Chapter 3 1. We discussed at length the evolution of “money” over time; from commodity money to currency backed by gold, to fiat money. What is “fiat” money? Fiat money is paper currency decreed by governments as legal tender (meaning that legally it must be accepted as payments for debts) but not convertible into coins or precious metals. 2. What are the components of M1 and M2? What two factors make it so difficult for the central bank to know the true money supply from month to month? M1 is defined as currency, travelers checks, and demand deposits. M2 is M1 + savings accounts, CDS, money market accounts. More money in the M2 supply. The new forms of money including electronic payment, e-money and e-cash makes it harder to measure the money supply, M1 and M2 can move in different directions in the short run. The choice between which to choose from is an important decision for policy makers because it has different impacts and effects. Fed is very concerned about the availability of accurate monetary date. Chapter 4 A. Simple and compound interest • Simple o FV = principle x (1+i) • Compound o FV = principle x (1+i)^n B. Simple future/present value • Simple o PV = FV / (1+i) • Compound o PV = FV / (1+i)^n C. Discount Bond Yield to Maturity • I = (F-P) / P o F = face value of the discount bond o P = current price of the discount bond’ o I = interest D. Rate of Return. What portion of this formula gives us the capital gain? • Rate of Capital Gain = ((Pt+1) - Pt) / Pt • R = (C / Pt) + (((Pt+1) – Pt) / Pt)) o R = return o Pt = price at time t o Pt+1 = price at time t plus one o C = Coupon payment2. Be able to explain why bond prices and interest rates are inversely related. Bond prices and interest rates are inversely related, because if the price of the bond falls, the interest rate goes up. If the price goes up, the interest rate falls. For example, if you are holding a $1000 coupon bond at par value at 10% interest, and the interest rate rises, then the present value of your bond must fall to entice people to buy it, because the return of 10% will be less than the bonds now currently on the market. If the interest rate were to fall instead of rise, your bond now makes a better return, and therefore the price of the bond must rise. 3. Why will rising interest rates make prices for previously issued bonds fall? What will happen to the true yield on a bond if its selling price falls/rises? Rising interest rates will make the price of a previously issued bond fall – that is because the new bonds with higher interest rates bring a greater return, so to sell your bond you have to drop the price. If interest rates were to fall, then your bond price would go up because you would be earning a greater return and this is a better bond to have because of more cash flow. 4. What is the difference between the “real interest rate”, and the nominal rate of interest? The nominal interest rate makes no allowances for inflation. The real interest rate is adjusted for changes in price level so it more accurately reflects the cost of borrowing, and is likely to be a better indicator of the incentives to borrow and lend. Which is the better measure of the true cost of borrowing or return from lending, and how will this affect the decisions of borrowers and lenders? The better measure is the return from lending and the real interest rate. When the real interest rate is low there are greater incentives to borrow and few incentives to lend because everyone knows the rate of interest is going to go up. If you were to borrow now, you would have to pay back the real interest rate less in terms of goods and services. The borrower would benefit here. As the lender, you would rather spend your money now than in the future because it can buy more goods and services now. Chapter 5 1. According to the Theory of Asset Demand, what factors will shift the Demand Curve for bonds? Wealth, expected return relative to other assets, risk relative to other assets and liquidity relative to other assets. How would these shifts affect bond prices and interest rates? If wealth increases, the demand curve would shift to the right raising prices and lowering interest rates. Higher expected interest rates in the future lower the expected return for long-term bonds, shifting the demand curve to the left lowering prices and raising the interest rate.An increase in the expected rate of inflation lowers the expected return for bonds, causing the demand curve to shift to the left lowering prices and raising the interest rate. An increase in the riskiness of bonds causes the demand curve to shift to the left lowering prices and raising the interest rate. An increased liquidity of bonds results in the demand curve shifting to the right increasing prices and lowering the interest rate. What factors will shift the Supply Curve for bonds? The expected profitability of investment opportunities, expected inflation and government budget deficits. How would these shifts affect bond prices and interest rates? Expected profitability of investment: opportunities: in an expansion the supply curve shifts to the right lowering prices and raising the interest rate. An increase in expected inflation shifts the supply curve for bonds to the right lowering prices and raising interest rates. Government budget: increased budget deficits shift the supply curve to the right lowering prices and raising the interest rate. 2. What is the impact upon bond prices and interest rates of • a. an increase in expected inflation An increase in expected inflation shifts the supply curve to the right because they are the borrowers of bonds and therefore want to borrow money today rather than in the future when prices are higher. The demand curve will shift to the left because these are the lenders of bonds and they want to spend their money today, rather than in the future when prices are going to be higher. • b. a business cycle expansion A business cycle expansion leads to an increase in both the supply and demand for bonds. The demand and supply curve will both shift to the right, this will make the prices fall and interest rates rise. • c. a business cycle contraction A business cycle contraction leads to a decrease in both the supply and demand of bonds. The demand and supply curve will both shift to the left, this will make prices rise and interest rates will fall. Chapter 6 1. Be able to