Lecture 4

Question 1

What are nominal interest rates?

Answer 1

the ordinary interest rates on money

Question 2

How are nominal interest rates normally quoted?

Answer 2

on an annualised compounding basis

the interest is paid and then you pay interest on interest

Question 3

What does the yield curve show?

Answer 3

interest rates that apply today and 1 yr, 2 yrs and 3 yrs into the future
ie. they are yields or interest rates across different contract maturity lengths for a similar debt contract

Question 4

If inflation is expected to rise, nominal interest rates are expected to what?

Answer 4

increase too

Question 5

What is the equation for compound interest and what do each of the components mean?

Answer 5

A = P(1+[r/n])^(rt)

where P = principle (ie. starting amount)
r = interest rate
n = number of times it is compounded per year

Question 6

A $1000 10% for 2 years means you are given $1000 now. At the end of 1 year, how much do you owe? How much do you owe after 2 years?

Answer 6

• 1 year: $1000 x (1 + (0.10/1)) = 1000 x 1.10 = $1100
• 2 years: $1100 x (1 + (0.10/1))
  = 1100 x 1.10 = 1210

A = $1000*(1 + 0.10)^2 = $1210

Question 7

A $1000 10% loan for 90 days (1/4 year) means you are given $1000 now and at the end of the 90 day, how much do you repay?

Answer 7

A = $1000*(1 + 0.10)^0.25 = $1025

Question 8

A $1000 invested at 10% for 2 years compounded monthly means you have to pay back how much at the end of the 2 years?

Answer 8

A = 1000(1+(0.1/12))^(12)(2) = $1220.39

Question 9

Built into the yield curve are expectations about

Answer 9

inflation

Question 10

What are the three different variations of the yield curve?

Answer 10

Positive yield curve
Inverted yield curve
Flat yield curve

Question 11

What does a positive yield curve indicate?

Answer 11

• investors expect strong future economic growth and higher future inflation (that is increasing inflation expectations and this, higher interest rates)

Question 12

What does an inverted yield curve indicate?

Answer 12

investors expect sluggish economic growth and lower inflation (that is falling expectations and thus lower interest rates)

Question 13

What does a flat yield curve indicate

Answer 13

this generally indicates that investors are unsure about future economic growth and inflation

Question 14

Someone investing for 2years could invest for 1 year now and reinvest for another year in a year’s time. If they equate returns then what is the equation?

Answer 14

(1 + i(t)2)^2 = (1 + i(t)1)^1 + (1 + i(t+1)1)^1

Question 15

What does (1 + i(t)2)^2 mean?

Answer 15

you invest today (t) for 2 years

Question 16

What does (1 + i(t)1)^1 mean?

Answer 16

you invest today (t) for 1 year (1)

Question 17

What does (1 + i(t+1)1)^1 mean?

Answer 17

you invest in one year for 1 year

Question 18

Investing today for m+n years is equal to what?

Answer 18

investing today for n years + investing in n years for m years

Question 19

Where can a good explanation of the future interest rates equation be found?

Answer 19

on slide 6 of 2a-1 Yield Curve

Question 20

Suppose 2 year rates are 6% and one year rates are 5%. What is the expected 1 year rate in 1 year’s time?

Answer 20

2i(t)^2 = i(t)^1 + i(t+1)^1
2 x 6 = 1 x 5 + i(t+1)^1
i(t+1)^1 = 7%

Question 21

Suppose 3 year interest rates are 6%, and 1 year interest rates are 5%. What is the expected 2 year rate in one years time?

Answer 21

3i(t)^2 = 1i(t)^1 + 2i(t+1)^2
3 x 6 = 1 x 5 + 2i(t+1)^2
2i(t+1)^2 = 13
i(t+1)^2 = 6.5%

Question 22

Suppose 3 year interest rates are 6%, and 1 year interest rates are 5%. What is the expected 2 year rate in one years time?

Answer 22

3i(t)^2 = 1i(t)^1 + 2i(t+1)^2
3 x 6 = 1 x 5 + 2i(t+1)^2
2i(t+1)^2 = 13
i(t+1)^2 = 6.5%

Question 23

Suppose real rates wee constant at 2%, and we expect 4% inflation this year, 2% in t+1 and 0% in year t+2. What would we expect the yield curve to look like and why?

Answer 23

We would expect it to be downward sloping because inflation is falling (and so interest rates are going to fall too)

Question 24

Where is the rest of lecture 4 and why?

Answer 24

on google docs because brainscape is a fucking piece of shit

Question 25

What is money?

Answer 25

Money is any good that is widely used and accepted in transactions involving the transfer of goods and services - it avoids the issue of double coincidence of wants

Question 26

What is commodity money? Give an example

Answer 26

This is a good whose value serves as the value of money. Gold coins are an example of commodity money. Commodity money has been generally replaced with fiat money

Question 27

What is fiat money?

Answer 27

This is a good, the value of which is less that the value it represents as money eg. their value as slips of printed paper is less than their value as money

Question 28

What are four functions of money?

Answer 28

Act as a medium of exchange
A measure of value or unit of account or means of valuation
Store of value
Standard of deferred payment

Question 29

The characteristics of money allow it to carry out what six functions?

Answer 29

Durability
Portability
Divisibility
Uniformity
Limited supply
Acceptability

Question 30

If money is less liquid, what does this mean?

Answer 30

It is less easily convertible into buying something

Question 31

Is M3 more or less liquid than M2?

Answer 31

Less liquid

Question 32

What are the three different measures for the money supply?

Answer 32

M1
M2
M3

Question 33

What is M1?

Answer 33

This includes cash and checking deposits

Question 34

What is M2?

Answer 34

This is all elements of M1 as well as “near money”

Question 35

What is near money?

Answer 35

This refers to savings deposits, money market securities, mutual funds and other time deposits

Question 36

What is M3?

Answer 36

This is a measure of the money supply that includes M2 as well as large time deposits, institutional money market funds, short term repurchase agreements and larger liquid assets.