ECO 3223 02 EVANS STUDY GUIDE FOR EXAM 2 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 CHAPTER 5 Asset market approach the dominant methodology used by economists because correctly conducting analyses in terms of flows is very tricky especially when we encounter inflation Demand Curve Shows the relationship between the quantity demanded and the price when all other economic variables are held constant Excess Demand When prices are driven up due to the fact that more people want to buy than those willing to sell Excess Supply Prices are driven down due to the fact that more people want to sell than those willing to buy Expected Return The return expected over the next period on one asset relative to alternative assets Fisher effect When expected inflation rises interest rates will rise Liquidity the ease and speed with which an asset can be turned into cash relative to alternative assets Liquidity preference framework determines the equilibrium interest rate in terms of the supply of and demand for money Market Equilibrium when the amount that people are willing to buy equals the amount that people are willing to sell at a given price Opportunity cost the amount of interest sacrificed by not holding the alternative asset Risk the degree of uncertainty associated with the return on one asset relative to alternative assets Supply Curve Shows the relationship between the quantity supplied and the price when all other economic variables are held constant Theory of asset demand holding all of the factors constant o The quantity demanded of an asset is positively related to wealth o The quantity demanded of an asset is positively related to its expected return relative to o The quantity demanded of an asset is negatively related to the risk of its return relative to o The quantity demanded of an asset is positively related to its liquidity relative to alternative alternate assets alternative assets assets Wealth The total resources owned by the individual including all assets 1 Why do interest rates fluctuate Interest rates fluctuate due to the changes in prices in the bond market which are set by the market through Supply and Demand In which Bond prices and interest rates are inversely related 2 bonds According to the Theory of Asset Demand what factors will shift the Demand Curve for 1 Make sure you know in which direction an increase decrease will shift the curve Increase in wealth will shift demand curve to the right Expected Interest rates rising will shift demand curve to the left Expected inflation rising will shift demand curve to the left Riskiness of bonds relative to other assets rising will shift demand curve left Liquidity of bonds relative to other assets rising will shift demand curve right According to the Theory of Asset Demand what factors will shift the Supply Curve for 3 bonds and in which direction with an increase decrease Profitability of investments increasing will shift supply right Expected inflation rising will shift supply right Government deficit rising will shift supply right 5 4 an increase in expected inflation Prices decrease interest rates increase a business cycle expansion Prices increase Interest rates decrease a business cycle contraction Price decrease interest rates increase What is the impact upon bond prices and interest rates of a b c The bond market represents the general level of longer term interest rates the money market for short term rates What factors determine and shift the supply and demand for money What do we mean by stating that the interest rate is the opportunity cost of holding money The income price level and Money supply are the factors that shift the demand for money Interest Rates are ultimately what we pay in order to be able to borrow money thus we have to pay for that opportunity in order to use that borrowed money Be able to draw the model of supply and demand for money and indicate how a shift in 6 either demand or supply will affect short term interest rates 7 interest rates do we say that the Fed can What is the secondary and undesirable economic effect of a decrease in short term which results from an increase in the supply of money In other words why target either inflation or interest rates but not both An increase in interest rates in the long term if all of other factors overpower the liquidity effect The Fed can only choose one because it has to choose if they prefer effects in the short run or long run 8 short run why do we actually see interest rates rising What is the Fisher Effect If an increase in the supply of money leads to lower interest rates and inflation in the When an increase in the supply of money leads to lower interest rates is known as the liquidity effect Milton Friedman argued that the liquidity effect might not leave everything else equal thus those other changes that might occur may be stronger than the liquidity effect and in fact raise interest rates The Fisher effect is that when expected inflation rises interest rates will rise 9 Describe Keynes liquidity preference framework in terms of the income and price level effects 2 A higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right A rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right CHAPTER 6 1 Credit rating agencies pg 126 Investment advisory firms that rate the quality of corporate and municipal bonds in terms of the probability of default Default pg 123 Occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures Default free Bonds pg 124 Bonds with no default risk Expectations Theory pg 132 The interest rate on a long term bond will equal an average of the short term interest rates that people expect to occur over the life of the long term bond Inverted yield Curve pg 130 a downward sloping yielding curve Junk Bonds pg 126 Bonds with ratings below Baa or BBB have higher default risk and have been aptly dubbed speculative grade Liquidity premium theory pg 136 the term structure states that 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 plus a liquidity