ECO 3223 SP2013 EVANS STUDY GUIDE FOR FINAL EXAM Note This is intended to direct you to the relevant topics that will be covered on the exam Questions will be worded differently so don t MEMORIZE this content use it to help you understand the concepts KNOW ALL OF THE KEY TERMS FROM EACH CHAPTER CHAPTER 3 WHAT IS MONEY 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 Paper currency decreed by governments as legal tender meaning that legally it must it must be accepted as payment for debts but not convertible into coins or precious metal page 57 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 The narrowest measure of money that the Fed reports includes the most liquid assets Currency held in cash and coins by nonbank public excludes ATM and vault cash Checking account deposits Traveler s checks M2 Money aggregate that adds assets to M1 that are not quite as liquid as M1 M1 plus Small denomination time deposits Savings deposits and money market deposit accounts Money market mutual fund shares retail A problem in the measurement of money is that the data are not always as accurate as we would like Substantial revisions in the data are not a reliable guide to short run say month to month movements in the money supply although they are more reliable over longer periods of time such as a year CHAPTER 4 UNDERSTANDING INTEREST RATES 1 For the exam you need to know how to calculate a Simple and compound interest single period and multiple periods Simple Interest p i n where p principal original amount borrowed or loaned i interest rate for one period n number of periods 1 b Simple future present value single period Future Present value multiple periods Simple Present Value CF 1 i n c Discount Bond Yield to Maturity Discount Bond A discount bond pays no interest payments It is bought at a price below face value at a discount and the face value is repaid at the maturity date Ex A one year discount bond with a face value of 1000 might be bought for 900 in a year s time the owner would be repaid the face value of 1000 d Rate of Return Which portion of this formula gives us the capital gain R C Pt 1 Pt Pt the portion that gives capital gain is Pt 1 Pt Pt g note the first portion of the equation C Pt gives you your current yield 2 Be able to explain why bond prices and interest rates are inversely related Bond prices and interest rates are inversely related due to supply and demand If you were to buy a bond yielding 4 with a maturity of one year and interest rates rise giving newly issued bonds a yield of 12 the 4 yield would no longer be attractive For it remain in demand the price of the 4 bond would drop to whatever price that would match a 12 yield Therefore as interest rates rise bond prices fall to where demand takes them and vice versa 3 Why will rising interest rates make prices for previously issued bonds fall What will happen to the true interest rate or yield on a bond if its selling price falls As explained in the last question the rising interest makes prices for previously issued bonds fall because of increased demand for the higher yield The interest rate on a bond will increase if its selling price falls 4 What is the difference between the real interest rate and the nominal rate of interest Which is the better measure of the true cost of borrowing or return from lending Real interest rate is the interest rate that is adjusted by subtracting expected changes in the price level inflation so that it more accurately reflects the true cost of borrowing Nominal interest rate does not allow for inflation Real interest rate is the better measure of the true cost of borrowing or return from lending because it is adjusted for expected changes in the price level The real interest rate is also a more accurate indication of the tightness of credit market conditions 2 CHAPTER 5 THE BEHAVIOR OF INTEREST RATES 1 According to the Theory of Asset Demand what factors will shift the Demand Curve for bonds Make sure you know in which direction an increase decrease will shift the curve How would these shifts affect bond prices and interest rates Know the same for Bond Supply Pg 99 Table 2 Wealth Expected interest rates Expected inflation Riskiness of bonds relative to other assets Liquidity of bonds relative to other assets 2 What is the impact upon bond prices and interest rates of a b an increase in expected inflation Bond price drops Interest rates increase a business cycle expansion Bond price drops inters rates increase c a business cycle contraction Bond price increases interest decreases CHAPTER 6 THE RISK AND TERM STRUCTURE OF INTEREST RATES 1 Be able to calculate taxable equivalent yields on municipal bonds Tax equivalent yield Tax free yield 1 your federal tax bracket Suppose the yield on a taxable fund is 1 50 percent while the yield on a tax free fund is 1 percent Your federal tax bracket is 28 percent 1 0 30 0 70 0 70 1 43 Tax equivalent yield is 1 43 percent the taxable fund at 1 50 percent would be the better deal 1 2 How do default risk liquidity and income tax considerations affect bond prices and interest rates on bonds 1 The greater a bond s default risk the higher its interest rate relative to other bonds 2 The greater a bond s liquidity the lower its interest rate 3 Bonds with tax exempt status will have lower interest rates then they otherwise would 3 3 What theory best explains why yield curves are generally upward sloping Liquidity premium the theory that the interest rates on a long term bond will equal an average of the short term interest rates expected to occur over the life of the long term bond plus a positive term liquidity premium CHAPTER 7 THE STOCK MARKET 1 Understand the Gordon Growth Model and what the variables represent be able to calculate the price of a stock From the resulting price you calculate interpret what the market price is telling you about investors beliefs when compared to the previous price for the stock The Gordon Growth Model page 150 is useful for finding the value of stock give a few assumptions 1 Dividends are assumed to continue growing at a constant rate forever 2 The growth rate is assumed to be less than the required return on equity 2 The perceived risk of holding stock is negatively positively related to stock price D1 ke g Positively 3