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Test 1 Ch. 2,3,4,7
Money & Banking
| What is the difference between money and currency? | Money is anything generally accepted in exchange for goods & services. Currency is issued by a bank or the government, but currency is not necessarily money. |
| When are money and currency the same? | They are the same when they are accepted in exchange for goods and services. |
| Why might they be different? | Currency can stop being money if people don’t accept them in exchange for goods and services. If a group of people stop using currency to get goods and services but instead use bananas, then the bananas are the money. |
| How many prices must a barter economy have if the economy has four goods? What if it has 400 goods? Explain why having a money in the second case is beneficial. | 4 goods = 6 prices; 400 goods = 79,800 prices. Money allows us to specialize and reduce our search cost. Money allows us to reduce the number of stated prices we need. |
| You read a news story about a country that is suffering from rapid, ongoing increases in the cost of living. Which characteristic of money is being directly negatively impacted in that economy? | Store of value |
| Bobby is confused. He states: “Since prisoners are not allowed to smoke in prisons any longer, Radford’s examples of cigarettes in POW camps no longer applies.” How would you explain to Bobby how Radford’s story demonstrates the concepts of the criteria o | Any asset that is able to be standardized, divisible, durable and in demand could be currency, as long as it is a medium of exchange, is a unit of account and has store of value. Cigarettes were money. |
| Proponents of the Gold Standard, or using gold as money, often argue that it will keep inflation under control. How does the experience of Europe in the sixteenth century raise doubts about that claim? | If people start to hoard gold or silver, there may not be enough money, and an economy could slide into recession. If gold or silver increases too rapidly the economy could suffer inflation. |
| If people start to hoard gold or silver, there may not be enough money, and an economy could slide into recession. If gold or silver increases too rapidly the economy could suffer inflation. | The rate of inflation increases. |
| A critic of money economics once stated, “if you cannot measure the money supply accurately, it is not worth discussing at all.” How would you refute this statement? | Due to changes in financial markets, financial innovation and changes in the way banks operate, led to the decline in the usefulness of M2 as a monetary aggregate. |
| Economists are searching for a “good” measurement of the money supply. What constitutes a good measurement of the money supply? | To economists, a “good” measurement of the money supply is one that conforms to economic theories regarding inflation and the economy. For example, if the money supply (according to a particular measurement) increases faster than the growth rate of the ec |
| Which of the following is the broadest or most inclusive measurement of the money supply? | M2 |
| Each person might have a different time preference. Explain why an older person might have a higher or lower time preference than a young person. | An older person might have a high time preference, consumer now vs. in the future. The older person will place higher value on the ability to consume now more than money in the future. |
| What is the future value of $500 in two years if the interest rate is 4%? How would you explain this to someone who has no training in economics? | 500(1.04)2 = $540.80 |
| If the annual interest rate is 2%, what is the quarterly interest rate? | 2% / 4 = 0.005 |
| Today, shoppers “clip coupons” before they go shopping. Explain how these modern coupons are similar and dissimilar to the “coupons” referred to in the bond market. | Today, though, most bonds are not physical printed pieces of paper with coupons that must be clipped off and mailed to the issuer. |
| The fact that the face value of a bond does not change over the life of the bond is generally considered a benefit to the borrower. Can you explain why? | If the market conditions change, say rates drop, the face value will not change |
| The rate of interest a bond pays is called the bond’s: | coupon rate |
| If you have a bond with a face value of $1,000 and a coupon rate of 2.25%, but the market interest rate for such bonds is 2.5%, will your bond sell at par, at a premium, or at a discount? Explain why. | When market interest rates rise relative to coupon rates on existing bonds, the price of these existing bonds decrease below face value. This meANSWER that this bond will be sold at a discount, since the market price is below the face value of the bond. |
| If you have a bond with a face value of $1,000 and a coupon rate of 2.5%, but the market interest rate for such bonds is 2.25%, will your bond sell at par, at a premium, or at a discount? Explain why. | Premium because the coupon rate is less than the market rate |
| If a three-year bond with a $1,000 face value has a coupon rate of 3.5%, and the current market interest rate is 2%, what is the market price of the bond? | $1,043.30 |
| You read in the financial press that market participants expect stock prices to increase dramatically in the near future, while at the same time business confidence is increasing. Explain in words and show graphically what will happen in the bond market i | Stocks and bonds are considered substitutes, the return on holding stocks are going to increase, you do not want to hold bonds. Demand for bonds will fall, relative return to bonds is declining. Business confidence is increasing so firms are going to f |
| Stories appear in the financial press reporting two economic developments: Wealth levels in the United States are increasing, while at the same time the relative riskiness of bonds issued by American corporations is decreasing. Explain in words what will | Increasing wealth levels cause an increase in the demand for bonds because households can use this wealth not only to increase consumption but also save. Some portion of these new savings will find its way into the bond market as households will purchase |
| If the market price for bonds is higher than the equilibrium price, what is the result, and what will change to bring about equilibrium as price falls, ceteris paribus? | Surplus; quantity demanded will decrease and quantity supplied will increase |
| During the Reagan Administration in the 1980s, the US government ran large government budget deficits, which many argued would slow down the US economy. Using the loanable funds framework, explain in words and graphically why this argument was being made. | Please refer to Fig. 3-12: The demand for loanable funds must increase, therefore increasing interest rates, which as stated, will cause borrowing to slow down. |
| During the Reagan Administration in the 1980s, while the US government was running large government budget deficits, the rest of the world was also bringing large amounts of their savings to the United States. Using the loanable funds framework, explain i | Rest of the World If interest rates in the United States increase relative to interest rates in the rest of the world, borrowers from the rest of the world who are borrowing in the United States may choose instead to borrow at home. Thus, as US interest r |
| Assume the loanable funds market is in equilibrium. An increase in the demand for loanable funds will result in a ______ equilibrium interest rate as the quantity of loanable funds demanded __________ and the quantity of loanable funds supplied __________ | higher; increases; increases |
| Explain why changes in the demand for bonds change the supply of loanable funds. | Understand how the bond market and the loanable funds market work in the same way and give us the same result. This occurs because the bond market is a subsector of the loanable funds market. Changes that impact the bond market also impact the overall loa |
| Explain why a change in the demand for loanable funds may not change the supply of bonds. | If consumers become more confident in the future, they might go out and borrow and spend more. While this increased consumer borrowing leads to an increase in the demand for loanable funds, it does not impact the supply of bonds because households cannot |
| You read in the financial press that the economy of Finland is sliding into a recession. What will happen in the bond market and the loanable funds market in Finland, ceteris paribus? | Bond prices will increase and interest rates will decrease. |
| Firms borrowing in developing countries such as Brazil often have to pay a higher default risk premium, ceteris paribus, than similar firms borrowing in the United States. Explain why this is the case. | The overall economy may enter into a recession or a natural disaster may occur, causing the borrower’s economic condition to worsen and rendering them unable to repay. |
| Offer an explanation to someone with no training in economics for why the yield on US government bonds is used as a substitute for the risk-free rate. | Bond buyers may be more likely to buy the “sure bet” of US Treasury securities. Thus the demand for US Treasury securities increases. This selling of corporate bonds and buying of governments bonds as a result of increased uncertainty is called a “flight |
| You read in the financial press that the recent flight to quality is reversing. What will happen in the bond market? | Yields of US Treasury bonds will increase relative to the yields of corporate bonds |
| Explain why businesspeople should use the real interest rate instead of the nominal interest rate when making economic decisions. | Real interest rates are a more accurate rate because they adjust for inflation |
| Explain why rapid changes in the rate of inflation, as well as inflationary expectations, make business investment decisions difficult | Inflation leads to higher interest rates, therefore causing investment decisions to be costly. |
| If the ex ante real interest rate is less than the ex post real interest rate, which of the following happened? | Actual inflation rate is less than the expected inflation rate |
| Do you think the preferential tax treatment of muni bonds should be eliminated? Or should the tax benefit of muni bonds be reduced? Why or why not? | Eliminated; the wealthy (income) in this country are getting a huge tax advantage due to interest income. |
| If Tommy is in the 15% income tax bracket and is considering buying a muni bond that yields 3%, what yield would a corporate bond have to pay to make him indifferent between the two bonds, ceteris paribus? | The investor would be indifferent between the corporate bonds and the muni bonds only if the after-tax rate on the corporate debt was equal to the before-tax rate on the muni bond. Or, Rate before tax = Interest rate after tax/(1- Marginal tax rate) = 0.0 |
| If Kari is the 35% income tax bracket and is thinking about buying a corporate bond that yields 2.5%, what yield must a muni bond pay to make her indifferent between the two bonds, ceteris paribus? | 1.625% |
| According to the pure expectations theory, what is happening when the yield becomes steeper from one time period to the next? What does that tell you? | Upward-sloping yield curve tells us the market thinks short-term rates are going to be higher in the future than what they currently are. Think about how amazing this is! If the pure expectations theory is correct, we now essentially have a way to look in |
| How would proponents of the term premium theory explain why a yield curve becomes steeper from one time period to the next? | Longer-term bonds have a higher yield than shorter-term bonds. This offers us an explanation for why the yield curve generally slopes upward, that is, because of the term premium that has to be paid to entice bond buyers to buy longer-term bonds. |
| Proponents of segmented market theory disagree with which of the following? | Bonds are promises to repay with interest. |
| Offer two different explanations for why an inverted yield curve might signal an economic slowdown is on the way. | An inverted yield curve suggests that short-term interest rates will be lower in the future than they are today. Thus, a contractionary monetary policy pushes up short-term interest rates. These short-term rates affect people’s credit card usage. |
| Offer an explanation of how Operation Twist may have resulted in a flat yield curve. | Under Operation Twist, the Federal Reserve purchased $400 billion worth of 15-year and 20-year Treasury bonds, while at the same time selling $400 billion worth of short-term securities. |
| Under which theory might a steep yield curve suggest market participants are worried that inflation will increase in the future? | Pure expectations theory |
| While Akerlof described adverse selection in the used car market, can you think of how adverse selection might arise in the labor market? Or even in dating? | In the Labor Market: Having better information as to candidates’ resumes. Seems that as the labor market gets more competitive, people are putting down false information on their resumes. In Dating: People may not be given truthful information as to inte |
| CarMax offers a solution to the lemons problem in the used car market. What other ways might the lemons problem be resolved? | Maybe provide a greater warranty on cars that are defined as lemons. |
| Akerlof changed the conditions of perfect competition by adding in what factor that often occurs in real life. | Price differences |
| How does the existence of “free riders” help to perpetuate the adverse selection problem? | If I am letting someone do all of the analysis and leg work on a particular company, and I try and utilize this information that I am not familiar with, I am at risk of making a very bad decision. |
| It is often stated that “we live in an information age,” yet the adverse selection problem still exists. Why? | We can only do the best with the information we can obtain on people. Lending money for example, as much as we can look at their past history, we still must worry that the loan may not be repaid. |
| Which government regulatory agency was created, in great part, to help overcome the adverse selection problem in equity markets? | The Department of Justice |
| What is the relationship between the principal–agent problem in corporate governance and the moral hazard problem? | Moral Hazard caused by lack of information on specific day-to-day running of an organization. The conservative management is actually destroying the wealth of the stockholders. While all of this is going on the stockholders are clueless, they can’t keep a |
| Explain how compensating balances help to resolve the moral hazard problem in bank lending. | They sometimes require that borrower to maintain at the bank a checking or savings account with a certain minimum balance. The purpose of this, in part, is to ensure that the borrower has some secondary meANSWER to make payments on the loan, just in case |
| High deductibles are used in which financial market to help address the moral hazard problem? | Insurance market |
| Explain why economies without banks suffer from high search costs. | To understand why search costs are important, think of what a hassle it would be if you were a saver and there were no banks. You, as a saver, would have to hunt high and low to find someone who wants to borrow your money. |
| Explain how banks offer diversification to savers even if a depositor puts all of their funds into a single bank account. | Instead of lending your savings to just one borrower, the bank spreads your savings among the thousands of borrowers to whom the bank lends. Thus, when you put your savings into a savings account at a bank, you are not “putting all your eggs into one bask |
| Which of the following has the highest level of liquidity? | A bank checking account |
| If $100 million is deposited into the banking system, what would happen to the money supply, according to the simple deposit multiplier, if the required reserve ratio is 4%? What if the required reserve ratio is 6%? What do you think will happen to inter | Money Supply will increase Deposit Multiplier = 1/RRR or 1/.04=25 creating 25MM new money. 16.66 is 1/.06. creating 16.6MM in new money. As Required Reserve ratio increases, excess increases, I would expect an increase in Interest rates. |
| If $100 million is withdrawn from the banking system, what would happen to the money supply, according to the simple deposit multiplier, if the required reserve ratio is 4%? What if the required reserve ratio is 6%? What do you think will happen to intere | According to the simple deposit multiplier formula, if $100 million were withdrawn from the banking system then the money supply would decrease by $100 million X (1/RRR), where RRR refers to the require reserve ratio. If the RRR is 4%, then the money supp |
| According to the simple deposit multiplier, what happens if there is a deposit and the required reserve ratio is zero? | The growth rate of the money supply is zero |
| Explain how architecture may have been used to avoid bank runs | Bank runs may have been avoided with the help of architecture. In the old days, architecture was used to make people believe the banking system is safe. Bank buildings were massive buildings with large cement pillars in front to give depositors confidence |
| You read a story in the press that there are growing fears of a credit crunch. What impact might this have in terms of the simple deposit multiplier? | It could affect the amount of new money a bank can create. |
| Which of the following is not an assumption of the simple deposit multiplier | Banks always earn a profit |
Created by:
Khall1229