Econ ch 1-6 slides Flashcards
How do interest rates impact health of the economy?
they impact consumer’s willingness to save or spend as well as business’ investment decisions
Financial markets
markets in which funds are
directly transferred from people and firms who
have an excess funds to people and firms who
need funds
Why is stock market important?
It affects people wealth and their willingness to
spend
It affects businesses’ investment decisions, they can obtain more funds and invest more.
Financial intermediary
Institutions that borrow
funds from people who have saved and in turn
make loans to other people who want to inves
examples of financial institutions
insurance companies, finance
companies, pension funds, mutual funds and investment
companies
Why are financial intermerdiaries important?
Without them, financial markets would not be able to dorect funds from savers to investors efficiently
Quantity theory
There is a connection between the money supply and the price level
Why are financial systems important to the economy?
channels funds from savers to investors which
1. promotes investment
2. economic growth
3. promotes standard of living
4. increase economic efficency
Function of financial system
Channeling funds from economic players that have saved surplus funds (savers or lenders) to those
that have a shortage of funds (investors or borrowers)
How is the efficient flow of funds through the financial system, direct or indirect, important?
Promotes economic efficiency by producing an efficient allocation of capital, which increases production
Directly improve the well-being of
consumers by allowing them to time their purchases better
Prime rate
the base interest rate on corporate bank loan as indicator of the cost to the corporation of borrowing from the bank
Federal Funds Rate
the interest rate on over night loans in the federal funds market as indicator of the cost to the
banks of borrowing funds from other banks
Libor Rate
the British Banker’s Association average of interbank rates for dollar deposits in the London market (Benchmark)
Eurobond
bond denominated in a currency other than that of the country in which it is sold
Eurocurrencies
foreign currencies deposited in
banks outside the home country
Why is indirect finance so important?
- Lowers transaction costs because of economies of scale and liquidity services
- Reduces exposure of risk to investors through risk sharing and diversification
- deals with assymetric information problems
adverse selection
(before the transaction): try
to avoid selecting the risky borrower by gathering information about them
Moral hazard
(after the transaction): ensure
borrower will not engage in activities that will prevent him/her to repay the loan
Examples of depository institutions
commercial banks, savings/loan institutions, mutual savings banks, credit unions
contractual savings institutions examples
life insurance companies, fire and casualty insurance companies, pension funds, gov retirement funds
Investment intermediaries
finance companies, mutual funds, money market mutual funds, hedge funds
Why regulate financial system?
increase information available to public and investors, ensure soundness of intermediaries
Functions of money
- medium of exchange
- unit of account
- store of value
Medium of exchange, why and requirements
eliminates trouble of finding double coincidence in Barter economy
- be easily standardized
- be widely accepted
- be divisible
- be easy to carry
- not deteriorate quickly
Unit of account meaning
measures value in the economy, reduces transactions costs
store of value meaning
preserves purchasing power over time
commodity money
has intrinsic value, easily standardized
cigs, precious metals
Fiat money
paper money decreed by goverment as legal tender
Included in M1
currency
travelers checks
demand deposits
other check deposits
Included in M2
M1
Small den deposits
savings and MM
MMF
Why are interest rates watched in households?
consume or save?
buy house or not?
buy stocks and bonds or put into savings accounts?
Simple loan
commercial loans to businesses
fixed payment loans
mortgages (ordinary annuities)
coupon bond
U.S. treasury and corporate bonds
Discount bonds
U.S Treasury saving bonds and long- term zero-coupon bonds
YTM
Yield to maturity: The interest rate that equates the present value of cash flow payments received from a debt instrument with its value today
When is the YTM of a coupon bond the same as its coupon rate?
When it’s priced at its fave value
formula for Return
Return = CY + Rate of capital gain
When is the return equal to the YTM in a bond
when the holding period equals time to maturity
How does the time until maturity impact changes in bond prices?
The more distant a bond maturity, the greater size price change it’ll have with changes in rates
LT bonds are more risky for this reason
When is there no interest rate risk?
When holding period matches time to maturity
Ex ante real interest rate
adjusted for expected changes in price levels
ex post real interest rate
real interest rate is adjusted for actual
changes in the price level
Fisher equation
Nominal int rate = real int rate + expected inflation
Real int rate = nominal int rate - exp inflation
Determinants of Quantity demanded on an asset
wealth
expected return
risk
liquidity
Two approaches to determine interest rates
supply and demand in bond market
supply and demand in money market
Shifts in demand for bonds
wealth
expected returns
expected inflation
risk
liquidity
How does an increase in the expected returns shift the demand for bonds
Higher int rates in the future lowers expected returns for LT bonds, shifting demand curve to the left
How does expected inflation shift the demand for bonds
increase in expected inflation lowers expected return for bonds, causing demand curve to shift left
Shifts in supply curve for bond
expected probabily of investment opportunities
expected inflation
gov budget
How does government budget play a role in shift of supply for bonds?
An increased budget deficit shifts supply curve to the right
What happens to int rates during a period of deflation?
Exp return on real assets decreases so bond return relatively increases, Bd shifts right
real int rates increase, increased real cost of borrowing, Bs shifts left
int rate falls
What happens to int rates during a recession?
profitable investment opportuntiies fall, Bs shifts left
wealth decreases, Bd shifts left but less than Bs
interest rate falls
Shifts in demand for money
Income effect
Price level effect
Exp inflation effect
Liquidity effect
Risk structure of interest rates
Bonds with the same maturity (term) have
different interest rates due to:
– Default risk
– Liquidity
– Tax considerations
risk premium
spread btn int rates on bonds with default risk and int rates on T bonds
How much additional interest people must earn to be willing to hold the risky bond
Term structure of int rates
Bonds with identical risk, liquidity, and tax characteristics may have different interest rates because the time remaining to maturity is different
Term structure of int rates must explain:
- int rates of diff maturities move together over time
- When ST yields are low, YC is upward
- YC almost always slope upwards
Expectations theory
The interest rate on a long-term bond will equal an
average of the short-term interest rates that people
expect to occur over the life of the long-term bond
Bond buyers will only hold bonds if expected return is higher
bonds w diff maturities are perfect substitutes
How would expectations theory explain upward sloping yield curve?
average of future ST rates are expected to be higher than current
only occurs if ST rates are expected to rise
How would expectations theory explain downward sloping yield curve?
average of future ST rates are lower than current
only occurs if ST rates are expected to fall
Segmented markets theory
bonds of diff maturities are not substitutes at all
int rates are determined by supply and demand for that bond
investors hold bonds with shorter maturities, which is why upward sloping
Liquidity premium theory
The interest rate on a long-term bond will equal an
average of short-term interest rates expected to
occur over the life of the long-term bond plus a
liquidity premium (term premium) that responds to
supply and demand conditions for that bond
Bonds of different maturities are partial (not perfect) substitutes
Preferred Habitat Theory
Investors have a preference for bonds of one
maturity over another.
Investors are likely to prefer short-term bonds
over longer-term bonds.
What does a steep upward yield curve project?
higher expected interest rates in the future, forecasting a future increase in economic expansions
what does a flat or downward sloping YC represent?
forecasts a decrease in inflation or recession
