DEFINITIONS:
municipal bond
zero coupon bond
financial intermediation
financial disintermediation
recession
consol
liquidity
Eurodollars
fiat money
menu cost
money illusion
Gresham's law (give two examples)
federal funds rate
real interest rate
Fisher effect
inflation
basis points
seasonally adjusted
bid vs. ask spread
interest rate risk
reinvestment rate (income) risk
capital (price) risk
TRUE, FALSE, UNCERTAIN - EXPLAIN (short essay)
1) Inflation benefits creditors.
2) Deflation causes money to decrease in value.
3) M3 is more liquid than M2.
4) M2 growth is more volatile than M1 growth.
5) The purchase of a share in a money market mutual fund is an example of a direct finance transaction.
6) An investor in the 28% tax bracket would be indifferent between a corporate bond paying 10.5% and a tax free municipal bond paying 7.75%.
7) The lower the degree of correlation between a given stock and your portfolio, the greater the benefits of adding that stock to your portfolio.
8) If the correlation coefficient between two assets is +1, there is are no financial benefits from combining these assets in a portfolio.
9) Economists are more concerned with nominal GDP than real GDP.
10) The yield to maturity and the current yield on a bond move in opposite directions.
11) The longer the term to maturity the greater the price risk when interest rates change.
12) In a period of deflation, an investor might be willing to accept a negative nominal interest rate. (Hint: think about the real return of holding cash)
13) In periods of inflation, an investor should never willing accept an investment that is expected to have a negative real rate of return.
14) If an asset's riskiness increases and its epected return increases, the quantity demanded will increase.
15) If an asset's liquidity increases and its expected return increases, the quantity demanded will increase.
ESSAY QUESTIONS
1) Explain the three functions of money.
2) Why should we try to avoid the "double coincidence of wants"?
3) Give several examples of when barter emerges.
4) In a barter economy with 90 items, how many price ratios would you need to know?
5) "Money is anonymous." So what?
6) Money has a fixed nominal value - what are the advantages and disadvantages of this condition?
7) Why don't banks issue interest bearing currency?
8) Why are government bonds risk-free?
9) Give three examples of when the unit of account and the medium of exchange are not the same.
10)What are the five desirable characteristics of money?
11)What are the advantages/disadvantages of using diamonds for money?
12) A rich billionaire wanted to leave a will whereby he could somehow benefit all of his fellow citizens. He left a very unusual will which specified that upon his death all of his assets were to be turned into cash and subsequently burned in a huge bonfire. What motivated the billionaire to do this, i.e. how would this action benefit the citizens of the billionaire's country??
13) What are the advantages/disadvantages of fiat money?
14) According to Milton Friedman "Inflation is always and everywhere a monetary phenomenon." Explain.
15) "There cannot be a more insignificant thing than money." What did J.S. Mill mean by this?
16)"The money economy has made barter easier rather than harder."
17) What are the three ways for the government to finance its spending?
18) What two factors affect real growth in the economy?
19) Why are bonds called fixed-income securities?
20) What effect might a social security system have on the savings rate?
21) What is the essential function that financial markets perform?
22) Why are savings so important for real output growth?
23) Give several examples of why savings rates are lower in the U.S. compared to Japan or Germany.
24) What effect would tax deductibility of home mortgage interest in the U.S have on house prices here compared to Canada where mortgage interest is not deductible.
25) Under what circumstances would we see negative real interest rates?
26) Before China developed financial markets and a banking system, there was a large market for used TVs and other used appliances, even ones that didn't work. People would buy broken TV sets and store them, without even fixing them. What function were used goods serving in the Chinese economy?
27) How could the Internet bring about financial disintermediation and direct finance.
28) How would someone's risk prefernce affect their decision to choose between an ARM (ajustable rate mortgage) and a fixed rate mortgage.
29) Gold pays no interest. Why would anyone bother to hold it as an asset?
PROBLEMS
1)Following is a list of prices for zero coupons bonds, assuming a face value of $1000:
Maturity(Yrs.) Price
1 $934.58
2 $857.34
3 $751.31
4 $683.01
a)calculate 1, 2, 3, and 4 year interest rates.
b)if inflation is expected to be 4%/yr for the next four years, calculate the real rate of interest for each year.
2)XYZ Co. stock was selling for $8 in 1960 when the CPI was 32. The stock is now at $90/share and the CPI=120.
a) what has been the average annual nominal compounded rate of appreciation?
b) what has been the average annual compounded rate of inflation?
c) what has been the annual real compounded rate of increase for XYZ stock?
3)Given the following information:
1970 CPI=42 Tuition=$800/yr.
1990 CPI=129 Tuition=$2200/yr.
Has tuition gone up or down in real terms? How much? (avg. annual compound rate of increase/decrease).
4)Investors want a 3% real return. If T-Bills are yielding 10%, what is the expected rate of inflation?
5)T-bills are yielding 10%. Inflation is expected to be 12%. What is the real rate of interest?
6)If corporate bonds are 11.1% and municipal bonds are 8.7%, what is the implied tax bracket for the marginal investor?
7)If sales for XYZ Co. grow from $100 in 1985 to $150 in 1990, at what growth rate have sales been increasing?
8) Given the following information on international treasury bonds yields and CPIs, in which country would you have gotten the highest real rate of return in 1996? Assume a one year period.
1 YR Bond rate CPI-1995 CPI-1996
Germany - 8% 123 128
Turkey - 40% 1525 2010
Brazil - 22% 876 970
Israel - 19% 444 522
A total of