ECON 311: EXAM 2
97 Cards in this Set
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Term Structures of Interest Rates
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Explains why otherwise, similar bonds with different maturities have different yields
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Three theories of the term structure of Interest Rates
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1. Expectations theory
2. Segmented Markets Theory
3. Liquidity Premium Theory
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Term Structure Observations (#1)
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1. Interest Rates for bonds with different maturities tend to move together
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Term Structure Observations (#2)
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Yield curves tend to slope up when short-term interest rates are low, and slope down when short-term interest rates are high
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Term Structure Observations (#3)
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yield curves are typically upward sloping
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Expectations
Theory (Notes)
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Bond investors view bonds of different maturities as perfect substitutes
- Don't care about maturity, only expected return
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Expectation Theory (book)
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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.
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This example shows what theory?
- Option 1: Buy a 2 year Bond
- Option 2: Buy a one year bond, and in one year, invest the proceeds in another one year bond.
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Expectations Theory
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Segmented Markets Theory (Notes)
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Assumes bond investors do not consider bonds with different maturities to be substitutes AT ALL
- Bond investors prefer short-term bonds to long-term bonds, have less interest rate risk
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Segmented Markets Theory (Book)
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-sees markets for different-maturity bonds as completely separate and segmented.
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Liquidity Premium Theory (Notes)
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Assumes that bonds of different maturities are substitutes but not perfect substitutes
- Assumes investors prefer shorter maturities to longer maturities
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Liquidity Premium Theory (Book)
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the interest rate on 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 premium that responds to supply and demand conditions for that bond.
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Exchange rates consist of what two currencies?
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- term currency (numerator)
- base currency (denominator)
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When the exchange rate increases, what happens to the base currency and the term currency?
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The base currency appreciates in value and the term currency depreciates
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Direct Exchange Rate:
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Home currency per unit of home currency
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Indirect Exchange Rate:
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foreign currency per unit of home currency
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"Units of foreign currency per dollar"
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Indirect Exchange rate
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What happens when the dollar appreciates against the yen?
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1. US goods become more expensive in Japan; this makes US businesses less competitive
2. Japanese goods become less expensive in the US, this benefits US consumers
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"Law of One Price"
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- suggests that in the absence of trade barriers and transaction costs, the price of good should be the same everywhere regardless of where it is sold.
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Purchasing Power Parity
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is the application of the law of one price to foreign exchange markets.
(a dollar should have the same value everywhere)
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In the long run, nominal exchange rates depend on?
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1. Relative price levels
2. Relative Trade Barriers
3. Relative preference for foreign and domestic goods
4. Relative productivity
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What is Money?
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anything that is generally accepted in payment for goods and services or in the repayment of debt
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Functions of Money
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1. Medium of exchange
2. Store of value
3. Unit of account
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Medium of exchange eliminates what problem of the barter system?
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double coincidence of wants
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Evolution of Money
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1. Commodity Money
2. Convertible paper money
3. Fiat Money
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Unit of Account
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Agreed upon measure for stating the prices of goods and services, and for stating the value of debts.
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Commodity Money
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A physical commodity that has value in its own right, but also serves as money
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Gold coin, silver coin, bananas could be examples of what kind of money?
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Commodity Money
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Convertible Paper Money
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A paper "claim" to a commodity
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Fiat Money
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- A commodity with no intrinsic value that also serves as money
- Money because the government says its money
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M1 includes
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1. Currency in the hands of the public
2. Demand deposits (Checking Deposits)
3. Other checkable deposits (Now Accounts)
4. Travelers checks
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M2 includes:
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a. everything in M1
b. Savings deposits
c. Time deposits (CDs)
d. Money Market Mutual Fund Accounts
(less than $100,000)
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Money Demand Theories:
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1. Fisher's Quantity Theory of Money
2. Keyne's Liquidity Preference Model
3. Baumol - Tobin Model
4. Friedman's Modern Quantity Theory
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Neutrality of Money
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changes in M have no impact on Y
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Spot Transactions
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involve the immediate (two-day) exchange of bank deposits
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Forward transactions
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involve the exchange of bank deposits at some specified future date
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Real exchange rate
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in effect, it is the price of domestic goods relative to the price of foreign goods denominated in the domestic currency.
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if a factor increases the demand for domestic goods relative to foreign goods
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the domestic currency will appreciate
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if a factor decreases the relative demand for domestic goods
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the domestic currency will depreciate
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In the long run, a rise in a country's price level (relative to the foreign price level)
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causes its currency to depreciate
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A fall in a country's relative price level
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causes its currency to appreciate
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Increasing trade barriers causes a country's currency to
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country's currency to
appreciate in the long run
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Increased demand for a country's exports causes its currency to
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appreciate in the long run
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increased demand for imports causes the domestic currency
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to depreciate in the long run
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In the long run, as a country becomes more productive relative to other countries...
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its currency appreciates
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An increase in the domestic interest rate iDshifts the demand curve for domestic assets,D,
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to the right and causes the domestic currency to appreciate
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A decrease in the domestic interest rate iD shifts the demand curve for domestic assets,D
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to the left and causes the domestic currency to depreciate
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An increase in the foreign interest rate iFshifts the demand curve D
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to the left and causes the domestic currency to depreciate
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A fall in the foreign interest rate iFshifts the demand curve D
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to the right and causes the domestic currency to appreciate
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A rise in the expected future exchange rate, Eet+1 shifts the demand curve
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to the right and causes an appreciation of the domestic currency
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A fall in the expected future exchange rate Eet+1 shifts the demand curve
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to the left and causes a depreciation of the domestic currency
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When domestic real interest rates rise
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the domestic currency appreciates
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When domestic interest rates rise due to an expected increase in flation
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the domestic currency depreciates
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A higher domestic money supply causes the domestic currency to
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depreciate
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Monetary Neutrality
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states that in the long run, a one-time percentage rise in the money supply is matched by the same one-time percentage ruse in the price level, leaving unchanged the real money supply and all other economic variables such as interest rates.
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What does the Monetary neutrality tell us interest rates?
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in the long run, the rise in the money supply would not lead to a change in the domestic interest rate so it would rise back to its old level.
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Exchange rate overshooting
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exchange rate falls by more in the short run than it does in the long run when the money supply increases
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Capital Mobility
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foreigners can easily purchase American assets, and Americans can easily purchase foreign assets
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Interest parity condition
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states that the domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency
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The time spent trying to exchange goods or services is called
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a transaction cost
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Payments System
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the method of conducting transactions in the economy
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Monetary Aggregates
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measure of the money supply
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Small denomination time deposits
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certificate of deposit with a denomination of less than $100,000 that can only be redeemed at a fixed maturity date without penalty
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(T/F) We probably should not pay much attention to short-run movements in the money supply numbers, but should be concerned only with long-run movements
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TRUE
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Velocity of Money
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the average number of times per year (turnover) that a dollar is spent in buying the total amount of goods and services produced in the economy
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Equation of Exchange
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M x V = P x Y
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Quantity Theory of Demand
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states that nominal income is determined solely by movements in the quantity of money
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Movements in the price level result solely from
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changes in the quantity of money
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Three motives behind the demand for money
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1. transactions motive
2. precautionary motive
3. speculative motive
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"individuals are assumed to hold money because it is a medium of exchange that can be used to carry out everyday transactions" - what motive is this?
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Transactions Motive
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"people hold money as a cushion against an unexpected need." - what motive is this?
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precautionary motive
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" people also hold money as a store of wealth" - what motive is this?
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speculative motice
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Money demand is _____ related to the level of interest rates
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negatively
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The precautionary demand for money is ____ related to interest rates.
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negatively related
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transactions component of the demand for money is _____ related to the level of interest rates.
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negatively
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Unlike Keyne's theory, which indicates that interest rates are a important determinant of the demand for money, Friedman's theory suggest....
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changes in interest rates should have little effect on the demand for money
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The argument for for why bonds of different maturities are not substitutes is that...
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investors have very strong preference for bonds of one maturity but not for another, so the will be concerned with the expected returns only for bonds of the maturity they prefer
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Fisher made what two assumptions about the Quantity theory of Money?
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1. Changes in velocity were constant. (v=0)
2. Neutrality of Money- changes in M have no impact on Y (Y=0)
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Quantity Theory of Money Demanded equation
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M = k(PY), where k = 1/v
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Quantity Theory of Money Demand
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- people are holding money for transaction purposes
- Money demand depends on nominal income and institutional factors
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Assuming velocity is constant, changes in the interest rate
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have no impact on money demand
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if yield curves on average were flat, what would this say about liquidity premiums in the term structure? would you be more or less willing to accept the expectations theory?
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if yield curves on average were flat, this would suggest the risk premium on long term relative to short term bonds would equal 0, and we would be more willing to accept the expectations theory.
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“If bonds of different maturities are close substitutes, their interest rates are more likely to move together.” Is this statement true, false, or uncertain? Explain your answer.
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When bonds of different maturities are close substitutes, a rise in interest rates for one bond causes the interest rates for others to rise because the expected returns on bonds of different maturities cannot get too far out of line.
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if the yield curve suddenly becomes steeper, how would you revise your predictions of interest rates in the future?
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you would raise your predictions because the higher long term rates imply that the average of the expected future short term rates is higher
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If expectations of future short-term interest rates sud-denly fall, what would happen to the slope of the yield curve?
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The slope of the yield curve would fall because the drop in expected future short rates means that the average of expected future short rates falls so that the long rate falls
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A country is always worse off when its currency is weak. T or F?
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False. A weaker currency makes domestically produced goods cheaper to foreign consumers, helping export industries. A weaker currency makes foreign goods more expensive to domestic consumers.
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The president of the United States announces that he will reduce inflation with a new anti-inflation program. If the public believes him, predict what will happen to the exchange rate for the U.S. dollar.
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Reduced inflationary expectations results in an increased in expected future exchange rate. This increases the expected return on dollar assets, increasing the demand for these assets. The dollar will increase in value.
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If the British central bank lowers interest rates to reduce unemployment, what will happen to the value of the pound in the SR and the LR?
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It will depreciate in both the SR and LR but fall more in the SR
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If nominal interest rates in America rise but real interest rates fall, predict what will happen to the U.S. exchange rate?
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it will depreciate
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If American auto companies make a breakthrough in automobile technology and are able to produce a car that gets 60 miles to the gallon, what will happen to the U.S exchange rate?
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it will appreciate
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If Mexicans go on a spending spree and buy twice as much French perfume, Japanese TVs, English sweaters, Swiss watches, and Italian wine, what will happen to the value of the Mexican peso?
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Demand for imports causes the domestic currency (Mexico) to depreciate
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If Mexicans go on a spending spree and buy twice as much French perfume, Japanese TVs, English sweaters, Swiss watches, and Italian wine, what will happen to the value of the Mexican peso?
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Demand for imports causes the domestic currency (Mexico) to depreciate
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If expected inflation drops in Europe so that interest rates fall there, predict what will happen to the exchange rate for the U.S dollar?
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Europe's currency appreciates while the U.S. exchange rate depreciates
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If the European central bank decides to contract the money supply to fight inflation, what will happen in the value of the U.S. dollar?
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Decreasing the money supply makes the domestic currency (Euro) appreciate, making relative currencies depreciate such as the U.S. dollar
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If there is a strike in France, making it harder to buy French goods, what will happen to the value of the euro?
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demand for imports will arise, causing the currency to depreciate
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In Keyne's analysis of the speculative demand for money, what will happen to money demand if people suddenly decide that the normal level of the interest rate has declined? Why?
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Money demand will decrease. If the "normal" level of interest rates has declined, people will expect rates to fall towards the new "normal" level. Thus, they expect bond prices to rise and money demand will fall
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Keynes dived the assets that can be used to store wealth into two categories
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money and bonds
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Econ 311: Test 1