FI 301 Exam #1 Jackson Mills

Mainly chapter 2 and 5

Surplus vs deficit units

o   Surplus units: Those who have excess funds

o   Deficit units: Those who need funds

Money vs capital markets

-  Money market securities: debt securities that have a maturity of 1 year or less (T-bills, federal funds)

-  Capital market securities: equity or debt securities whose maturity is greater than 1 year (New stocks, bonds, mortgages)

Primary vs secondary markets

o   Primary markets: facilitate the issuance of new securities (issuers raise capital)

o   Secondary markets: facilitate the trading of existing securities, allows for a change in ownership of the securities (doesn’t raise capital, facilitate incorporation of new info into security prices)

A transaction is considered to occur in the primary market when a new security is issued

Debt vs. Equity

Debt represents borrowed money that must be repaid with interest, while equity represents ownership in a company.

Depository vs non-depository institutions

o Examples of each

o Key characteristics of institutions we covered

Examples: of depository institutions include commercial banks, while non-depository institutions include insurance companies and mutual funds.

Key characteristics vary but may involve regulatory oversight, services offered, and sources of funds.

Broker vs dealer

o   Brokers: facilitate transactions between buyers and sellers

o   Dealers: buy and sell assets directly from their own inventory

Systemic risk

Spread of financial problems among financial institutions and across financial markets that could cause a collapse in the financial system

How do interest rates affect cost of borrowing?

Changes in interest rates directly affect the cost of borrowing. Higher rates increase borrowing costs, while lower rates decrease them.

How do borrowers (Firms and households / Government) respond to changes in interest rates?

Firms and households tend to borrow less at higher interest rates due to increased borrowing costs. Government demand for funds is less elastic and remains relatively constant.

How do interest rates affect security prices?

Higher rates = lower security prices | due to TVM, as rates rise, PV decreases

TVM: lower PV when r is higher

What happens to interest rates when the demand for loanable funds increases?

When the demand increases (shift right of demand curve), interest rates tend to rise

What causes the demand for loanable funds to increase?

o   Economic expansion

o   Higher government deficits (crowding out effect)

o   Higher foreign interest rates

o   Increased inflationary expectations

What happens to interest rates when the demand for loanable funds decreases?

When the demand decreases (left shift of demand curve), interest rates tend to fall

What causes the demand for loanable funds to decrease?

o   Economic contraction

o   Lower government deficits

o   Lower foreign interest rates

o   Reduced inflationary expectations

What happens to interest rates when the supply of loanable funds increases?

An increase in the supply tends to lower interest rates

What causes the supply of loanable funds to increase?

o   Increase in money supply (stimulative monetary policy by Fed)

o   Decrease in foreign interest rates

o   Decrease in taxes on interest income

o   Reduced inflationary expectations

What happens to interest rates when the supply of loanable funds decreases?

A decrease (left shift of supply curve) in supply tends to raise interest rates

What causes the supply of loanable funds to decrease?

o Decrease in money supply (restrictive monetary policy by Fed)

o Increase in foreign interest rates

o Increase in taxes on interest income

o Increased inflationary expectations

Fisher effect equation

nominal interest rates = real interest rates + expected inflation

OR

real interest rates = nominal interest rates – expected inflation

Fisher Effect

o   Higher inflation pushes nominal interest rates up

o   For a given nominal interest rate, higher inflation reduces real returns

• Inflation is a source of investment risk

Fed's dual mandate

Simply, keeps unemployment down and inflation down

Federal funds rate

Interest rate at which banks lend reserves to other banks overnight.

Key in monetary policy

Components of Fed

The two main components are the Board of Governors (BoG), and the Federal Open Market Committee (FOMC)

BoG sets reserve requirements and conducts bank exams. FOMC makes monetary policy decisions, including open market operations

How does Fed increase money supply?

They purchase securities (T-bills)

Sellers receive money, which is held in deposits at banks (injects cash into banking system), decreases interest rates.

How does Fed decrease money supply?

They sell securities (T-bills)

Buyers pay money for securities, which decreases their bank deposits (withdraws cash from banking system), increases interest rates.

How do open market operations affect interest rates?

By changing the supply of loanable funds - with buying securities, lowering rates, and selling securities, raising rates.

Reserve requirements

Regulations that determine the amount of reserves banks must hold relative to their deposits. Adjusting these can influence money supply

Higher reserve ratio = less funds available to be loaned out

Lower supply of loanable funds = higher interest rates

Member Banks

Must purchase fed stock (6% max dividend), can borrow from Fed through "discount window"

Common metrics of inflation

o   The Consumer Price Index (CPI), and Producer Price Index (PPI)

o   These measure the average price changes of consumer and producer goods respectively

Common metrics of economic growth & employment

Gross Domestic Product (GDP), the unemployment rate, and non-farm payroll employment data

Leading vs. coincident vs. lagging indicators

o   Leading indicators: variables that tend to change before the overall economy does (Stock market performance)

o   Coincident indicators: move in line with economy (GDP)

o   Lagging indicators: interest rates, unemployment rates.

When will the Fed implement stimulative monetary policy?

When unemployment is high and/or when growth is weak to boost economic activity

How does stimulative monetary policy work?

Works by the Fed purchasing securities, increasing the supply of funds, reducing interest rates, encouraging borrowing and spending, and stimulating aggregate demand.

When will the Fed implement restrictive monetary policy?

They will implement this when inflation is high

How does restrictive monetary policy work?

Works by the Fed selling securities, reducing the supply of funds, raising interest rates, discouraging borrowing and spending, and reducing inflation.

Tradeoffs in monetary policy

o   When central bank tries to stimulate economic growth and reduce unemployment through lower interest rates, it may contribute to inflation

o   On the other hand, when central bank tightens policy to control inflation, it may slow down economic growth and increase unemployment

How do exchange rates, state of global economy affect Fed's decision making?

Fed tends to be more proactive when dollar is strong, and when global economy is weak

Inflation targeting

Central bank’s commitment to maintaining a specific target rate of inflation, which helps anchor inflation expectations and guide policy decisions

Global crowding out effect

Occurs when capital flows into the US in response to higher US interest rates, leading to a stronger US dollar and potentially “crowding out” US exports