Economics of Money, Banking, and Financial Markets

Comprehensive question-and-answer flashcards reviewing Chapters 1, 2, 3, and 4 on money, banking, financial markets, interest rate measurement, and monetary aggregates.

What is the primary function of financial markets in the economy?

Financial markets transfer funds from people and entities with an excess of available funds to those with a shortage of funds.

What is a security (or financial instrument)?

A security is a claim on the issuer's future income or assets.

What is a bond and how does an interest rate relate to it?

A bond is a debt security promising periodic payments for a specified period of time. The interest rate is the promised price paid for renting funds, representing the cost of funds to the issuer.

What does a share of stock represent?

A stock represents a share of ownership in a corporation, granting a claim on the corporation's earnings and assets.

How do banks and other financial institutions facilitate economic growth?

Financial institutions transfer funds from savers to individuals and firms with productive investment opportunities. Banks specifically accept deposits and make loans.

What defines a financial crisis?

A financial crisis involves major disruptions in financial markets characterized by sharp declines in asset prices and widespread failures of financial and nonfinancial firms.

What is the difference between monetary policy and fiscal policy in Canada?

Monetary policy involves managing the money supply and interest rates, conducted by the Bank of Canada. Fiscal policy involves setting government expenditures and tax revenues, conducted by federal and provincial governments.

What is the foreign exchange market, and how is an exchange rate defined?

The foreign exchange market is where currencies are converted. The exchange rate is the price of one currency expressed in terms of another currency.

How do direct finance and indirect finance channel funds through the financial system?

In direct finance, borrowers sell securities directly to lenders in financial markets. In indirect finance, funds flow through financial intermediaries that stand between lenders and borrowers.

What are the three maturity categories for debt instruments?

Debt instruments are categorized as short-term (maturity $< 1\text{ year}$), intermediate-term (maturity $1\text{ to }10\text{ years}$), or long-term (maturity $> 10\text{ years}$).

Why are equity holders classified as residual claimants?

Equity holders own a portion of the corporation and are entitled to dividends or residual asset value only after all debt holders and prior claims are satisfied.

What is the functional difference between primary and secondary financial markets?

Primary markets sell newly issued securities to initial investors (often aided or underwritten by investment banks). Secondary markets facilitate the trading of previously issued securities.

How do brokers and dealers differ in secondary market transactions?

Brokers act as agents to match buyers with sellers. Dealers buy and sell securities for their own account at stated bid and ask prices.

What distinguishes organized exchanges from over-the-counter (OTC) markets?

Organized exchanges execute trades in a single central physical or electronic location (such as the Toronto Stock Exchange), while OTC markets involve dealers at multiple locations trading bilaterally.

What is the key distinction between money markets and capital markets?

Money markets trade short-term debt instruments with maturities $< 1\text{ year}$, whereas capital markets trade longer-term debt ($> 1\text{ year}$) and equity instruments.

What is the distinction between a foreign bond and a Eurobond?

A foreign bond is sold in a foreign country and denominated in that country's currency. A Eurobond is sold in a foreign country but denominated in a currency other than the local currency.

What are Eurodollars?

Eurodollars are U.S. dollars deposited in foreign banks outside the United States or in foreign branches of U.S. banks.

What three primary advantages do financial intermediaries provide?

1) Reduced transaction costs (through economies of scale, scope, and liquidity services), 2) Improved risk sharing (via asset transformation and diversification), and 3) Mitigation of asymmetric information.

How do adverse selection and moral hazard differ regarding asymmetric information?

Adverse selection occurs before a transaction, as high-risk borrowers actively seek loans. Moral hazard occurs after a transaction, when borrowers engage in risky activities undesirable to lenders.

What regulatory roles do OSFI and the CDIC perform in Canada?

OSFI sets capital adequacy, accounting, and board standards while auditing federally regulated institutions. CDIC provides deposit insurance up to $100 000 per depositor and restricts asset holdings of insured institutions.

What general formula calculates the present value ($PV$) of a future cash flow ($CF$) received in $n$ years at discount rate $i$?

The present value formula is $PV = \frac{CF}{(1+i)^n}$.

If a simple loan promises a single payment of $250 in 2 years at a discount rate of 15%, what is its present value?

The present value is $PV = \frac{\$250}{(1+0.15)^2} = \$189.04$.

What are the four types of credit market instruments?

1) Simple Loan, 2) Fixed Payment Loan, 3) Coupon Bond, and 4) Discount Bond.

How is yield to maturity defined for any financial instrument?

Yield to maturity is the interest rate $i$ that equates the present value of all future cash flow payments received from a debt instrument with its value or market price today.

What formula gives the yield to maturity ($i$) on a simple loan or discount bond?

The yield to maturity is calculated as $i = \sqrt[n]{\frac{CF}{PV}} - 1$.

What equation determines the yield to maturity ($i$) for a coupon bond with price $P$, yearly coupon $C$, face value $F$, and $n$ years to maturity?

The equation is $P = \frac{C}{1+i} + \frac{C}{(1+i)^2} + \dots + \frac{C}{(1+i)^n} + \frac{F}{(1+i)^n}$.

What is a consol (perpetuity), and how is its yield to maturity ($i_c$) calculated?

A consol is a bond with no maturity date that pays a fixed yearly coupon $C$ forever. Its yield to maturity is $i_c = \frac{C}{P}$, where $P$ is the price.

What three relationships exist between a coupon bond's price, face value, coupon rate, and yield to maturity?

1) When priced at face value, yield to maturity equals coupon rate. 2) Bond price and yield to maturity are negatively related. 3) Yield to maturity exceeds coupon rate when price is below face value, and is lower when price is above face value.

How is the rate of return ($R$) on a bond calculated across a holding period from $t$ to $t+1$?

Rate of return is the sum of current yield and rate of capital gain: $R = \frac{C}{P_t} + \frac{P_{t+1}-P_t}{P_t}$, where $P_t$ is purchase price and $P_{t+1}$ is sale price.

What is interest-rate risk?

Interest-rate risk is the risk level associated with an asset's return caused by interest-rate changes, which produce capital losses on long-term bonds when holding periods are shorter than maturity.

What is the Fisher Equation, and how does it relate nominal interest rates, real interest rates, and expected inflation?

The Fisher Equation is $i = r + \pi^e$, where $i$ is the nominal interest rate, $r$ is the real interest rate, and $\pi^e$ is the expected inflation rate.

How does money differ from wealth and income?

Money is anything generally accepted as payment for goods/services or debt repayment. Wealth is the total collection of property storing value. Income is a flow of earnings per unit of time.

What are the three core functions of money?

1) Medium of exchange (facilitates transactions and specialization), 2) Unit of account (measures value across the economy), and 3) Store of value (stores purchasing power over time).

What is the difference between commodity money and fiat money?

Commodity money is composed of valuable goods or precious metals with intrinsic value. Fiat money is paper currency decreed by a government as legal tender without intrinsic value.

According to the Bank of Canada, what components form the $M1+$ and $M1++$ monetary aggregates?

$M1+$ consists of currency outside banks plus all chequable deposits at chartered banks, TMLs, and CUCPs. $M1++$ includes $M1+$ plus all nonchequable deposits at chartered banks, TMLs, and CUCPs.

According to the Bank of Canada, what components form the $M3$ monetary aggregate?

$M3$ includes $M2$ (currency outside banks, personal deposits, non-personal demand/notice deposits, and fixed-term deposits at chartered banks) plus non-personal term deposits and foreign currency deposits of residents at chartered banks.

How do weighted monetary aggregates differ from conventional simple-sum monetary aggregates?

Conventional aggregates use a simple sum $M = x_1 + x_2 + \dots + x_n$ weighing all components equally, while weighted aggregates assign different weights based on component liquidity to better predict inflation and business cycles.