ECO 3223-SP2013 EVANSSTUDY 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 CHAPTERCHAPTER 3: WHAT IS MONEY? 1. We discussed at length the evolution of “money” over time; from commodity money to currencybacked 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 bankto 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 * nwhere: p = principal (original amount borrowed or loaned) i = interest rate for one period n = number of periods1b. Simple future/present value, single period. Future/Present value, multiple periods. Simple Present Value = CF/ (1+i)nc. Discount Bond Yield to MaturityDiscount 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 = gnote: 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 thetrue 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 isthe 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. 2CHAPTER 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 ofa. an increase in expected inflation Bond price drops, Interest rates increaseb. a business cycle expansionBond price drops, inters rates increasec. a business cycle contractionBond price increases, interest decreases CHAPTER 6: THE RISK AND TERM STRUCTURE OF INTEREST RATES1. 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). 1 / 0.70 = 1.43 Tax-equivalent yield is 1.43 percent; the taxable fund, at 1.50 percent, would be the better deal.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. 33. 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) premiumCHAPTER 7: THE STOCK MARKET1. 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