1 CHAPTER 3 WHAT IS MONEY ECO 3223 02 EVANS STUDY GUIDE FOR EXAM 3 Final Exam 1 2 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 Also referred to as the money supply is Anything that is generally accepted in payment for goods or services or in the repayment of debts Fiat money paper money decreed by governments as legal tender Holds no real intrinsic value 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 Currency Traveler s checks Demand deposits Other Checkable deposits M2 Small denomination time deposits Savings deposits and money market deposit accounts Money market mutual fund shares 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 PV amount borrowed 100 CF cash flow in one year 110 n number of years 1 For simple loans the simple interest rate equ als the b Simple future present value single period Future Present value multiple periods 100 110 i 1 1 1 100 110 i i 1 110 100 0 10 10 i yield to maturity PV today s present value CF future cash flow payment i the interest rate PV CF i 1 n c Discount Bond Yield to Maturity For any one year discount bond i F P P F Face value of the discount bond P current price of the discount bond The yield to maturity equals the increase in price over the year divided by the initial price As with a coupon bond the yield to maturity is negatively related to the current bond price d Rate of Return Which portion of this formula gives us the capital gain 2 The payments to the owner plus the change in value expressed as a fraction of the purchase price RET return from holding the bond from time t to time t 1 RET C Pt Pt 1 Pt Pt Pt price of bond at time t Pt 1 price of the bond at time t 1 C coupon payment C current yield ic Pt Pt 1 Pt rate of capital gain g Pt The return equals the yield to maturity only if the holding period equals the time to maturity 2 Be able to explain why bond prices and interest rates are inversely related The biggest economic threat to bonds is rising interest rates If you own a bond and interest rates go up the value of your bond on the open marketwill go down 3 4 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 Because rising falling interest rates affect the cash flow a bond holder gets each month year it may make older issue bonds with more less attractive interest rates more attractive 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 Nominal interest rate makes no allowance for inflation Real interest rate is adjusted for changes in price level inflation so it more accurately reflects the cost of borrowing The real interest rate is the one that should be used when measuring the true cost of borrowing or return from lending because it takes into account the natural influence that inflation has on interest rates and yields from bonds From the borrowers perspective you want to be able to successfully measure inflation s effect on your loan because it will help you determine whether or not it would be supplemental and worth the risk you re taking From the lender s perspective the real interest rate should be used to measure the true cost of return because it reflects the natural influence inflation has on price levels which in turn shows you if you should lend your money 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 in an expansion with growing wealth the demand curve for bonds shifts to the right higher expected interest rates in the future lower the expected return for long term bonds BOND DEMAND an increase in the expected rate of inflations lowers the expected return for bonds causing Wealth Expected Returns shifting the demand curve to the left Expected Inflation the demand curve to shift to the left Risk Liquidity an increase in the riskiness of bonds causes the demand curve to shift to the left increased liquidity of bonds results in the demand curve shifting right 3 Expected profitability of investment opportunities Expected inflation Government budget an increase in expected inflation shifts the supply curve for bonds to the right increased budget deficits shift the supply curve to the right in an expansion the supply curve shifts to the right BOND SUPPLY 2 What is the impact upon bond prices and interest rates of a an increase in expected inflation A one time increase in the money supply will cause prices to rise to a permanently higher level by the end of the year The interest rate will rise via the increased prices Price level effect remains even after prices have stopped rising A rising price level will raise interest rates because people will expect inflation to be higher over the course of the year When the price level stops rising expectations of inflation will return to zero Expected inflation effect persists only as long as the price level continues to rise b a business cycle expansion Suppose there is an expansion GDP supply of bonds shifts right demand for bonds shifts right If supply shifts more than demand bond price P decreases i rises If demand shifts more than supply bond price P increases i falls c A business cycle contraction In either case quantity of bonds sold Decrease in Demand and Supply Opposite idea in b CHAPTER 6 THE RISK AND TERM STRUCTURE OF INTEREST RATES 1 2 3 1 2 3 1 Be able to calculate after tax yield on a bond 4 How do default risk liquidity and income tax considerations affect bond prices and interest rates on bonds Default risk probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value Liquidity considerations the cots of selling your bond The amount of buers sellers theyre in the bond market Tax Considerations Interest payments on municipal bonds are exempt from federal income taxes What theory best explains why yield curves are generally upward