Unit 8-Economic Activity, Gvt Policy, and Interest Rates Flashcards
1
Q
Business Cycle
A
-Expansion
-Peak
-Contraction
-Trough
-Short term contraction are recessions, longer are depressions
NOTE: Always start with expansion if asked
2
Q
Definition of Recession
A
Decline in GDP for 6+ months
3
Q
Definition of Depression
A
Decline in GDP for 6 quarters (18 months) with an unemployment rate of 15%+
4
Q
Signs of Business Downturns
A
- Rising bankruptcies and defaults
- Rising inventories
- Falling stock prices
- Rising consumer debt
- Falling GDP
5
Q
Countercyclical Investments
A
Those that rise during a recession (gold)
6
Q
GDP (may show as Gross National Product-GNP)
A
The sum of all annual goods and services produced within a year within a country. Includes:
-Govt spending
-Personal consumption
-Gross private investment
-Foreign investment
-Total value of exports
NOTE: To compare a current period with a previous one, GDP is set to constant dollars
7
Q
Consumer Price Index (CPI)
A
Measures overall rate of increase/decrease of a basket of goods:
- Transportation
- Food
- Housing
- Clothing
- Electricity
- Medical Care
- General Entertainment
8
Q
Inflation
A
Increase in prices overall
- Good if mild, as it stimulates growth
- Bad if inflation is high, weakens buying power
- Drives up interest rates and drives down bond prices
- Low inflation leads to stable prices, low rates
9
Q
Deflation
A
Period of falling prices
- Rare
- Usually only occurs when there is a severe depression and high unemployment
10
Q
Leading Indicators
A
Up is good (expansion), down is bad (contraction):
- Money Supply (M2)
- Building permits and housing starts
- New weekly unemployment claims
- Average work week in manufacturing
- New orders of consumer goods
- Machine tool orders
- Changes in inventories of durable goods
- Changes in sensitive material prices
- Stock prices
- Changes in business and consumer borrowing
11
Q
Coincident Indicators
A
Used to confirm where economy is:
- Hours worked (proxy for personal income)
- Employment levels
- Nonagricultural employment
- Personal income
- Industrial Production
- Manufacturing and Trade Sales
- GDP
12
Q
Lagging Indicators
A
Serve to confirm new trend in business cycle:
- Corporate profits
- Average duration of unemployment
13
Q
Keynesian Theory
A
- Govt involvement is key to economic stability
- Demand for goods ultimately determines employment and prices
- Govt should control demand by altering spending levels and taxation
- Fiscal Policy
14
Q
Monetarist Theory
A
- Milton Friedman
- Prices are determined by quantity of money in the economy
- Business owners are better at stimulating economy that the government
- FED should control money supply with reserve requirements, discount rate, and open market operations
15
Q
Supply Side Economics
A
A subset of monetarist theory:
- Government should reduce spending and taxes
- Sellers can then price goods to meet demand and still make a profit
16
Q
Laffer Curve
A
Shows relationship between tax rates and tax revenue collected by govt.
- Higher tax rates lead to more govt revenue, but only to a point.
- When taxes are too high, people are disinclined to work, which will lead to falling income and lower taxes
17
Q
Primary Difference Keynes and Monetarists
A
Mainly, what should the role of govt be?
- Keynes believes govt should be primary force in economy via fiscal policy
- Monetarists believe business know what’s best, and that the govt should only intervene to stabilize economy
18
Q
M1
A
Hard cash and demand deposits (checking account) that can be converted to cash immediately
-M1 is by far the largest and most liquid form of money
19
Q
M2
A
- All of M1 and:
- Time deposits (less than 100K)
- Savings accounts, money markets, CDs, overnight repurchase agreements, and any other instruments that can be converted to cash relatively quickly
20
Q
M3
A
- All of M1 and M2
- Time deposits exceeding 100K
- Repurchase agreements of longer than 1 day
21
Q
FED Composition
A
- 12 regional banks
- Hundreds of national and state banks
22
Q
FED Roles
A
- Acts as an agent of US Treasury
- Regulating money supply
- Setting Reserve Requirement
- Auditing member banks
- Supervising printing of money
- Clearing fund transfers (e.g., wires)
23
Q
Open Market Activities (FOMC)
A
When the FED manipulates money supply by buying or selling U.S. Govt securities in the open market
-Sales to banks tighten money on reserve, reduces number of loans that can be made, rising interest rates
24
Q
Discount Rate
A
The rate the FED charges member banks for short term loans
25
Fed Funds Rate
The rate banks charge each other for loans (overnight)
-The most volatile interest rate
-Lowering the rate reduces the cost of borrowing money which increases demand for loans
NOTE: The FED does not set Fed Funds Rate
26
Reserve Requirement and Federal Funds
Commercial banks are required to deposit a certain amount of customer funds with the FED
- All deposits (including excess) is known as Federal Funds
- When the FED raises the reserve requirements, banks must deposit more cash, and thus have less to loan out
27
Fiscal Policy
-Govt Spending
-Taxes
-Federal budget surplus/deficits
Based on the Keynes idea that the govt can control unemployment and inflation by manipulating overall demand for goods and services
28
Disintermediation
Often occurs when FED is tightening money supply
-Is when money is moved from low yielding instruments to higher yielding instruments without the bank acting as an intermediary
EX. Pulling money from a savings account to buy a mutual fund direct
29
Balance of Payments
Measures of net surplus/deficit of money between nations
| -A deficit may occur when another country is offering higher interest rates
30
Balance of Trade
Largest component of Balance of Payments
31
Value of Dollar Consideration
- When dollar is weak, foreign currency buys more goods and exports increase
- When dollar is strong, foreign currency buys less US goods. The dollar buys more foreign goods, so imports increase
32
What determines a bond's yield?
-The market
-Issuer's Credit Rating
-Current interest rates
-Time to maturity
-call/put features
NOTE: Bonds may be quoted /traded in terms of yield or dollar per par
33
Nominal Yield
The stated yield per par
| -Fixed Rate
34
Current Yield
Annual coupon/Current bond price
| -When bonds trade at discount, current yield rises and vice versa
35
Yield to Maturity (also called basis)
- Annualized return of bond if held to maturity
- Factors in price paid for bond and par value
- If bought at discount, increase is total return and vice versa
36
Yield to Call
Calculates early redemption and accelerated discount gain or premium loss from purchase price
- YTC for a premium bond called at par is always lower than nominal yield, current yield, and YTM
- Higher than all if bought at discount
37
Yield Curve
- Bond prices and yields are inversely related
- Typically, the longer a bonds maturity, the higher its yield. This can lead to credit and inflation risks over time
- In a normal (positive yield curve) the difference between short maturities and longer maturities can be about 3% (300 basis points)
38
Inverted Yield Curve
- Occurs during high inflation. Longer term bonds decline in price. Shorter term bonds have a higher yield than longer
- FED tightening
- Anticipated lower rates in the future
39
Positive Yield Curve
- Economic Expansion
| - Anticipated higher rates in the future
40
Flat Yield Curve
-Indicative of an economy that has peaked
41
Selling Bonds in the Secondary (during rising rates)
EX. You have a 10 year bond with a 5% nominal yield. Suddenly, interest rates on similar 10 year bonds rise to 6%. In order to entice a buyer to buy your bond, you need to discount the price so the manipulated yield will be equal to, or exceed 6%
42
Potential Test Scenarios
1) If given 2 bonds at discounts, and asked to choose which one will appreciate most if rates fall, choose the bond with the deeper discount (lower coupon)
2) If given 2 callable bonds and asked which will appreciate most if rates fall, choose the one with the farther out call date
43
Calculating Current Yield
Ex. What is the current yield of a 6% (1000 par) bond trading at $800?
$60/800=7.5% Bond is trading at discount
EX. What is the current yield of a 6% (1000 par) bond trading at $1200?
$60/1200=5%
EX. A bond with a stated rate of 6% has a current yield of 7.5%. The bond must be trading at [discount]
44
Average Bond Price
(price paid for bond) + (par received at maturity)/2
It is a simple average
45
Calculating YTM
[Annual interest (in dollars)-(premium or discount/years to maturity)]/Average Bond Price
46
YTM Calculation Example
An investor buys a $1000 par bond at 105 ($1050). The bond pays 10% What is YTM?
1) Find Average Price of bond (1050+1000)/2=1025
2) Annual interest is $100 (10% of $1000)
3) Premium is $50
4) Plug & Chug:
$100-($50/10)/1025
$100-$5=95
95/1025=9.3%
47
Important note of rate and price volatility
Short term interest rates are more volatile than long term
| Long term bond prices are more volatile than short
48
Important Note on Supply and Demand of Interest Rates
In an inverted yield curve situation, people expect interest rates to fall. As such, they scramble to lock in the current long-term rates. This increase demand causes bond prices to rise--BUT, a rise in price will cause yields to fall. Hence the inversion.
