ECO 3223 EVANS – SP 2014STUDY GUIDE FOR FINAL EXAM Note: This is intended to direct you to the relevant topics that will be covered on the exam. Questionswill be worded differently, so don’t MEMORIZE this content; use it to help you identify and understandthe concepts that might be used for the exam questions. INTRODUCTION: AGGREGATE DEMAND and AGGREGATE SUPPLY ANALYSIS1. Working with the AD/SRAS Model: Know this model thoroughly, including shifts inAD/SRAS/LRAS. Be able to draw and explain events like oil shocks, aggregate demand shocks, etc. inboth the short-run and long-run. How are outcomes different following a demand shock versus a supplyshock? - Aggregate demand is made up of four components parts:o C + I + GP + NEo Factors that shift ADo Increase in Autonomous monetary policy, AD shift lefto Increase in Autonomous Net exports, Ad shift right- LRAS o Shift to the right 1. Increase in the total amount of capital in the economy 2. Increase in the total amount of labor supplied 3. Increase in the available technology 4. A decline in the natural rate of unemployment- SRAS - increase in these factors shift SRAS to the left o Expected inflation o Price shock – shift to o Output gap- A shift in the aggregate demand curve affects output only in the short run and has no effecton long run- Temporary supply shock affects output and inflation only in the short run and has no effect inthe long run2. Stagflation: What causes it, and why are the results so damaging to the economy? - Stagflation occurs when the economy isn't growing but prices arewhich is not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp inflation in developed countries. For these countries, including the U.S., stagnation increased the inflationary effects. CHAPTER 3: WHAT IS MONEY? 1. We discussed at length the evolution of “money” over time; from commodity money to currency1backed by gold, to fiat money. What is “fiat” money?- Fiat money – paper currency decreed by the governments as legal tender, but not convertible into coins or precious metal.- Commodity money has inherent value to it, for example a gold coin, a horse, a cow2. 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 = currency + travelers’ checks + demand deposits + other checkable depositsM2 = m1 + small-denomination time deposits+ savings deposits and money market deposits account + Money market mutual funds sharesCHAPTER 4: UNDERSTANDING INTEREST RATES 691. For the exam, you need to know how to calculate:a. Simple and compound interest (single period and multiple periods).b. Simple future/present value, single period. Future/Present value, multiple periods. - Pv = cf / 1 + i)^n- FV = 100 * (1+i)^nc. Discount Bond Yield to MaturityYield to maturity – the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today.d. Return. Which portion of this formula gives us the capital gain?2. Be able to explain why bond prices and interest rates are inversely related. 3. Why will rising interest rates make prices for previously issued bonds fall? What will happen to thetrue yield on a bond if its selling price falls/rises? 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, and how will this affect the decisions of borrowers and lenders?- Real interest rate – is adjusted for changes in price level so it more accurately reflects the cost of borrowing- Nominal interest rate – makes no allowance for inflationCHAPTER 5: THE BEHAVIOR OF INTEREST RATES 911. According to the Theory of Asset Demand, what factors will shift the Demand Curve for bonds?2(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.)Increase in in these variables will shift demand curve to the right- 1. Wealth- 2. Expected Returns- 5. Liquidityo Risk and expected inflation will do the oppositeTheory of Asset demand - which states that holding all of the other factors constant:- 1. An increase in wealth raises the quantity demanded of an asset.- 2. An increase in an asset’s expected return relative to that of an alternative asset, raises the quantity demanded of the asset.- 3. If an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall.- 4. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets.2. What is the impact upon bond prices and interest rates of?a. an increase in expected inflationb. a business cycle expansionc. a business cycle contractionCHAPTER 6: THE RISK AND TERM STRUCTURE OF INTEREST RATES 1651. Be able to calculate tax-equivalent yield on a municipal bond. - TEY = CM / 1 - t2. How do default risk, liquidity and income tax considerations affect bond prices and interest rates on bonds? Bonds with the same maturity have different interest rates due to- 1. Default risk – probability that the issue of the bond is unable or unwilling to make interest payments or pay off the face value.o Increase in default risk, lowers the price of corporate bonds and increase interest rates- 2. Liquidity - the less liquid, higher interest rate paid by the issuer- 3. Tax considerations – higher tax, higher interest rate.3. What theory best explains why yield curves are generally upward-sloping?- Yield curve – a plot of the yield on bonds with differing terms to maturity but the same risk, liquidity and tax considerationso 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 + a liquidity premium that responds to supply and demand conditions for that bond4. Be able to interpret the various yield curve shapes visually, and discuss their macroeconomic implications.- Upward-sloping yield curve – long-term rates are above short-term rateso This is the normal yield curve- Steep upward slope of the yield curve – short terms rates are expected to rise in the future.3- Relatively flat yield curve – short and long term rates are the