TVM & Economics

Question 1

Nominal and Effective Interest Rates

Answer 1

Nominal Rates: a stated or reported rate which does not consider compounding within the annual period
Effective Rates: an annualized rate that considers the frequency by which interest is compounded within a year

Question 2

Real interest rate

Answer 2

(1 + nominal rate) = (1 + real interest rate) (1 + inflation rate)

VERY IMPORTANT: Do not simply subtract inflation from a nominal rate on your exams. That will give you the wrong answer. You must use this equation.

Question 3

Ordinary annuity vs annuity due

Answer 3

Ordinary Annuity: a finite series of periodic cash flows where cash flow (incoming or outgoing) occurs at the end of the period
Annuity Due: a finite series of periodic cash flows in which the cash flow (incoming or outgoing) occurs immediately

Question 4

Internal Rate of Return

Answer 4

also called the effective interest rate;

• IRR is a dollar weighted return;
• IRR is the discount rate at which the net present value of all cash flows equal zero;
• IRR is the discount rate at which present value of all future cash flows is equal to the initial investment or cash outlay (i.e., at which the investment breaks even)

Question 5

Classical Economics

Weakness

Answer 5

Adam Smith
Supply creates its own demand

This school cannot explain a prolonged depression as any declines in aggregate demand would/should be temporary and self correcting

Question 6

Utility function

Answer 6

the perception that something

will satisfy a need or desire

Question 7

Marginal utility

Answer 7

concept that value increases for each unit of consumption up to a point at which value begins decreasing for each additional unit consumed an important concept to grasp

Question 8

Austrian School of Economic Thought

Answer 8

• This school is similar to neoclassical but considers the role of the money supply and government actions.
• Government intervention may cause a boom and bust cycle.
• Friedrich (F.A.) Hayek a pioneer of Austrian economic theory.

Question 9

Who was John Maynard Keynes?

Answer 9

Keynes (1883 - 1946) was a British economist known for his work in macroeconomic theory and business cycles. Keynes refuted neoclassical economics theories that suggested free market forces would effectively correct or manage swings in cycles and unemployment.

Question 10

Key Economic Principles of Keynes

Answer 10

Keynesian economics theory suggests that in the short run, economic productivity is highly impacted by aggregate demand (spending) and this demand is not equal to the capacity of an economy. Especially in times of recession, the economy is influenced by myriad factors that can cause economic and financial disruptions. Hence, government intervention is necessary to correct these short run inefficiencies.
Very low interest rates would not stimulate the economy because confidence would be too low. Government should intervene in a crisis, running a deficit.

Question 11

Criticism of Keynesian economics theory

Answer 11

–Government debt could get out of control.
–Expansionary policy may cause the economy to grow too fast, resulting in inflation and other ills.
–It takes time for fiscal policies to work, so they may be ill
timed for a short term crisis.

Question 12

Who was Milton Friedman?

Answer 12

Friedman (1912-2006) was a U.S. economist, statistician and scholar who taught at the University of Chicago. Freidman is known for his work on monetary history and models, consumption, and stabilization policy. Freidman won the Nobel Prize in Economics in 1976.

Question 13

Key Economic Principles Milton Friedman

Answer 13

Friedman ultimately opposed Keynesian theories, supported monetarism and opposed the creation of the Federal Reserve. Friedman believed in letting free markets operate with minimal intervention from the government and that small, incremental expansion of the money supply was optimal.

Question 14

Monetarism

Answer 14

Monetarists contend that inflation is a function of how much money a government prints. Advocate for a steady increase in the money supply and a limited role of government.

Question 15

Those following the monetarist school of thought object to the Keynesian approach because Keynesian theory:

Answer 15

–does not consider the role of the money supply.
–is not logical in light of utility maximizing market participants.
–ignores the long term cost of government intervention.
–does not consider the unpredictability of the timing of fiscal policy changes on the economy.

Question 16

Elasticity

Answer 16

The ratio of the percentage change in the quantity to the percentage change in the price.

Question 17

Own price elasticity

Answer 17

(% change in quantity demanded)/(the % change in price)

Question 18

Cross price elasticity of demand

Answer 18

the response in the demand of a good to a change in the price of another good.
–A substitute is a good that has a positive cross price elasticity.
–A complement is a good that has a negative cross price elasticity.

If demand for good B goes up when price of good A up the cross price elasticity will be positive (a substitute)

Question 19

Demand-side Policy

Answer 19

• Fiscal policy the government’s spending and taxing actions

- Monetary policy manipulation of the money supply

Question 20

Supply- Side Policies

Answer 20

Goal: To create an environment in which workers and owners of capital have the maximum incentive and ability to produce and develop goods.
Supply siders focus on how tax policy can be used to improve incentives to work and invest.

Question 21

Liquidity trap (monetary policy)

Answer 21

occurs when market participants hold large cash balances, so changes in the money supply will not affect real activity. This is a problem in the monetary policy transmission mechanism.

Question 22

Risk of quantitative easing (QE)

Answer 22

A risk of QE is that if the securities with credit risk are purchased,
the central bank is taking on a significant risk.

Question 23

Structurally adjusted (or cyclically
adjusted) budget deficit

Answer 23

Takes into account automatic stabilizers:
In a downturn, government transfer payments increase (for example, unemployment benefits).
In a booming economy, taxes increase (especially if progressive).

Question 24

Difficulties with Fiscal Policy to stabilize aggregate demand

Answer 24

-There are lags.
• There is a lag between a slowing economy and the data to assess such (the recognition lag
• It may take several months to implement (the action lag)
• It may take time for there to be any impact on the economy (the impact lag ).
–it is difficult to predict where the economy is heading apart from any fiscal policy, and some policies may make things worse.

Question 25

Overview of the business cycle

Answer 25

An expansion occurs after a low point (the trough) and a contraction (ie recession) occurs after the highest point (the peak)

Question 26

Operating leverage

Answer 26

Operating leverage refers to the sensitivity of a company’s profits to changes in revenue. The higher the fixed costs relative to variable costs that a company must meet regardless of sales, the larger the impact that a decline in revenue will have on income. These fixed costs include, but are not limited to, debt payments.

Question 27

Business Cycle Summary

Answer 27

Slide 143; inflation is highlighted

Question 28

Hyperinflation

Answer 28

Hyperinflation is an extremely fast increase in the aggregate price level.
–
It generally occurs when government spending is not backed with tax revenues and the money supply is increased (or unlimited).

Question 29

Producer Price Index (PPI)

Answer 29

a measure of average change in price in goods and services received by domestic producers; three areas of production included: commodity based, industry based, and stage of processing based

Question 30

Consumer Price Index (CPI)

Answer 30

a broad measure of inflation; measures prices by taking a weighted average of a basket of consumer goods and services including food, medical care, transportation, energy, etc.

Question 31

Difference between CPI and PCE

Answer 31

In summary, the CPI represents a basket of goods and services that a consumer would buy without making substitution changes when prices change. The PCE encompasses a broader range of goods and services than the CPI, from a broader range of buyers. It tries to track what is actually purchased, and represents how consumers change their buying patterns when relative prices change. This leads to smoother price changes in the PCE and typically lower levels of reported inflation, at least as experienced by consumers.

Sources of data: The CPI uses data from household surveys; the PCE uses data from the gross domestic product report and from suppliers. In addition, the PCE measures goods and services bought by all U.S. households and nonprofits. The CPI only accounts for all urban households.

Coverage: The CPI only covers out-of-pocket expenditures on goods and services purchased. It excludes other expenditures that are not paid for directly (e.g., medical care paid for by employer-provided insurance, Medicare, or Medicaid). These are included in the PCE.

Question 32

GDP Deflator

Answer 32

a measurement that adjusts Gross Domestic Product (GDP) for the impact of inflation

Question 33

3. Reflation

Answer 33

a condition in which prices begin rising again; a term used to describe monetary or fiscal policy designed to raise output and counter the effects of falling prices or deflation; often occurs after an economic contraction and fall in financial markets

Question 34

leading economic indicator

Answer 34

• Average weekly hours
• Average weekly initial claims for unemployment insurance
• Manufacturers’ new orders for consumer goods and materials
• Vendor performance, slower deliveries diffusion index
• Manufacturers’ new orders for non-defense capital goods
• Building permits for new private housing units
• S&P 500 Index
• Money supply, real M2
• Interest rate spread between 10 year Treasury yields and the federal funds rate
• Index of Consumer Expectations

Question 35

coincident economic indicator

Answer 35

• Aggregate real personal income
• Employees on nonfarm payrolls
• Industrial Production Index
• Manufacturing and trade sales

Question 36

lagging economic indicator

Answer 36

• Average duration of unemployment
• Inventory to sales ratio
• Change in unit labor costs
• Average bank prime lending rate
• Commercial and industrial loans outstanding
• Ratio of consumer installment debt to income
• Change in consumer price index for services

Question 37

Gross national product (GNP) VS Gross domestic product (GDP)

Answer 37

GDP includes goods and services produced by country’s citizens outside of country but not below
GNP includes G&S produced by foreigners within the country but not above

Question 38

Are currency exchange rates volatile in the short-term?

Answer 38

Yes, very

Question 39

Currency exchange rate convention

How to write: “1 Euro can be exchanged for 1.1126 US Dollars”

Is this real or nominal?

Answer 39

Standard exchange rate format for is B:C in which
B = Base (or “Fixed” or “Unit”) Currency
C = Counter (or “Price” or “Variable”) Currency

EUR:USD 1.1126

Nominal

Question 40

Real currency exchange rate

Answer 40

(nominal or spot exchange rate)*[(price level country A)/(price level country B)]

(price level country A)/(price level country B) is the relative price level

Question 41

Spot and Forward Rates

Answer 41

• A spot exchange rate is an exchange rate for an immediate delivery (that is, exchange) of currencies.
• A forward exchange rate is an exchange rate for the exchange of currencies at some specified, future point in time.

Question 42

Mark to market value for forward contracts

Answer 42

is the profit or loss that would result from closing out a position at current market prices.
Mark to market is zero at inception of the contract, but then changes over the life of the contract.

Question 43

Foreign exchange carry trade

Is there alpha?

Answer 43

A strategy in which there is a long position in high yielding currencies (that is, countries with higher interest rates) and short positions in low yielding currencies (that is, countries with lower interest rates, referred to as funding currencies).

Evidence indicates excess returns to this strategy, which may be attributable to the riskiness of the high interest rate currencies highly leveraged position).

Question 44

Special Drawing Rights (SDRs)

Answer 44

supplementary foreign exchange reserve assets created and

managed by the International Monetary Fund (IMF)