Exam 2 Flashcards
What is Inflation and how do we measure it?
Consumer Price Index; which is different from GDP deflator
CPI Calculation
Price in today’s dollars = price in year t x CPI today/CPI in year t
CPI Accuracy
The CPI may overstate true inflation due to substitution bias, changes in quality, and new products and locations.
Problems Created by Inflation: Shoe leather costs
Resources are wasted when people change behavior to avoid holding money
Problems Created by Inflation: Money Illusion
People interpret nominal wage or price changes as real changes
Problems Created by Inflation: Menu costs
These are the costs of changing prices
Problems Created by Inflation: Uncertainty about future price levels
Long-term agreements become riskier
Problems Created by Inflation: Wealth redistribution
Surprise inflation redistributes wealth from lenders to
borrowers. Also need to know how surprise inflation redistributes wealth
Problems Created by Inflation: Price confusion
Inflation makes it difficult to read price signals, leading to
misallocation of resources
Problems Created by Inflation: Tax distortions
Inflation makes capital gains appear larger and increases tax
burdens.
Causes of Inflation
-Expansion in the nation’s money supply is the primary cause of inflation.
-Equation of exchange: know how to apply it
Loanable Funds Market:
The loanable funds market includes stock exchanges, investment banks, mutual
fund firms, and commercial banks. It channels funds from savers to borrowers. Borrowers use funds for businesses, while savers lend to businesses
Importance of Borrowing
Borrowing is essential because firms need to borrow before production begins. Savings lead to borrowing, which leads to investment and ultimately GDP
growth. The higher the investment the higher the GDP
Interest Rates
Interest rates are determined by supply and demand in the loanable funds market. Savers are rewarded for saving (explains the shape of the supply curve), while
borrowers pay the cost of borrowing.
Rate of Return
The rate of return is calculated with a formula. Know how to use it and when
businesses will make a decision to borrow based on the rate of return. Need to
understand that the rate of return explains the shape of the demand curve.
Equilibrium
The supply of loanable funds is savings, and the demand for loanable funds is
firms wanting to borrow for investment. Savings equals investment in equilibrium.
Shifts in Supply of Loanable Funds
Movements along the supply curve occur with changes in interest rates.
o Shifts are caused by changes in income and wealth, time preferences,
consumption smoothing, and foreign lending to the U.S
Changes in income and wealth (Shift in Supply of Loanable Funds)
Increases in income generally increase savings,
shifting the supply curve to the right.
Time preferences:
An increase in time preferences decreases the supply of
loanable funds, shifting the supply curve to the right. A decrease in time
preferences increases the supply of loanable funds, shifting the supply curve to
the left.
Consumption smoothing:
An increase in the share of the population in their
midlife leads to higher savings, shifting the supply curve to the right. Know how
consumption smoothing might shift the supply curve to the left.
Changes in foreign lending
If foreign lending to the U.S. increases, the supply
of loanable funds increases.
Shifts in Demand for Loanable Funds
Demand is driven largely by firms needing to borrow for large capital projects
and by governments. Shifts are caused by changes in the productivity of capital and changes in investor
confidence
Productivity of capital
An increase in the productivity of capital increases the
demand for loanable funds, shifting the demand curve to the right.
Investor confidence
Optimistic firms borrow more, shifting demand to the right,
while pessimistic firms borrow less, shifting demand to the left.
Direct vs. Indirect Finance
- Indirect finance is when savers and lenders utilize banks in the market for loans.
- Direct finance is when borrowers go directly to lenders (stock or bond purchases).
Financial Intermediaries
- Financial intermediaries, such as banks, channel funds from savers to borrowers.
- Banks accept deposits and extend loans.
Direct Finance
- Firms sell securities (stock or bond) directly to the public in exchange for funds.
- A security provides future income and/or gives part ownership of the firm.
Financial Tools
Key financial tools include bonds, stocks, treasury securities, home mortgages,
and private sector securities (created by securitization).
Financial Tools Markets
- The supply of financial tools comes from companies/government looking to
borrow money. - The demand for financial tools comes from savers (home and foreign).
- Demand shifters include associated risk, confidence in the future of the U.S.
economy, and secondary markets.
Bond Principles
- The dollar price of a bond determines its interest rate (and vice versa).
- The dollar price and interest rate of a bond have an inverse relationship.
- Bond interest rates rise with default risk.
- Need to be able to apply the formula for interest rate
Risk and Return Tradeoff
- Riskier assets pay a higher return, on average, to compensate for the extra risk of
holding them. - Riskier bonds have a lower price and higher interest rate.
Stock
- Stock represents ownership shares in the firm
-Firms can sell shares and move forward without the burden of debt from having to pay back a bond in the future
Secondary Markets
Stock markets are secondary markets where securities are traded after their first
sale.
Treasury Securities
The U.S. government borrows by selling Treasury securities.
Mortgages
Individuals use loans to pay for homes (mortgage).
Securitization
Securitization is the creation of a new security as a combination of other securities
and loan agreements, which diversifies risk and can lower interest rates
Key Elements of a Financial Crisis
- Large decline in some asset prices, such as real estate.
- Insolvencies at financial institutions.
- Decline in confidence in financial institutions.
- Credit Crunch: Trouble getting loans, savings are not turned into investment.
- Economic downturn: Decline in demand for goods and services.
Which of the following is correct?
a. The CPI is better than the GDP deflator at reflecting the goods and services bought by
consumers
b. The GDP deflator and the CPI are equally good at reflecting the goods and services bought
by consumers
c. The CPI measures the price level of goods and services produced within a country in a
given period of time
d. The GDP deflator is better than the CPI at reflecting the goods and services bought by
consumers
e. The GDP deflator is more commonly used as a gauge of inflation that the CPI is
The CPI is better than the GDP deflator at reflecting the goods and services bought by
consumers
The signing of long-term wage and price agreements and the relationship to inflation most likely raises the
issue of
a. price confusion problems.
b. deflationary tendencies.
c. consumer price index (CPI) heteroscedasticity.
d. money illusion.
e. future price uncertainty
e. future price uncertainty
Assume deflation is occurring in a nation; the implication(s)
a. is that time preferences in the nation have fallen.
b. is that the real rate of interest exceeds the nominal rate of interest.
c. is that the nominal interest rate exceeds the real interest rate.
d. are that both real and nominal interest rates are positive.
e. are that both real and nominal interest rates are negative.
b. is that the real rate of interest exceeds the nominal rate of interest.
If everyone began feeling better about the economic future, “animal spirits” would become
a. more positive and firms would invest more, causing the demand for loanable funds to
increase.
b. more positive and firms would invest more, causing the supply of loanable funds to
decrease.
c. more positive and firms would invest more, causing the demand for loanable funds to
decrease.
d. more positive and firms would invest more, causing the supply of loanable funds to
increase.
e. negative
a. more positive and firms would invest more, causing the demand for loanable funds to
increase.
You decide to save money for retirement by purchasing Apple stock.
a. You plan to use direct financing and your actions are a part of the supply of loanable funds
b. You plan to use indirect financing and your actions are a part of the demand for loanable
funds
c. You plan to use direct financing and your actions are a part of the demand for loanable
funds
d. You plan to use indirect financing and your actions are a part of the supply of loanable
funds
e. You plan to use indirect financing and your actions would not show up on the loanable
funds market model
a. You plan to use direct financing and your actions are a part of the supply of loanable funds
As income and wealth rise, we would expect
a. foreigners with more wealth to move their assets out of the United States to foreign
markets.
b. savings to fall, since people would spend the extra income or wealth.
c. savings to increase as people save some of the extra wealth or income they have.
d. people to have a negative rate of time preference.
e. interest rates to rise.
c. savings to increase as people save some of the extra wealth or income they have.
Inflation sometimes causes people to pay ________ capital gains tax than they ought to, ________.
a. more; if much of their calculated profits from selling assets was due to inflation
b. less; because inflation creates the opportunity for a tax write-off
c. less; because tax laws do not typically account for inflation
d. more; because the inflation adjustments in tax laws overcompensate for inflation
e. more; if they neglect to claim the inflation adjustment that tax laws allow
a. more; if much of their calculated profits from selling assets was due to inflation
Which of the following best describes a mortgage-backed security?
a. A mortgage-backed security is a bond offered by a mortgage company.
b. A mortgage-backed security is a bundle of mortgages. The new security is then put up for
auction by the government.
c. A mortgage-backed security is a combination, or bundle, of mortgages. The new security
is then available for resale in secondary markets.
d. A mortgage-backed security is simply the stock of a mortgage company.
e. A mortgage-backed security is an investment with a very high interest rate and very low
return. This security is available for resale in secondary markets.
c. A mortgage-backed security is a combination, or bundle, of mortgages. The new security
is then available for resale in secondary markets.
If a firm takes a loan from a bank, in essence, the firm is
a. neither a borrower nor supplier of funds in this case, since the firms has neither lent nor
borrowed money.
b. not a supplier of funds, since mutual funds are the source of lending to firms.
c. a borrower of of funds, since the bank simply is an intermediary between those who want
to borrow loanable funds and those who are willing to lend them (depositors).
d. a supplier of funds, since the bank loans money to the government for daily operations.
e. a borrower, since all bank funds are borrowed from the federal government.
c. a borrower of of funds, since the bank simply is an intermediary between those who want to borrow loanable funds and those who are willing to lend them (depositors).
Inflation reached its peak (of at least 14 percent) in the late 1970s to the early 1980s. If this statement is true,
then
a. it is certain the real rate of interest was greater than the nominal rate.
b. the real rate of interest must have been constant, even if the nominal rate varied because of
consumption smoothing.
c. it is certain the nominal rate of interest was greater than the real rate.
d. borrowers would borrow more because, automatically, real rates would fall.
e. if higher nominal rates were charged, it would be certain that lower real rates would be
received.
c. it is certain the nominal rate of interest was greater than the real rate.
The securitization of home mortgages
a. harms most home buyers, by raising the cost of borrowing.
b. harms most home buyers, by raising the sales prices of homes.
c. benefits most home buyers, by lowering the cost of borrowing.
d. benefits most home buyers, by lowering the sales prices of homes.
e. neither harms nor benefits most home buyers.
c. benefits most home buyers, by lowering the cost of borrowing.
One example of a financial intermediary is a
a. security.
b. bond.
c. stock.
d. bank.
e. financial market.
d. bank
The notion of consumption smoothing means
a. people tend to spend about the same amount each year, and if more is spent this year than
in the past, they would tend to spend less next year.
b. consumption patterns tend to correlate perfectly with income. People spend the exact
amount of their incomes over their lifetimes.
c. consumption tends to vary more than income over a person’s lifetime. Although people
should smooth their consumption over the years, they don’t. If consumption were
smoothed, people would be better off.
d. consumption varies less than income over a person’s lifetime. In early life people tend to
borrow, in late life people tend to dissave, but in their middle years they tend to save.
e. people tend to spend about the same amount each month.
d. consumption varies less than income over a person’s lifetime. In early life people tend to
borrow, in late life people tend to dissave, but in their middle years they tend to save.
Which of the following reflects an accurate economic chain of events?
a. Higher interest rates increase savings, which causes consumption smoothing.
b. Investment finances future consumption, which allows incomes—and thus savings—to
grow.
c. Savings finances investment, which allows the economy to grow from a larger capital
stock.
d. Savings finances future consumption, which allows future production to increase from a
larger capital stock.
e. Investment finances savings, which causes the economy to shrink.
c. Savings finances investment, which allows the economy to grow from a larger capital
stock.
