ECO 3223 EVANS STUDY GUIDE FOR Final Exam Part Two Cumulative Material Only 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 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 Commodity money is money made up of precious metals or another valuable commodity o Problem heavy o Oldest standardized form of commodity money is cattle o Longest standing form is cowrie shells o Specie money is precious metals o People would steal gold so people started bringing gold to a goldsmith to store in a safe This led to high transaction costs for people to gain access to their money so the goldsmith started issuing receipts for the gold These receipts could be used for trade This caused the money supply to double because there were now the receipts and the gold supply Fiat money Paper currency decreed by a government as legal tender but not convertible into coins or precious metal 35 per ounce o Problem Easily stolen and large amounts are hard to transport o Bretton Woods After World War II America decides price of gold for everyone to go on o We went off the gold standard in 1971 because the dollar was losing its value fast and people all wanted their gold from the Fed but they were running out of gold o You could then no longer redeem your money for anything fiat money 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 o Currency doesn t include cash in ATM or bank vault o Travelers checks not issued by banks o Demand deposits include travelers checks given by banks and business checking accounts o Other checkable deposits mostly interest bearing checking accounts M2 o M1 o Small denomination time deposits less than 100 000 with maturity date o Savings deposits and money market deposit accounts o Money market mutual fund shares retail accounts which households can write checks on The Central bank isn t sure what to include in the money supply anymore M1 M2 M3 o Because of financial innovation Electronic payment E money money that exists only electronically 1 Debit card Stored value card smart card can be loaded with cash from bank account E cash Bank account links to the internet o M1 and M2 s relationship has reversed since the 1980 s M2 is more representative of the behavior of money so policy makers should focus more on it More money was moved into M2 in the 80 s because interest is now allowed on checking accounts 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 P C 1 i C 1 i n b Simple future present value single period Future Present value multiple periods Present Value o P Payment o C coupon o i yield to maturity o n number of years to maturity o PV FV 1 i n PV Present Value FV Future Value i Yield to maturity n number of years to maturity Future Value o FV Principle 1 i n FV future value N number of years to maturity i Yield to maturity instrument with its value today o i FV MV MV i Yield to Maturity FV face value MV market value c d Discount Bond Yield to Maturity The interest rate that equates the present value of cash flow payments received from a debt Rate of Return Which portion of this formula gives us the capital gain R C Pt Pt 1 Pt Pt o Capital gain Pt 1 Pt Pt o Current yield C Pt R return from holding the bond from time t to time t 1 Pt price of the bond at time t Pt 1 price of the bond at time t 1 C coupon payment 2 2 Be able to explain why bond prices and interest rates are inversely related The interest rate is in the denominator of the PV equation so when the interest rate goes up the price goes down Another way to explain why the bond price falls when the interest rate rises is that a higher interest rate implies that the future coupon payments and final payment are worth less when discounted back to the present hence the price of the bond must be lower 3 Why will rising interest rates make prices for previously issued bonds fall What will happen to the true yield on a bond if its selling price falls rises The only bond whose return equals the initial yield to maturity is one whose time to maturity is the same as the holding period A rise in interest rates is associated with a fall in bond prices resulting in capital losses on bonds whose terms to maturity are longer than the holding period Less people want a bond whose interest rate is lower than that of the market The more distant a bond s maturity the greater the size of the percentage price change associated The more distant a bond s maturity the lower the rate of return that occurs as a result of the increase with an interest rate change in the interest rate Even though a bond has a substantial initial interest rate its return can turn out to be negative if interest rates rise If the price rises the capital gain will increase and the return will normally increase If the price falls the capital gain will decrease and the return will normally decrease it could even decrease so far as to be negative o R C Pt Pt 1 Pt Pt 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 and how will this affect the decisions of borrowers and lenders Real interest rate is adjusted for inflation o Ex ante real IR adjusted for expected inflation o Ex post real IR adjusted for actual changes in the price level Fisher Equation real IR Expected Inflation Nominal IR o Real IR Nominal IR Expected Inflation o If expected inflation is higher than the nominal interest rate real returns can be negative as shown in the late 1970 s when inflation was very high Nominal and real interest rates don t always move together The real return is more important If real interest rates are expected to fall borrowers will be more eager to borrow and lenders will be less eager to lend o The price level is expected to rise so people will want to allocate the most money to buying things now while the prices are low CHAPTER 5 THE BEHAVIOR OF INTEREST RATES 3 1 According to the Theory of Asset …