Study Guide for Test I
Money and Banking
Econ 320
Tips: Your starting point should be the homework! Know the definitions, however, I will not ask you to directly define a word. You will be expected to use the jargon to answer the questions.
The first and third chapters are quick intros. Everything covered in these chapter is discussed in greater detail in other chapters. The key issues in these sections are the jargon and the services provided by the financial system.
WHY STUDY MONEY, BANKING, AND FINANCIAL MARKETS?
What are the five core principles of the financial system? Be able to relate these to specific markets and institutions.
Bond Market
Stock Market
Foreign Exchange Market
Why Study Banking and Financial Institutions?
Chapter 2
This should be a review of a Econ 204 section.
What is money?
What are the four main functions of money? Describe each.
How does money permit specialization?
What is the difference between commodity money and fiat money?
How does inflation change the value of money?
How does it change the usefulness of money as a medium of exchange?
Is the store-of-value function unique to money?
Must money be a store of value to serve its function as a medium of exchange?
Are credit cards money?
Thought provoking question: What are the pros and cons of switching to a paperless form of money?
Chapter 3
Chapter three is also an intro chapter. It basically covers the same material as chapter 1, but it has several words to add to your economic jargon.
The main theme is that the financial system brings savers and borrowers together.
What is liquidity?
How does the financial system improve liquidity?
How does the financial system improve information exchange?
What is meant by integration of financial markets? What effect would increased integration of financial markets, domestically and internationally, have on returns for savers? On costs to borrowers?
Tons of Jargon:
portfolio, pooling effect, diversification, primary markets, secondary markets, debt, principal, equity, dividend, initial public offering, investment banks, capital markets, money markets, auction markets, exchanges, OTC, NYSE, NASDAQ, derivatives, options, futures, financial institutions, brokers, dealers, integration, negotiable CDs, commercial paper, Banker's acceptances, repurchase agreements, fed funds, eurodollars, stocks, mortgages, corporate bonds, t-bills, t-notes, t-bonds, Ginnie Mae, TVA, munis, bank loans, second mortgages, investment banks, banks, S&Ls, mutual saving banks credit unions, life insurance, fire and casualty insurance, pension funds, finance companies, Equifax, GMAC, mutual funds, money market mutual funds, SEC, FDIC, etc, etc…..
Chapter 4. Present value and future value.
The best practice for this section is the homework.
Be able to calculate the present value, internal rate of return, current yield, and return for problems similar to the homework.
Be able to explain the difference between real and nominal interest rates.
Chapter 5 Risk.
Be sure to read the chapter. We cover all of the material, but in a large example. We looked at portfolio allocation with a risky and risk-free bond and them compared the results to an individual asset. You do not need to be able to derive all of the equations, but you should be able to apply the equations as in the homework
Because most people are risk-averse savers they evaluate the variability of expected returns as well as their size.
a. Risk-neutral savers judge assets only on their expected returns; variability of returns is not a concern.
b. Risk-loving savers prefer to gamble by holding a risky asset with the possibility of maximizing returns.
Advantages of Diversification
A. To compensate for the inability to find a perfect asset, individuals engage in diversification, which is allocation of savings among many different assets.
B. Returns on assets do not move together perfectly because their risks are imperfectly correlated.
C. The strategy of dividing risk by holding multiple assets ensures steadier income.
D. Savers cannot eliminate risk entirely because assets share some common risk called market (or systemic) risk.
E. Diversification reduces the riskiness of the return on a portfolio unless assets’ returns move together perfectly.
F. To measure systematic risk, financial economists calculate a variable called beta, the responsiveness of a stock’s expected return to changes in the value of all stocks.
1. If a 1% increase in the value of the market portfolio leads to a 0.5% increase in the value of the asset, the asset’s beta is 0.5.
2. When an asset has a high value of beta, its return has a lot of systematic risk.
3. Because systematic risk cannot be diversified away, investors are less willing to hold an asset with a high beta.
Supply and Demand in the Bond Market
A. The interest rate that prevails in the bond market is determined by the demand for and supply of bonds.
B. If we view bonds as the good, then the lender is buying the bond, the borrower is selling the bond, and the amount the lender pays for the bond is the price of the bond.
C. If we view the use of the funds as the good, then the borrower is the buyer, the seller is the supplier of funds, and the price of the funds is the interest rate.
D. The demand curve for bonds (with the price of bonds on the vertical axis and the quantity of bonds on the horizontal axis) slopes down because the lender desires to purchase more bonds when the price of bonds is low.
1. The supply of loanable funds is equivalent to the demand for bonds.
2. The supply curve for loanable funds (with the interest rate on the vertical axis and the quantity of loanable funds on the horizontal axis) slopes up because lenders desire to loan more funds at higher interest rates.
E. The supply curve for bonds slopes up because borrowers are willing to supply more bonds at higher prices.
Explaining Changes in Equilibrium Interest Rates
A. The same factors that savers use to select investments in the theory of portfolio allocation are those that cause the demand curve for bonds to shift.
1. As wealth increases in the economy, the demand curve for bonds and the supply curve of loanable funds shift to the right.
2. An increase in the expected return on other assets or an increase in expected inflation shift the demand curve for bonds and the supply curve of loanable funds to the left.
3. An increase in the riskiness of bonds relative to other assets shifts the demand curve for bonds and the supply curve of loanable funds to the left.
4. An increase in liquidity in the bond market will shift the demand curve for bonds and the supply curve of loanable funds to the right.
5. A rise in the information costs for bonds relative to other assets shifts the demand curve for bonds and the supply curve of loanable funds shift to the left.
B.
Shifts in the supply curve for bonds and the demand curve for loanable funds result from changes in the willingness and ability of borrowers to issue bonds at any given price or interest rate.1. An increase in the expected profitability of capital shifts the supply curve for bonds and the demand curve for loanable funds to the right.
2. A decrease in business taxes shifts the supply curve for bonds and the demand curve for loanable funds to the right.
3. A decrease in expected inflation shifts the supply curve for bonds and the demand curve for loanable funds to the right.
C. An increase in government borrowing shifts the bond supply curve to the right.
D. During recessions interest rates fall because the bond supply curve shifts to the left (due to declining expected profitability of capital) by more than does the bond demand curve (due to declining wealth).
E. Higher expected inflation shifts the bond demand curve to the left and the bond supply curve to the right, thereby lowering bond prices and raising interest rates.
The last chapter provided the final bridge to interest rates.
Risk Structure
Be able to use the two graph framework to explain
default risk
tax difference
information differences
liquidity difference
Term Structure
Be familiar with the issue of term structure and how an economist might explain the patterns we see in the real world.
Remember that our text used math at every corner, I am not interested in the math here, but rather the big picture.