Chapter 6

Question 1

Cost of Money: Four Factors

Answer 1

1. Production Opportunities
   - If Increases, then Demand for $ Increases, and Cost of $ Increases.
   - If Decreases, then Demand for $ Decreases, and Cost of $ Decreases.
2. Time Preferences for Consumption
   - If Net Savers Save More, Supply of $ Increases, and Cost of $ Decreases.
   - If Net Savers Save Less, Supply of $ Decreases, and Cost of $ Increases.
3. Risk
   - If Risk Increases, Demand for $ Decreases, and Cost of $ Decreases.
   - If Risk Decreases, Supply for $ Decreases, and Cost of $ Increases.
   - Cost of $ Changes Depending on Which Factor is Stronger.
4. Inflation
   - If Inflation Increases, Demand for $ Increases, and Cost of $ Increases.
   - If Inflation Increases, Supply for $ Decrease, and Cost of $ Increases.

Question 2

Macroeconomic factors that influence interest rate levels?

Answer 2

1. Federal Reserve Policy.
   -Central Banks Increase the MS to lower interest rates.
   (by buying US Treasury Bills, Notes and Bonds)
   -Central Banks Decrease the MS to raise interest rates.
   (by selling US Treasury Bills, Notes and Bonds)
2. US Federal Government Budget Deficits or Surpluses.
   - If Budget shortfall, then Demand for $ increases, Up pressure on I.
   - If Budget surpluses, then Demand for $ decreases, Down pressure on I.
3. International Factors.
   - If Foreign Trade shortfalls, then Demand for $ increases, up pressure on I.
   - If Foreign Trade surpluses, then Demand for $ decreases, down pressure on I.
   - US Interest Rates complete with Foreign Interest Rates.
4. Business Activity.
   - If production opportunities Increase, Demand for $ increases, I increases.
   - If production opportunities Decrease, Demand for $ decreases, I decreases.

Question 3

What are the determinants of market interest rates?

Answer 3

1. The Risk-Free Inflation-Free (Real) Rate of Return
2. The Inflation Risk Premium (IRP)
3. The Maturity Risk Premium (MRP)
4. The Default Risk Premium (DRP)
5. The Liquidity Risk Premium (LRP)
6. The Tax Risk Premium (TRP)

US Treasury Bill is used to represent 1 + 2.
Long-Term US Treasury Note/Bond is used to represent 1+2+3, as these are considered to have 0% DRP

Question 4

The Default Risk Premium (DRP)

Answer 4

The difference between the interest rate on a US Treasury bond and a corporate bond of equal maturity and marketability.

Question 5

The Maturity Risk Premium (MRP)

Answer 5

A premium that reflects interest rate risk.

Question 6

Term Structure of Interest Rate

Answer 6

The relationship between bond yields and maturities.