midterm Flashcards
What is the relationship between increasing money supply and inflation?
Increasing the money supply can lead to higher inflation.
When more money circulates in the economy without a corresponding increase in goods and services, prices tend to rise.
How do higher inflation rates affect interest rates?
Higher inflation often leads to higher interest rates.
Lenders demand higher interest rates to compensate for the decreased purchasing power of future repayments due to inflation.
What is the effect of a higher money supply on interest rates?
Higher money supply leads to lower interest rates.
Higher interest rates make holding money less attractive due to increased opportunity costs.
Define ‘financial system’.
The financial system is made up of markets, securities, and institutions that connect borrowers with lenders.
List the 4 social functions of the financial system.
- Production efficiency
- Consumption smoothing
- Asset/maturity transformation
- Risk sharing/Asset diversification
What is production efficiency in the context of the financial system?
The financial system helps allocate capital efficiently to increase the production of goods and services.
What does consumption smoothing refer to in financial systems?
It allows consumers to borrow money when needed and repay it later, helping them time their purchases better.
Explain asset/maturity transformation.
The financial system turns short-term assets into long-term ones, creating risks from mismatched time frames.
What is risk sharing/asset diversification?
It spreads risk across different people based on their preferences, shifting risk from older individuals to younger ones.
Why is for-profit lending important?
Lenders need to make money, ensuring they only lend to borrowers who can repay, promoting economic growth and stability.
List the three layers of responsibility in lending.
- Personal ethical code
- Enough skin in the game
- Financial regulations and auditing
What is the personal ethical code in lending?
Lenders must treat borrowers fairly and check carefully if they can pay the loan back.
Explain ‘skin in the game’ in lending.
Lenders put some of their own money into the loan, ensuring they care about the outcomes and help borrowers succeed.
What role do financial regulations and auditing play in lending?
They ensure that lending practices are honest and mitigate risks.
What is the connection between the layers of responsibility and moral hazard?
Without these rules, lenders might make bad loans, thinking someone else will pay if things go wrong.
What is the main difference between money markets and capital markets?
Money markets deal in short-term debt instruments (1 year or less), while capital markets deal in longer-term debt and equity instruments.
List 4 money market instruments.
- T-Bills
- Federal Funds
- Repos
- Commercial Paper
What are T-Bills?
Short-term government loans that mature in less than a year.
What is Federal Funds?
Overnight loans between banks to meet reserve requirements.
Define repos in the context of money market instruments.
Short-term loans where securities are sold and later repurchased.
What is Commercial Paper?
Short-term loans issued by companies to cover expenses.
List 4 capital market instruments.
- T-Notes
- T-Bonds
- Municipal Bonds
- Corporate Bonds
What are T-Notes?
Medium-term government bonds that pay interest every six months.
Define T-Bonds.
Long-term government bonds that pay interest for many years.
What are Municipal Bonds?
Bonds issued by local governments to raise money for public projects.
What are Corporate Bonds?
Loans issued by companies that pay interest over time.
List the 3 most important functions performed by commercial banks.
- Intermediation
- Payment System
- Financial Services
What is intermediation in commercial banks?
Commercial banks take money from savers and lend it to borrowers.
Explain the payment system function of commercial banks.
Banks help people pay for things using services like checks and online transfers.
What financial services do commercial banks provide?
They help people save money, provide advice, and offer investment options.
List the 3 most important functions performed by investment banks.
- Underwriting of Securities
- Mergers & Acquisitions
- Trading of Securities in Secondary Markets
What does underwriting of securities entail?
Investment banks help companies sell stocks and bonds to raise money.
Explain the mergers & acquisitions function of investment banks.
They assist companies in buying or merging with other companies.
What is the role of investment banks in trading securities?
They buy and sell stocks and bonds in the market for investors.
What is a negative feedback loop?
A system gets off balance, but natural forces push it back to normal without help.
What is a positive feedback loop?
A system gets off balance and keeps moving further away from normal unless something intervenes.
What is speculative demand?
People buy assets not for use, but to sell later for profit.
What is the widespread use of debt in financial markets?
People buy assets using borrowed money, increasing both profits and losses.
Explain collateralized lending.
Borrowing money secured by an asset, which can cause problems if asset values drop.
What is mark-to-market accounting?
Updating the value of assets based on current market prices, which can lead to instability.
What is inertia or momentum in asset prices?
When asset prices go up, they often continue to rise, leading to risky behavior.
Explain fractional reserve banking.
Banks keep a small part of deposits and lend out the rest, which can lead to financial crises.
Is speculative demand a sufficient condition for instability in financial markets?
No, it needs additional factors like excessive leverage to create volatility.
What was Friedman’s view on speculation in financial markets?
Speculative demand reflects rational expectations and bubbles are temporary and self-correcting.
What was Minsky’s view on speculation?
Speculative demand, combined with financial instability, leads to inevitable bubbles in capitalism.
List Minsky’s 5 stages of a financial bubble.
- Displacement
- Credit Creation
- Euphoria
- Critical Moment
- Revulsion/Panic
What is displacement in Minsky’s theory?
A new trend excites investors, driving up prices.
Explain credit creation in the context of financial bubbles.
Lenders offer more loans, increasing asset purchases and prices.
What happens during the euphoria stage of a bubble?
Investors believe prices will keep rising, leading to reckless investments.
What is the critical moment in a financial bubble?
A trigger causes investors to panic and rethink asset values.
What occurs during the revulsion/panic stage?
Investors rush to sell, causing prices to crash and leading to bankruptcies.
What is money?
Money is anything people accept as payment for goods, services, or debts.
List the 4 functions of money.
- Medium of Exchange
- Store of Value
- Unit of Account
- Standard of Deferred Payments
What is the medium of exchange function of money?
Money is used to buy goods and services immediately, accepted by everyone.
Explain the store of value function of money.
Money retains value over time, allowing future purchases.
What is the unit of account function of money?
Money helps compare prices and measure the value of things.
What does standard of deferred payments mean?
Money is used to settle future debts, provided its value remains stable.
List the 10 characteristics of good money.
- Recognizability
- Widespread Acceptability
- Integrity
- Fungibility
- Divisibility
- Transportability/Transferability
- Durability
- Scalability
- Limited Supply
- Stability in Value
How does the U.S. dollar satisfy the characteristics of good money?
It best meets the characteristics, facing challenges like inflation and limited supply.
What characteristics does Bitcoin meet as money?
Recognizability, integrity, and transportability, but struggles with acceptability, scalability, and stability.
What strengths does gold have as money?
Durability, limited supply, and fungibility, but lacks in divisibility, transportability, and scalability.
What is meant by demand for money?
The need to hold money instead of spending or investing it.
Why is the demand for money limited?
Too much money can cause inflation, reducing its value.
List the three reasons why people demand money.
- Transactional
- Precautionary
- Speculative
What are quasi-monies?
Assets that fulfill some, but not all, functions of money.
What are near-monies?
Assets that almost function like money but are not widely accepted.
Is Bitcoin considered a near money?
Yes, because it serves as a store of value and medium of exchange but has limitations.
