ECO 3223 EVANS SP 2014 STUDY 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 identify and understand the concepts that might be used for the exam questions INTRODUCTION AGGREGATE DEMAND and AGGREGATE SUPPLY ANALYSIS 1 Working with the AD SRAS Model Know this model thoroughly including shifts in AD SRAS LRAS Be able to draw and explain events like oil shocks aggregate demand shocks etc in both the short run and long run How are outcomes different following a demand shock versus a supply shock Stagflation What causes it and why are the results so damaging to the economy 2 CHAPTER 3 WHAT IS MONEY 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 paper money decreed by governments as legal tender 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 most liquid assets The narrowest measure of money that the Fed reports includes the most liquid assets currency traveler s checks demand deposits other checkable deposits M2 M2 adds to M1 other assets that are not so liquid M1 small denomination time deposits savings deposits and money market deposit accounts money market mutual fund shares Because criminals and foreigners are holding large amounts of their money 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 long 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 n where p principal original amount borrowed or loaned i interest rate for one period n number of periods 1 For Simple loans the simple interest rate equals the yield to maturity Simple future present value single period Future Present value multiple periods 1 x 1 i Let 10 i In one year 100 X 1 0 10 110 In two years 110 X 1 0 10 121 or 100 X 1 0 10 2 In three years 121 X 1 0 10 133 or 100 X 1 0 10 3 PV today s present value CF future cash flow payment i the interest rate PV CF 1 i n b c years 100 X 1 n i Discount Bond Yield to Maturity In n 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 Discount 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 A zero coupon bond also discount bond or deep discount bond is a bond bought at a price lower than its face value with the face value repaid at the time of maturity It does not make periodic interest payments or have so called coupons hence the term zero coupon bondEx 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 Return Which portion of this formula gives us the capital gain R C Pt 1 Pt Pt the portion that gives capital gain is note the first portion of the equation C Pt gives you your current yield Pt 1 Pt Pt g 2 Be able to explain why bond prices and interest rates are inversely related A rise in interest rates is associated with a fall in bond prices resulting in a capital loss if time to maturity is longer than the holding period Bond prices and interest rates are inversely related due to supply and demand If you were to buy a bond yielding 4 with a 2 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 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 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 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 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 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 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 What is the impact upon bond prices and interest rates of a an increase in expected inflation an increase in the expected rate of inflations lowers the expected return for bonds causing the demand curve to shift to the left Bond price drops Interest rates increase 3 4 2 b a business cycle expansion 3 Bond price drops inters rates increase c a business cycle contraction Bond price increases interest decreases CHAPTER 6 THE RISK AND TERM STRUCTURE OF INTEREST RATES 1 Be able to calculate tax equivalent yield on a municipal bond Coupon 1 Tax rate 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 Tax equivalent yield Tax free yield 1 your federal tax bracket Tax equivalent yield is 1 43 …