1.7 Determinants of Interest Rates - Solutions

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1.7 Determinants of Interest Rates - Solutions


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3
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University of Texas at Austin
Course:
Fin 320f - Foundations of Finance
Foundations of Finance Documents

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FIN 320F Foundations of Finance 1.7 Determinants of Interest Rates - Solutions 1. If the Federal Reserve takes actions that increase (loosen) the money supply, what is the impact on interest rates? Explain. When the money supply increases, the initial impact is that interest rates decrease (money is cheap!). In response, people and companies borrow more money and buy more things. As a result, GDP and inflation both increase. 2. If the Federal Reserve takes actions to decrease (tighten) the money supply, what is the initial impact on interest rates? Explain. When the money supply decreases, the initial impact is that interest rates increase (money is scarce, therefore, expensive). In response, people and companies borrow less money and buy fewer things. As a result, GDP and inflation both decrease. 3. What are foreign trade deficits and surpluses? How do they arise? The foreign trade balance equals exports minus imports. If the result is positive, we had a trade surplus. In other words, we exported more than we imported. If the result is negative, we had a trade deficit. In other words, we imported more than we exported. 4. For the year 2014, did the US experience a trade surplus or a trade deficit? What was its dollar value? We experienced a foreign trade deficit of $505 billion in 2014. 5. How do trade surpluses and deficits impact interest rates? When we have a trade deficit, it means we imported more stuff than we exported. Our cash left the country to pay for the imported goods & services. As a result, our money supply went down. When the money supply goes down, the initial impact is that interest rates go up. With a trade surplus, the answer is just the opposite: money supply goes up, interest rates go down. 6. What are federal budget deficits and surpluses? How do they arise? The federal budget balance equals receipts (also called revenues) minus outlays (also called expenses). If the result is positive, we had a budget surplus. In other words, we collected more tax dollars than we needed. If the result is negative, we had a budget deficit. In other words, we (Congress) agreed to spend more than we collected. 7. For the year 2014, did the US experience a federal budget surplus or federal budget deficit? We experienced a federal budget deficit of $483 billion in 2014. This was an amazing improvement from the $1.1 trillion deficit we experienced in 2012. We have had a budget deficit for each of the last 14 years. 8. How do budget surpluses and deficits impact interest rates? When we have a budget deficit, it means the country does not have enough money to pay for everything we said we would pay for. So we have to borrow the money. (Just as what you might do when you do not have enough cash on hand to buy groceries: use a credit card.) The government borrows money by issuing Treasurys. When investors buy the Treasurys, the investors’ ...


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