Economics of Financial Markets Unit 1 Flashcards
(128 cards)
1
Q
What role did the technology boom and interest rates play in the housing market “bubble”, the financial crisis and the subsequent Great Recession?
A
In response to the Dot.com bust and then the 9/11 attacks, the Fed lowers interest rates to prevent a prolonged recession. Low interest rates led to increase in demand for housing and financing. Risky financing and mortgage-backed security losses leads to financial crisis.
2
Q
What were the significant trends in the performance of the Dow Jones Industrial Average since 1990?
A
3
Q
What are the current levels in U.S. GDP (relative to potential), unemployment, price levels, and interest rates (not actual values, but trends).
A
?
4
Q
What significant event during the 1980s is associated with former Federal Reserve Chair, Paul Volker?
A
Volcker is associated with bringing the inflation rate from 13.5% in 1980 to 1.9% in 1986.
5
Q
What were the four major ways that the Federal Reserve responded to the financial crisis that intensified after the collapse of Lehman Brothers.
A
- Lender of Last Resort:
- Provision of Liquidity to Financial System:
- Open Market Operations (conventional and unconventional):
- Regulatory and Supervisory:
- These initiatives have been credited with preventing the complete collapse of our financial system.
6
Q
What is “debt deflation”, and how has it affected recovery from the Great Recession?
A
A situation in which a substantial decline in the price level sets in, leading to a further deterioration in firms’ net worth because of the increased burden of indebtedness.
7
Q
What is the aggregate demand curve?
A
describes the relationship between the quantity of aggregate output demanded and the inflation rate when all other variables are held constant.
8
Q
What component parts make up Aggregate Demand?
A
Y(AD)=C+I+G+NX
C=consumption expenditure=the total demand for consumer goods and services
I=planned investment spending=the total planned new spending by business firms
G=government purchases=spending by all levels of government
NX=net exports=exports minus imports.
9
Q
What are demand shocks?
A
shift the aggregate demand curve to a new position:
(1) autonomous monetary
policy,
(2) government purchases,
(3) taxes,
(4) autonomous net exports
(5) autonomous consumption expenditure
(6) autonomous investment
(7) financial frictions: the relative difficulty of
conducting a transaction(research, regulations, fees, etc.)
10
Q
What is the aggregate supply curve?
A
the relationship between the quantity of output supplied and the price level(ii/inflation rate).
11
Q
What is natural rate of unemployment?
A
The rate of unemployment consistent with full employment at which the demand for labor equals the supply of labor.
-This is not 0%, some economists believe it is currently at 5%.
12
Q
What determines the amount of output that can be produced in the economy in the long run(LRAS)?
A
determined by the amount of capital in the economy, the amount of labor supplied at full employment, and the available technology.
13
Q
What is natural rate of output?
A
The level of aggregate output produced at the natural rate of unemployment, often referred to as potential output
-It is where the economy settles in the long run for any inflation rate.
14
Q
What is output gap?
A
defined as the difference between aggregate output and potential output, Y − YP.
15
Q
What are Supply shocks?
A
occur when there are shocks to the supply of goods and services produced in the economy that translate into price shocks.
16
Q
What are price shocks?
A
Shifts in inflation that are independent of the amount of slack in the economy or expected inflation.
(example: terrorists destroy oil fields, causing less supply, and AS to shift left and up)
17
Q
What are cost-push shocks?
A
in which workers push for wages higher than productivity gains, thereby driving up costs and inflation.
18
Q
What drives inflation and therefore the Short-Run Aggregate Supply Curve?
A
p = pe + g(Y - YP) + r
(Inflation=Expected inflation + g * Output gap + Price Shock)
g=the sensitivity of inflation to the output gap
19
Q
What causes The long-run aggregate supply curve to shift to the right?
A
when there is
1) an increase in the total amount of capital in the economy,
2) an increase in the total amount of labor supplied in the economy
3) an increase in the available technology
4) a decline in the natural rate of unemployment(more capable workers)
20
Q
What causes the short-run aggregate supply(SRAS) curve to shift to the left?
A
When there is an:
1) increase of Expected inflation.
2) Price shock increase
3) Output gap, (Y - YP) increase
21
Q
What is equilibrium?
A
the point where the quantity of aggregate output demanded equals the quantity of aggregate output supplied.
-There is a short run and a long run equilibrium
22
Q
How does the Short run equilibrium change when it is above LRAS?
A
23
Q
How does the Short run equilibrium change when it is below LRAS?
A
24
Q
What is the self-correcting mechanism?
A
A characteristic of the economy that causes output to return eventually to the natural rate level regardless of where it is initially.
25
What effect happens when there is a positive demand shock(and therefore a rightward shift in the aggregate demand curve)?
Although the initial short-run effect of the rightward shift in the aggregate demand curve is a rise in both inflation and output, the ultimate long-run effect is only a rise in inflation because output returns to its initial level at YP.
26
What is stagflation?
a situation of rising inflation but a falling level of aggregate output.
-(a combination of the words stagnation and inflation).
27
What is real business cycle theory?
A theory that views real shocks to tastes and technology as the major driving force behind short-run business cycle fluctuations.
28
What is the difference between a temporary negative supply shock and a permanent negative supply shock?
a temporary one leads to a temporary rise in inflation and temporary decline in output initially, A permanent one will also cause those but will lead to a shift rightward in the long run aggregate supply, which results in a fall in potential output, leads to a permanent decline in output and a permanent rise in inflation.
29
What are financial markets?
markets in which funds are transferred from people who have an excess of available funds to people who have a shortage.
30
What is a security?
a claim on the issuer’s future income or _assets_: (any financial claim or piece of property that is subject to ownership).
-also called a financial instrument
31
What is a bond?
a debt security that promises to make payments periodically for a specified period of time.
32
What is an interest rate?
the cost of borrowing or the price paid for the rental of funds (usually expressed as a percentage of the rental of $100 per year).
33
What is a stock?
represents a share of ownership in a corporation. It is a security that is a claim on the earnings and assets of the corporation(equity).
34
What are financial intermediaries and what are it's 3 major benefits?
institutions that borrow funds from people who have saved and in turn make loans to others. Therefore they are indirect.
1. Lower transaction costs
2. Reduce the exposure of investors to risk
3. Deal with asymmetric information problems
35
What are Banks?
financial institutions that accept deposits and make loans.
-Included under the term banks are firms such as commercial banks, savings and loan associations, mutual savings banks, and credit unions.
36
What is Financial innovation?
the development of new financial products and services, can be an important force for good by making the financial system more efficient.
37
What is e-finance?
A new means of delivering financial services electronically.
38
What is Money(money supply)?
defined as anything that is generally accepted in payment for goods or services or in the repayment of debts.
39
What is aggregate output?
the total production of final goods and services in the economy.
40
What is unemployment rate?
The percentage of the labor force not working.
41
What are business cycles?
the upward and downward movement of aggregate output produced in the economy.
42
What are recessions?
periods of declining aggregate output.
43
What is monetary theory?
the theory that relates the quantity of money and monetary policy to changes in aggregate economic activity and inflation.
44
What is aggregate price level?
The average price of goods and services in an economy.
45
What is inflation?
The condition of a continually rising price level.
46
What is inflation rate?
the rate of change of the price level, usually measured as a percentage change per year.
47
What is monetary policy?
The management of the money supply and interest rates.
48
What is a central bank?
The organization responsible for the conduct of a nation’s monetary policy. The United States’ central bank is the _Federal Reserve System_ (also called simply the Fed).
49
What is Fiscal policy?
involves decisions about government spending and taxation.
50
What is a budget deficit?
the excess of government expenditures over tax revenues for a particular time period, typically a year,
51
What is a budget surplus?
arises when tax revenues exceed government expenditures. The government must finance any deficit by borrowing, while a budget surplus leads to a lower government debt burden.
52
What is gross domestic product (GDP)?
The value of all final goods and services produced in the economy during the course of a year.
53
What is foreign exchange market?
The market in which exchange rates are determined.
54
What is foreign exchange rate?
The price of one currency stated in terms of another currency.
55
the relationship between money supply growth(M2) and business cycles
Rising supply of money will expand the economy and vise versa.
56
the reason for the “crossover” of M2 and the GDP Deflator depicted in Figure 4
- tech. allowed companies to increase productivity
- tech weakened the inflationary effects of money policy
57
how to calculate a growth rate; real versus nominal GDP growth?
Real GDP(new)= Nom GDP x (Defl Old/Defl New)
Growth Rate %=(New Real GDP - Old Nom GDP/Old Nom GDP) x 100
58
How do you do CPI Inflating to current value?
Current Value Infl=Prior Value x (CPI Current / CPI Prior)
59
What are liabilities?
IOUs or debts for the individual or firm that sells (issues) them.
60
What is capital?
(wealth, either financial or physical, that is employed to produce more wealth), which contributes to higher production and efficiency for the overall economy.
61
What is "maturity" of a debt instrument
the number of years (term) until that instrument’s expiration date.
62
What are the different terms for maturity of a debt instrument?
A short-term is if maturity is less than a year.
intermediate-term is if maturity is between one and ten years.
long-term is if maturity is ten years or longer.
63
What are equities?
claims to share in the net income (income after expenses and taxes) and the assets of a business such as common stock.
-stock is an equity, bond is a debt instrument.
64
What are dividends?
Periodic payments by equities to their holders.
considered long-term securities because they have no maturity date.
65
What is a primary market?
a financial market in which new issues of a security, such as a bond or a stock, are sold to initial buyers by the corporation or government agency borrowing the funds.
66
What is a secondary market?
a financial market in which securities that have been previously issued can be resold.
67
What is investment banks?
Firms that assist in the initial sale of securities in the primary market by _underwritting_ securities:(purchase securities from a corporation at a predetermined price and then resell them in the market)
68
two reasons that the secondary market is important to the primary market for stock...
1. First, they make it easier and quicker to sell these financial instruments to raise cash; that is, they make the financial instruments more liquid.
2. they determine the price of the security that the issuing firm sells in the primary market.
69
What is the difference between brokers and dealers?
_Brokers_ are agents of investors who match buyers with sellers of securities; _dealers_ link buyers and sellers by buying and selling securities at stated prices.
70
What does the term liquid mean in finance?
Easily converted into cash.
71
What are exchanges?
where buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades such as the NYSE.
72
What are over-the-counter (OTC) markets?
where dealers at different locations who have an inventory of securities stand ready to buy and sell securities “over the counter” to anyone who comes to them and is willing to accept their prices.
73
What is the difference between a Money market and a Financial market?
a Financial market in which only short-term debt instruments (generally those with original maturity of less than one year) are traded.
Capital market is the market in which longer-term debt (generally those with original maturity of one year or greater) and equity instruments are traded.
74
What are the largest components of the money and capital markets, respectively?.
MM: U.S. Treasury bills, Negotiable bank certificates of deposit large denominations) ,Commercial paper, Federal funds and security repurchase agreements
CM:Corporate stocks, Residential mortgages, Corporate bonds, U.S. government securities, commercial loans
75
What is default?
a situation in which the party issuing the debt instrument (the federal government in this case) is unable to make interest payments or pay off the amount owed when the instrument matures.
76
What is currency?
Paper money (such as dollar bills) and coins.
77
What is federal funds rate?
a closely watched barometer of the tightness of credit market conditions in the banking system and the stance of monetary policy.
\*Federal funds are the most important financial instrument
-When high, it indicates that banks are strapped for funds; when the rate is low, banks’ credit needs are low.
78
What are mortgage-backed securities?
a bond-like debt instrument backed by a bundle of individual mortgages, whose interest and principal payments are collectively paid to the holders of the security.
79
What is the difference between a Foreign bond and a Eurobond?
Foreign bonds are sold in a foreign country and denominated in that country’s currency.
Eurobonds are denominated in a currency other than that of the country in which it is sold—for example, a bond denominated in U.S. dollars sold in London.
80
What are Eurocurrencies?
in which are foreign currencies deposited in banks outside the home country. One of the most important ones is Eurodollars for US $,
81
What are transaction costs?
the time and money spent in carrying out financial transactions, are a major problem for people who have excess funds to lend.
82
What are liquidity services?
Services financial intermediaries provide to their customers to make it easier for them to conduct their transactions (ie. checking accounts.
83
What are the flow of funds through the financial system; major lenders/major borrowers (top two).
Borrowers: Business firms, government
Lenders: Households, Business Firms
84
If interest rates rise in China, the U. S. dollar will most likely depreciate against the yuan?
True
85
What is risk sharing(also called asset transformation)?
The process of creating and selling assets with risk characteristics that people are comfortable with and then using the funds acquired by selling these assets to purchase other assets that may have far more risk.
86
What is Diversification?
entails investing in a collection (portfolio) of assets whose returns do not always move together,
87
What is asymmetric information?
The unequal knowledge that each party to a transaction has about the other party.
88
What is adverse selection?
the dilemma that those most likely to produce an undesirable (adverse) outcome—the bad credit risks—are the ones who most actively seek out a loan, and are thus most likely to be selected.
-problem created by asymmetric information before the transaction occurs
89
What is Moral hazard?
the risk (hazard) that the borrower might engage in activities that are undesirable from the lender’s point of view, because they make it less likely that the loan will be paid back.
\*the problem created by asymmetric information after the transaction occurs.
90
economies of scope?
ability to lower the cost of information production for each service by applying one information resource to many different services.
-This can also lead to however lead to a _Conflict of interest._
91
What are thrift institutions (thrifts)?
savings and loan associations, mutual savings banks, and credit unions.
92
What is financial panic?
The widespread collapse of financial markets and intermediaries in an economy.
93
What is indirect finance and what is direct finance?
Indirect Finance is for example when you put money in your savings account, the banks lend your money, it is less risky and therefore smaller return.
Direct Finance is buying securities or perhaps company bonds.
94
What are two ways regulation of financial markets protects investors?
1. Increasing Information Available to Investors
2. Ensuring the Soundness of Financial Intermediaries
95
What are the regulatory bodies for different financial institutions?
96
What are the functions of money?
1. _medium of exchange_; it is used to pay for goods and services.
2. _unit of account_; that is, it is used to measure value in the economy, it is divisible.
3. _store of value_; it is a repository of purchasing power over time.
97
What is the difference between commodity money and fiat money?
_Commodity money_ has value, something backing it.
_Fiat money_, is paper currency decreed by governments as legal tender but not convertible into coins or precious metal.
98
What is hyperinflation?
in which the inflation rate exceeds 50% per month.
99
What is payments system?
the method of conducting transactions in the economy such as:
_e-money_ (or electronic money): money that exists only in electronic form.
_smart card_: sophisticated stored-value card.
_e-cash:_ used on the Internet to purchase goods or services.
100
What are monetary aggregates?
The measures of the money supply used by the Federal Reserve System (M1 and M2).
101
What are the components of M1 and M2 money supply?
M1: currency, checking account deposits, and traveler’s checks. (most liquid)
M2: M1, Savings deposits and money market deposit, Small-denomination time deposits(CDs), Money market mutual fund shares (retail)
102
What is barter?
Early form of money. Exchanging goods.
Problem: double coincidence of wants.
103
What was the precursor to our modern system of banking/depository accounts.
the use and safekeeping of specie money during the Middle Ages?
104
After the early 1980s, the growth rate of M1 began to exhibit a much different pattern that it did in prior years. What might explain this?
Regulation Q was repealed in 1986, allowing banks to pay interest on demand deposits.
105
What are Cash flows?
The difference between cash receipts(coming in) and cash expenditures(going out).
106
What is present value?
Today’s value of a payment to be received in the future when the interest rate is i. Also called present discounted value.
107
How do you calculate the future value of a loan or deposit?
Formula: FV=Pricipal x (1+i)^n
108
How do you calculate the present value of a loan or deposit?
PV=CF/(1+i)^n
109
What are the four major types of credit market instruments:
1. simple loan
2. fixed-payment loan
3. coupon bond
4. discount bond
110
What is a simple loan?
loan that must be repaid to the lender at the maturity date, along with an additional payment for the interest.
111
What is a fixed-payment loan(also called fully amortized loan)?
loan where the the same payment is made every period (such as a month), consisting of part of the principal and interest for a set number of years.
112
What is a coupon bond?
pays the owner of the bond a fixed interest payment (coupon payment) every year until the maturity date, when the specified final amount (face value/par value) is paid.
113
What is coupon rate?
the dollar amount of the yearly coupon payment expressed as a percentage of the face value of the bond.
114
What is a discount bond (also called a zero-coupon bond)?
a bond bought at a price below its face value, and the face value is repaid at the maturity date. Unlike a coupon bond, a discount bond does not make any interest payments; it just pays off the face value.
115
What is yield to maturity?
the interest rate that equates the present value of cash flow payments received from a debt instrument with its value today.
116
What should you pay for a three-year $8,000 bond with a coupon of 3%, if interest rates have risen, and you require a YTM of 4%?
P = C/(1+i) + C/(1+i)^2 + C/(1+i)^3 + F/(1+i)^3
P= $240/1.04 + $240/1.04^2 + $240/1.04^3 + $8,000/1.04^3
answer:$7,809.37
117
What is a consol or a perpetuity
a perpetual bond with no maturity date and no repayment of principal that makes fixed coupon payments of $C forever.
118
What is current yield?
An approximation of the yield to maturity that equals the yearly coupon payment divided by the price of a coupon bond.
119
What is the YTM on a $10,000 Discount Bond that you purchase for $9,875?
YTM = [(Pt+1 - Pt)/Pt] x 100
YTM = [($10,000-$9,875)/$9,875] x 100
answer:1.2658
120
What is rate of return?
The payments to the owner of a security plus the change in the security’s value, expressed as a fraction of its purchase price. More precisely called the rate of return.
121
What is rate of capital gain?
the change in the bond’s price relative to the initial purchase price:
122
What is the difference between the “real interest rate”, and the nominal rate of interest
nominal interest rate does not take inflation into account, while real interest rate does therefore reflects the true cost of borrowing.
-often do not move together; when U.S. nominal rates were high in the 1970s, real rates were actually extremely low (often negative)
123
What is your true return on a $7,000, 3% coupon bond that you purchased at face-value, which you later sell for $7,500?
Return = [(C/Pt)x100] + [Pt+1 - Pt)/Pt] x 100
Return = [(210/$7,000)x 100] + [($7,500-$7,000)/7,000] x 100
answer=10.14%
124
In what circumstance does the coupon rate on a bond = the yield to maturit
the holding period and the maturity of the bond must be identical
125
Why bond prices and interest rates are inversely related, using the concept of PV?
current bond prices and interest rates are negatively related: when the interest rate rises, the price of the bond falls, and vice versa.
126
Why do rising or falling interest rates make previously issued bonds’ prices change (interest-rate risk); what happens to the true return on a bond if its selling price rises/falls?
- prices and returns for long-term bonds are more volatile than those for shorter-term bonds
- changes in interest rates lead to capital gains and losses that produce substantial differences between the return and the yield to maturity known at the time the bond is purchased
127
How does expected inflation affects the decisions of borrowers and lenders?
when the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend
128
In an economy with 500,000 goods and services to be traded, how many prices would be needed in order for these goods and services to be exchanged?
Number of prices = N(N-1)/2
Number of prices =500,000 (499,999)/2
Answer: 124,999,750,000
