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Factors to produce high economic growth and what happens when those factors are missing Money, ―cash flow,‖ plays an important role in generate business cycles Monetary Theory ties changes in the money supply to changes in aggregate economic activity and the price level ^ in money supply (money to be spent)  ^ inflation (price level); Rate of money growth is important determinant of interest rates—positive A key factor in producing high economic growth is high interest rates 2. Financial crisis—major disruptions in financial markets that are characterized by sharp declines in asset prices and failures of financial and nonfinancial firms 3. Define money—anything that is generally accepted in payment for goods or services or in the repayment of debts; examples—cash, debit card = money; credit card = ―loan‖; checks = ―promise to pay‖ The difference between money and income is that money is a stock and income is a flow 5. Foreign Exchange: funds are converted from one currency to another How can you tell what conversion is—foreign exchange rate o Know how to determine whether currency is depreciating/appreciating  If it takes less US dollars to equal 1 euro—US dollar is appreciating; euro is depreciating 6. Organization of Financial Markets Financial markets—markets in which funds are transferred from people who have an excess of available funds to people who have a shortage of funds Bond: claim against an asset; debt security that promises to make payments periodically for a specified period of time; holders cannot vote o The bond markets are important because they are the markets where interest rates are determined Stock: ownership of company; stock holders can vote in company shareholder meetings o The stock market is important because it is the most widely followed financial market in the US Financial markets promote (greater) economic efficiency by channeling funds from savers to investors/borrowers Well-functioning financial markets promote growth Poorly performing financial markets can be the cause of poverty Interest rates on 3-mo Treasury bills fluctuate more and are lower on average Increase in stock prices increases size of people’s wealth and may increase their willingness to spend, everything else held constant Flows of Funds through the Financial System—FIGURE 1, ch. 2 7. Asymmetric information Adverse selection: before the transaction—try to avoid selecting the risky borrower; Gather info about potential borrower Moral hazard: after the transaction—ensure borrower will not engage in activities that will prevent him to repay loan; Sign a contract with restrictive covenants o If bad credit risks are the ones who most actively seek loans, and therefore, receive them from financial intermediaries —moral hazard Typically, borrowers have superior information to lenders about the potential returns and risk associated with an investment project. The difference in information is called asymmetric information Regulation of the Financial System: To increase info available to investors—reduce adverse selection and moral hazard problems; reduce insider trading (SEC) To ensure soundness of financial intermediaries—restrictions on entry (chartering process); disclosure of info; restrictions on assets and activities (control holding of risky assets); deposit insurance (avoid bank runs); limits on competition (mostly in past)—branching, restrictions on interest rates Agencies of the federal/state gov’t take actions to reduce asymmetric info— SEC: organized exchanges and financial markets—requires disclosure of info, restricts insider trading CFTC: futures market exchanges—regulates procedures for trading in future markets Office of Comptroller of Currency: federally chartered commercial banks— charters and examines the books of federally chartered commercial banks and imposes restrictions on assets they can hold NCUA: federally chartered credit unions—same as above, except credit unions State banking and insurance commissions: state-chartered depository institutions—charter and examine the books of state-chartered banks and insurance companies, impose restrictions on assets they can hold, and impose restrictions on branching FDIC: commercial banks, mutual savings banks, savings and loan associations—provides insurance of up to $100000 for each depositor at a bank, examines books of insured banks, and imposes restrictions on assets they can hold Federal Reserve System: all depository institutions—examines books of commercial banks that are members of system, sets reserve requirements for all banks Office of Thrift Supervision: savings and loan associations —examine books of savings and loan associations, imposes restrictions on assets they can hold

Examples of financial institutions—life insurance, pension fund, credit union 8. What are the functions of money? Examples—paper money and coins Medium of exchange—eliminates the trouble of finding a double coincidence of needs (reduces transaction costs); promotes specialization o A medium of exchange must be easily standardized; be widely accepted; be divisible; be easy to carry; not deteriorate quickly o Distinguishes money from other assets Unit of account—used to measure value in economy; reduces transaction costs Store of value—used to save purchasing power over time; other assets also service this function; money is the most liquid of all assets but loses value during inflation Money is used to make purchases; wealth is the total collection of pieces of property that serve to store value Income—flow of earnings per unit of time Money is a stock variable—quantity of money measured at given point in time 9. Know the formula for prices in barter economy: [n * (n-1)]/2 Compared to an economy that uses a medium of exchange, in a barter economy transaction costs are higher 10. Liquidity –A liquid asset is an asset that can easily and quickly be sold to raise cash; Money is the most liquid Ranking assets from most liquid to least liquid: currency, savings bonds, house 11. Hyperinflation—a period of extreme inflation generally greater than 50% per month Money no longer functions as a good store of value and people may resort to barter transactions on a much large scale M1 is the narrowest monetary aggregate that the Fed reports M1 includes… M2 includes… 12. Concept of present value—a dollar paid to you in the future is less valuable to you than a dollar today—[$1 x (1+i)] A dollar paid to you one year from now is less valuable than a dollar paid to you today An increase in the time to the promised future payment decreases the present value of the payment Formula 13. Best way to measure interest rate Economists consider _(yield to maturity)_ to be most accurate measure of interest rates 14. Bonds: Calculate price of bond Use formulas As bonds get longer terms, more volatile price is Figure 1—Supply and Demand for Bonds, ch 5 A discount bond pays the bondholder the face value at maturity If wealth increases, the demand for stocks increases and that of long-term bonds increases, everything else held constant Everything else held constant, a V in wealth reduces the demand for silver Hold the expected return on bonds constant, an increase in the expected return on common stocks would decrease the demand for bonds, shifting the demand curve to the left If prices in the bond market become more volatile, everything else held constant, the demand curve for bonds shifts left, and interest rates rise 15. Nominal interest rate—rate you pay; makes no allowance for inflation Real interest rate—nominals rate minus inflation; adjusted for changes in price level so it more accurately reflects the cost of borrowing Real interest rate is used to make decisions Borrow/lend based on the nominal interest rate; decisions are made based on real rate The ex ante real interest rate is adjusted for expected changes in price level Know how to calculate— If the nominal rate is 2%, and the expected inflation rate is -10%, the real interest is 12% Nominal rate > real rate = inflation; Nominal rate < real rate = deflation When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend. The price paid for the rental of borrowed funds (usually expressed as a percentage of the rental of $100 per year) is commonly referred to as the interest rate Channeling funds from individuals with surplus funds to those desiring funds when the saver does not purchase the borrower’s security is known as financial intermediation A fully amortized loan is another name for a fixed-payment loan If a security pays $55 in one year and $133 in three years, its present value is $150 if the interest rate is 10 percent 16. Factors that influence asset demands and how do they behave Wealth—in an expansion with growing wealth, the demand curve for bonds shifts to the right Expected return—higher expected interest rates in the future lower expected return for long-term bonds, shifting demand curve left Expected inflation—an increase in expected rate of inflation lowers the expected return for bonds, causing demand curve to shift left

and tax considerations Typically. default risk. Incentive for using rational vs. the way in which expectations of the variable are formed will change as well. liquidity. the expected return on money falls relative to the expected return on bonds. when interest rates rise. Difference between risk/term structures of interest Know characteristics of each. and an increase in its default risk leads to an increase in the risk premium o Liquidity—the relative ease and speed with which an asset can be converted into cash (more liquid. US Treasury bonds are the most liquid of all long-term bonds  Cost of selling a bond  Number of buyers/sellers in a bond market o Tax considerations—interest payments on municipal bonds (lower interest rate) are exempt from federal income tax The risk structure of interest rates is the relationship among interest rates of different bonds with the same maturity Three factors explain the risk structure of interest rates: liquidity.Risk—an increase in the riskiness of bonds causes the demand curve to shift to the left Liquidity—increased liquidity of bonds results in the demand curve shifting right Shifts in the Supply of Bonds: Expected profitability of investment opportunities: in an expansion. yield curves are more likely to have an upward slope. downward. when short-term rates are high. Theory of Rational Expectations—Expectations will be identical to optimal forecasts using all available information (best guess of the future) Even though a rational expectation equals the optimal forecast using all available information. Keynes’ Liquidity Preference Framework What is the assumption? Two main categories of assets that people use to store their wealth—money and bonds Total wealth in the economy = Bs + Ms = Bd + Md  Bs – Bd = Ms – Md If the market for money is in equilibrium (Ms = Md). yield curves are gently upward sloping Upward-sloping: long-term rates are above short-term rates Flat: short and long-term rates are the same Inverted: long-term rates are below short-term rates 20. on average. Funds rate Liquidity preference framework leads to the conclusion that an increase in the money supply will lower interest rates—the liquidity effect Income effort finds interest rates rising because increasing the money supply is an expansionary influence on the economy (demand curve shifts to the right) Increased money supply  increased wealth  increased demand for assets (money) Price Level effect predicts an increase in the money supply leads to a rise in interest rates in response to the rise in the price level (demand curve shifts to the right) Expected-inflation effects: shows an increase in interest rates because an increase in the money supply may lead people to expect a higher price level in the future (demand curve shifts to the right) 18. yield curves are more likely to slope downward and be inverted (markets react to high and low rates) Yield curves almost always slope upward Expectations Theory: does not explain why yield curves usually slope upward The interest rate on a long-term bond will equal an average of the shortterm interest rates that people expect to occur over the life of the longterm bond Assumptions—buyers of bonds do not prefer bonds of one maturity over another. Optimal Forecast—best guess based on all available information 25. Excess demand for money = excess supply of bonds Keynes assumed that money has a zero rate of return. explained by the first term in the equation Yield curves tend to slope upward when short-term rates are low and to be inverted when short-term rates are high. a prediction based on it may not always be perfectly accurate. but still rational 26. The forecast errors of expectations will. Risk free bonds 22. then the bond market is also in equilibrium (Bs = Bd) Cannot assume Bs = Ms OR Bd = Md Excess supply of bonds implies an excess demand for money. liquidity. and tax characteristics may have different interest rates because the time remaining to maturity is different The term structure of interest rates is the relationship among interest rates on bonds with different maturities Interest rates on bonds of different maturities move together over time (market behaves consistently) When short-term interest rates are low. 4 Market Models—Understand what these market models are defined as… what are the assumptions associated with each model 23. what you earn for taking the higher risk  A bond with default risk will always have a positive risk premium. more desirable). adaptive (from past experience only) when trying to make a forecast—will not incur costs of not using rational expectations Rational expectations lead to anticipated changes If there is a change in the way a variable moves. Expectations/Liquidity Premium—Sometimes curve says same thing in both models 21. explained by a larger liquidity premium as the term to maturity lengthens 19. Rational expectations—must use ALL info available to be rational If info is available and you are aware of it. they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. we can expect market participants to change the way they form expectations about future values of the variable People have a strong incentive to form rational expectations because it is costly not to do so. be zero and cannot be predicted ahead of time If market participants notice that a variable behaves differently now than in the past. according to rational expectations theory. so you can identify them Know theories/components Risk Structure of Interest Rates: Bonds with the same maturity have different interest rates due to: o Default risk—probability that the issuer of the bond is unable or unwilling to make interest payments of pay off the face value  US Treasury bonds are considered default free  Risk premium: the spread between the interest rates on bonds with default risk and the interest rates on (same maturity) Treasury bonds. then this explains why yield curves usually slope upward (fact 3) Liquidity Premium & Preferred Habitat Theories: The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond Bonds of different maturities are partial (not perfect) substitutes Liquidity Premium----formula Preferred Habitat Theory: o Investors have a preference for bonds of one maturity over another o They will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return o Investors are likely to prefer short-term bonds over longer-term bonds Interest rates on different maturity bonds move together over time. . o It takes too much effort to make the expectation the best guess possible o Best guess will not be accurate because predictor is unaware of some relevant information If expectations are formed adaptively. thus. and the income tax treatment of a security Term Structure of Interest Rates: bonds with identical risk. causing the demand for money to fall Demand for Money in the Liquidity Preference Model: increase interest rate  increase opportunity cost  decrease quantity demand Shifts in the Demand for Money: Income effort: increased income  increased demand  increased interest rates Price-Level Effect: increased price level (inflation)  increased demand  increased interest rates Shifts in the Supply of Money: Increased money supply  increased supply  decreased interest rate Decreased money supply  increased Fed. Circumstances involved with yield curve—upward. flat Yield curve—a plot of the yield on bonds with differing terms to maturity but the same risk. bond holders consider bonds with different maturities to be perfect substitutes According to the expectations theory of the term structure yield curves should be equally likely to slope downward as slope upward Segmented Markets Theory: Bonds of different maturities are not substitutes at all The interest rate for each bond with a different maturity is determined by the demand for and supply of that bond (individual analysis) Investors have preferences for bonds of one maturity over another If investors generally prefer bonds with shorter maturities that have less interest-rate risk. then. explained by the liquidity premium term in the first case and by a low expected average in the second case Yield curves typically slope upward. the supply curve shifts to the right Expected inflation: an increase in expected inflation shifts the supply curve for bonds to the right Gov’t budget: increase in budget deficits shift supply curve to the right 17. then people use only the info from past data on a single variable to form their expectations of that variable 24. but do not change prediction— irrational forecast If forecast is made with all available info but is not perfectly accurate— prediction is still wrong.