, and those investments are government guaranteed -traditional banking system, and those investments are not government guaranteed -shadow banking system, and those investments are not government guaranteed
-shadow banking system, and those investments are not government guaranteed
Initial Public Offering (IPO)
The first public offering of a corporation's stock.
There were many causes that contributed to the financial crisis of 2007-2008. Which of the choices most accurately describes the role of securitization in contributing to the crisis? -Banks bundled mortgages together and then sold them on the market as a financial asset. However, the risk level of these securitized assets was often much higher than the purchaser thought. -Globalization has increased the connectedness of the major economies of the world. Correspondingly, there has been a decrease in the economic security of the U.S., where the U.S. has been adversely affected by the many European nations that have suffered recessions. -Banks failed to securitize their loans by requiring sufficient down payments from home buyers. This resulted in small declines in housing prices causing many homes to go into foreclosure. -In providing aid to firms that were at risk of becoming insolvent, the U.S. government securitized these firms. In the future, firms are more now likely to engage in risky investments since the government securitizes these behaviors.
Banks bundled mortgages together and then sold them on the market as a financial asset. However, the risk level of these securitized assets was often much higher than the purchaser thought.
