AP Macro Module 4.1-4.2

What is the most familiar type of financial asset?

cash

Why do individuals and firms find it useful to hold some of their assets as cash?

convenience it provides → can easily be used to make purchases directly while other assets can’t

What is cash’s opportunity cost?

cash held in your wallet earns no interest

What is interest?

Amount paid to borrow money, determined by interest rate

What is interest rate?

price, calculated as a percentage of the amount borrowed, charged by lenders to borrowers for the use of their savings

What is the trade off of keeping money in a checking account?

trade off between convenience and interest payments → can be earning higher interest

What is a certificate of deposit (CD)?

Pays higher interest rate than ordinary bank accounts

However, CDs carry a penalty if you withdraw the funds before a certain amount of time has elapsed

What are financial markets?

where households invest their current savings and their accumulated savings/wealth by purchasing financial assets

What is a household’s wealth?

the value of its accumulated savings

What is an asset?

something of value

What is a financial asset?

nonphysical asset that entitles the buyer to future income from the seller

What is a physical asset?

a tangible object that the owner has the right to use or dispose of as they wish

In a loan, does the borrower or lender own the loan?

lender

What is a liability?

a requirement to pay money in the future

Why is a well-functioning financial system a critical ingredient in achieving long-term growth?

encourages greater and more efficient savings and investment spending

What are the three tasks of a well-functioning financial system? Why?

1. reducing transaction costs

2. reducing financial risk

3. providing liquidity

They enhance the efficiency of financial markets by making it more likely that savers and borrowers will make mutually beneficial trades, which make society as a whole richer

What are transaction costs?

the expenses of actually putting together and executing a deal

How does reducing transaction costs work?

there are costs in creating deals

• eg. loans require spending time and money negotiating terms of deal, verifying borrower’s ability to pay, and legal deals

• also if they need to raise a lot of money, getting loans from a bunch of people will have crazy transaction costs

financial markets easen this by letting large businesses get loans from a bank (reduces transaction costs by having one borrower and lender) or sell bonds in bond market

What is the principal reason for the bond market?

allows companies to borrow large sums of money without incurring large transaction costs

What is financial risk?

uncertainty about future outcomes that involve financial losses/gains

How does a well-functioning financial system help people reduce their exposure to risk?

rather than exposing themselves to a lot fo risk due to uncertainty about how well/poor their business will perform, the financial market helps businesses share the risk of purchasing new stuff by also sharing some profit as well throught he stocks market. Allows owners to reduce personal losses if profit is less than expected as they won’t lose their other assets. If things go well, shareholders earn a share of profit as a return of their investment

also allows for diversification reducing risk

What is diversification?

investing in several assets with unrelated, or independent, risks → helps reduce the total risk of loss

Why do we have stocks and a stock market?

the desire of individuals to reduce their total risk by engaging in diversification

Why would somebody not be willing to invest all their savings in their business?

they might find themselves suddenly with the need of cash

When is an asset liquid?

it can be quickly converted into cash without much loss of value

When is an asset illiquid?

it cannot easily be converted to cash without much loss of value

How does a financial market provide liquidity?

the initial sale of stocks and bonds can resolve some liquidity problems by raising money for new and expanding projects.

Taking deposits and lending them out, banks allow individuals to own liquid assets while financing investments in illiquid assets such as businesses/homes

What are the 4 basic types of financial assets?

stocks

loands

bonds

bank deposits

What is a loan?

lending agreement between an individual lender and an individual borrower

How can loans provide a greater benefit to borrowers when they are tailored to the needs of the borrower?

before a small business gets a loan, it usually has to discuss its business plans, its profits, and so on with the lender, resulting in a loan that meets borrower’s needs and ability to repay

How do loans create a relatively complex transaction?

loans create transaction costs associated with identifying qualified buyers

What is a bond?

an interest-bearing asset that represents a loan to a company/government

seller of bond promises to pay fixd sum of interest each year and to repay principal (value stated on face of bond) to the owner of the bond on a particular date

Who issues the bond → borrower or lender?

borrower

Bond is a financial asset from _____ point of view

Bond is a liability from ______ point of view

owner, issuer

What is an maturity date?

A maturity date is the specific date when a financial obligation, like a loan, bond, or certificate of deposit (CD), ends

What do bond issuers do?

they sell a number of bonds with a given interest rate and maturity date to whoever is willing to buy them

How do bonds reduce transaction costs?

unlike a loan, reduces costly negotiation of the terms of a loan with many individual lenders

How do bond purchasers acquire information free of charge, on the quality of the bond issuer?

bond-rating agencies put out this information, such as issuer’s credit history, so purchasers don’t have to incur the expense of investigating it themselves

What is defaulting?

the possibility that a bond issuer might fail to make payments as specified by the bond contract

Once a bond’s risk of default has been rated, what can it do?

be sold on the bond market as a more or less standardized product → a product with clearly defined terms/quality

Why must a bond with a higher default risk pay a higher interest rate?

to attract investors

T/F Bonds are easy to resell.

What advantage does it provide?

True

It provides liquidity to bond purchasers. Bond will usually pass through many hands before it is finally due

Why is the price of a previously issued bond inversely related to the interest rate in the economy?

When the interest rate in the economy increases, preexisting bond prices generally fall because bond buyers could purchase a new bond paying the higher interest rate. They wouldn’t be willing to buy a preexisting bond unless the price of the bond decreases (to make up for the difference in preexisting and new interest rates)

When interest rates in the economy decrease, preexisting bond prices generally rise, because bond purchasers are buying the new bonds at a lower interest rate, so bond owners can raise the price of higher interest pre-existing bonds

What is a stock?

share in the ownership of a company

What is an equity?

ownership in the value of an asset or business

A share of a stock is a ______ from its owner’s point of view

A share of a stock is a _____ from the company’s point of view

financial asset

liability

t/f Not all companies sell shares of their stocks

True

What are privately held companies?

they are owned by an individual or few partners that get to keep all of the company’s profit

Why don’t companies keep complete ownership for themselves and just sell bonds for their investment spending?

risk

few individuals are risk-tolerant enough to face risk involved in being the sole owner of a large company

What are shareholders?

investors who buy stocks

Do stocks have a higher rate of return than bonds?

yes

What is the rate of return on a financial asset?

net gain/loss expressed as a percentage of initial amount

T/F Owning the stock of a given company is risker than owning a bond issued by the same company

True

Bond is a promise while a stock is a hope. By law, company must pay back what it owes to lenders(bondholders) before it distributes any profits to shareholders

If the company should fail (unable to pay it interest obligations and declare bankruptcy) → financial assets/physical assets go to bondholders/lenders while shareholders typically receive nothing

What is a financial intermediary? What are examples?

an institution that transforms funds gathered from many individuals into financial assets

banks, mutual funds

What is a diversified portfolio of stocks? What does it do for investors? What is a con of it?

a group of stocks in which risk are unrelated to or offset one another, rather than concentrating investment in a single/group of related companies, investors can reduce stocks

It can incur high transaction costs, such as fees paid to stockbrokers, since they are investing in a lot of companies

What are mutual funds? How do they reduce transaction costs?

A mutual fund is a financial intermediary that creates a stock portfolio by buying and holding shares in companies and selling shares of the portfolio to individual investors.

By buying these shares, investors with a relatively small amount of money to invest can indirectly hold a diversified portfolio, achieving a better return for any given level of risk they could otherwise achieve

What is a bank?

An institution that helps resolve the conflict between lenders’ need for liquidity and the financing needs of borrowers who don’t want to use the stock or bonds market

How does a bank work?

first accepts funds from depositors where you put your money in the bank, essentially becoming a lender of your money to the bank

you then receive credit for a bank deposit

What is a bank deposit?

a claim on a bank that obliges the bank to give the depositor their cash

What is a demand deposit?

bank is required to give a depositor their cash immediately when they demand it

A bank deposit is a ______ by the depositor

A bank deposit is a _______ by the bank

financial asset, liability

What does the bank do with customers’ deposits

they keep a fraction of it in ready cash

Most of it is lent out to businesses, buyers of new homes, and other borrowers.

What is the long-term commitment by the bank to the borrower through loands

their loan cannot be recalled by the bank and converted to cash as long as the borrower could make their payments on time

What is a bank?

A financial intermediary that provides financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance borrowers’ investment spending on illiquid assets

How do banks lend for large periods of time but still be subject to the condition that its depositors that depositors could demand their funds back at any time?

they count on fact that o average, only small fraction of depositors will want their cash back. Also some people will make withdrawals while some will make deposits, cancelling out.

Thus, banks only need to keep a lmited amount of cash on hand to satisfy depositors.

Also, if a bank becomes financially incapable of paying its depositors, individual bank deposits are currently guaranteed to depositors up to $250,0000 by the FDIC (Federal Deposit Insurance Corporation)→ reduces risk of holding a bank deposit and reduces incentive to withdraw funds if concerns about financial state of bank arise

Rank the following assets from the lowest level to the highest level of (i) rate of return, (ii) risk, and (iii) liquidity. Ties are acceptable for items that have indistinguishable rankings.

a. a bank deposit with a guaranteed interest rate

b. a share of a highly diversified mutual fund, which can be quickly sold

c. a share of the family business, which can be sold only if you find a buyer and all other family members agree to the sale

Rate of return:

• a: it has a guaranteed but fairly low return

• b: it has a generally higher return that the bank deposit

• c: could be very high based on the success of the business

risk:

• a: lowest from bank deposit since assisted by FDIC

• b: Still has risk to investing in stocks

• c: the business may not be profitable causing a lot of risk

liquidity:

• c: its not easy to resell so pretty illiquid

• b: can usually sell stocks really easily. only a few days will elapse between processing of payment

• a: can easily withdraw money

Explain how each of the following will affect the rate of return on a financial asset.

i. higher risk

ii. increased liquidity

Higher risk will mean that there must be a potential higher rate of return to balance the risk

An asset with less liquidity must have a higher rate of return since people are giving up easy access to cash

Why does cash carry less risk?

It will not lose its value

Assume that a country's government increases borrowing. What will most likely happen to the prices of previously issued bonds and the price level in the short run?

A. Increase, Increase

B. Increase, Decrease

C. Increase, No change

D. Decrease, increase

E. Decrease, decrease

D. Decrease, increase

Module 4.2

What is the interest rate?

the opportunity cost of holding money and the return from holding financial assets

What is the interest rate on a loan?

percentage of the loan amount that the borrower must pay back to the lender over time

What is the nominal interest rate?

the interest rate that is actually paid for a loan, unadjusted for the effects of inflation

What is the real interest rate?

nominal interest rate adjusted for inflation

takes into account the opportunity cost of loaning the funds and the value of what can be purchased after an increase in prices

How can we calculate the real interest rate if we know the nominal interest rate and inflation rate?

How can we calculate the nominal interest rate if we know the real interest rate and inflation rate?

real interest rate = nominal interest rate - inflation rate

nominal interest rate = real interest rate + inflation rate

t/f the actual rate of inflation over the period of the loan is known

false

How can we calculate the expected real interest rate if we know the nominal interest rate and expected inflation rate?

How can we calculate the nominal interest rate if we know the expected real interest rate and expected inflation rate?

Expected real interest rate = nominal interest rate - expected inflation rate

nominal interest rate = Expected real interest rate + Expected inflation rate

If the actual inflation rate is higher than expected, who benefits? Why?

borrowers gain at the expense of lenders since they’re paying back their loans with funds that have a lower real value than expected (funds can purchase fewer goods and services than expected, due to the higher-than-expected inflation rate)

If the actual inflation rate is lower than expected, who benefits? Why?

lenders because they are getting back with funds that have a higher real value than expected (funds can purchase more goods and services than expected, due to lower-than-expected inflation rate)

What is the difference between nominal and real interest rates?

inflation rates

T/F Nominal interest rates can be negative

False (there’s exceptions tho in some economic situations such as in deflation)

Can real interest rates be negative?

Yes, if the inflation rate is higher than the nominal interest rate

What would it mean for nominal interest rates to be negative? Why won’t this happen

borrowers would pay back their loan minus a percentage of that amount, basically being paid to borrow funds.

Since zero is the lowest possibile opportunity cost (earning 0 interest), lenders would never pay anyone to take out a loan.

In a situation where deflation is expected, what will lenders do with their funds?

they will hold their funds as cash and purchase goods at lower prices in the future (probably wouldn’t be maximizing their returns by lending out since there’s higher chance of borrowers defaulting)

What happens when expected inflation turns out to be incorrect and there is UNEXPECTED inflation?

• The REAL rate of return on the financial asset falls

• The REAL value of the financial asset falls

Real interest rates can be negative when which of the following is true?

Inflation rates are high.

Lenders expect high inflation.

Actual inflation is greater than expected inflation.

Actual inflation is greater than the nominal interest rate.

all of the above.

Actual inflation is greater than the nominal interest rate.

As the expected rate of inflation decreases, does each of the following increase, decrease, or not change? Explain.

a. nominal interest rates

b. real interest rates

c. actual inflation rates

a. decrease: nominal rates will not need to compensate as much for inflation

b. stay the same: nominal and inflation both adjusting, so real stays the same

c. decrease: inflationary expectations will reduce inflation

If both the nominal interest rate and the expected inflation rate increase, what will happen to the real interest rate?

A It will increase because the expected inflation rate has increased.

B It will increase because the nominal interest rate has increased.

C It will increase if the expected inflation rate increases by more than the nominal interest rate.

D It will decrease because the nominal interest rate has increased.

E It will decrease if the expected inflation rate increases by more than the nominal interest rate.

E

In the labor markets, who benefits from unanticipated inflation?

employers because they get higher profits if input costs don’t adjust yet

employees get hurt because their wages won’t adjust but there purchasing power is reduced