Midterm 1 Flashcards Flashcards by Angeline Rechilma

What are the 3 functions of money?

Medium of exchange, unit of account, store of value.

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Why is money better than barter?

It reduces transaction costs and eliminates the need for a double coincidence of wants.

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What makes a good medium of exchange?

Portability, divisibility, durability, uniformity, and acceptability.

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What is commodity money?

Money with intrinsic value (e.g., gold, silver).

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What is fiat money?

Money that has value because the government declares it legal tender.

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What is M1?

Currency + demand deposits (most liquid money).

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What is M2?

M1 + savings deposits + time deposits + money market funds.

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What is liquidity?

How easily an asset can be converted into cash without loss of value.

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How does inflation affect money as a store of value?

High inflation reduces purchasing power, weakening money’s store-of-value function.

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What is the present value (PV) concept?

The current worth of future cash flows discounted at the interest rate.

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Simple loan future value formula?

FV=PV(1+i)

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Four types of credit market instruments?

Simple loans, fixed-payment loans, coupon bonds, discount bonds.

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What is yield to maturity (YTM)?

Interest rate equating present value of payments to bond price.

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Relationship between bond price and yield?

Inversely related — when prices rise, yields fall.

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What is current yield?

Annual coupon divided by current price.

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What is interest rate risk?

Risk that bond prices fall when interest rates rise.

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What is real interest rate?

Nominal interest rate minus expected inflation (
𝑟=𝑖−𝜋𝑒

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Why are shorter-term bonds preferred when rates rise?

They carry less price risk.

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What are the main determinants of asset demand?

Wealth, expected return, risk, and liquidity.

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How does wealth affect bond demand?

↑ Wealth → ↑ Demand for bonds.

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How do expected returns affect bond demand?

↑ Expected return → ↑ Demand.

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How does risk affect bond demand?

↑ Risk → ↓ Demand.

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How does liquidity affect bond demand?

↑ Liquidity → ↑ Demand.

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What is market equilibrium in the bond market?

When quantity demanded = quantity supplied (Bd = Bs).

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If Bd > Bs, what happens?

Excess demand → Price rises → Interest rate falls.

If Bd < Bs, what happens?

Excess supply → Price falls → Interest rate rises.

What shifts the demand for bonds right?

↑ Wealth, ↓ Expected inflation, ↓ Risk, ↑ Liquidity.

What shifts bond supply right?

Investment opportunities, ↑ Inflation expectations, ↑ Gov’t deficits.

What does the Fisher effect predict?

Nominal interest rates move one-for-one with expected inflation.

What happens to interest rates during business cycle expansion?

Interest rates rise (bond supply increases more than demand).

What is the liquidity preference framework?

Keynes’s theory that interest rates are determined by money supply & demand.

What happens if money supply increases?

Interest rates fall (liquidity effect).

What shifts money demand right?

↑ Income or ↑ Price level.

What shifts money supply right?

Central bank increases money supply.

What is the liquidity effect?

An increase in money supply lowers interest rates.

What are the opposing effects of money growth?

Income effect, price-level effect, and expected-inflation effect raise rates.

When does interest rate rise after money growth?

When price-level and inflation expectations dominate the liquidity effect.

What is the risk premium?

Extra yield required by investors for riskier securities.

Why are government bonds more liquid?

Trade in larger markets with lower transaction costs.

Why do corporate bonds yield more than government bonds?

Higher default risk.

How do taxes affect yields?

Tax-exempt bonds (municipal) have lower yields.

Three risk components in interest rate differentials?

Default risk, liquidity risk, tax considerations.

What is the term structure of interest rates?

Relationship between yields and maturities.

Upward-sloping yield curve implies what?

Future short-term rates expected to rise / liquidity premium.

What does a yield curve show?

Yields on bonds with different maturities.

Downward-sloping yield curve implies what?

Expected future short-term rates will fall (possible recession).

What are the three theories of term structure?

Expectations theory, segmented markets theory, liquidity premium theory.

One-period valuation model formula?

𝑃0=𝐷1+𝑃1/1+𝑘𝑒

What does expectations theory state?

Long-term rates = average of expected future short-term rates.

What does liquidity premium theory add?

Investors need a premium for holding longer-term bonds due to risk.

What happens if required return (risk) rises?

Stock prices fall.

What is the rational expectations theory?

People use all available information efficiently to form expectations

What determines stock prices?

Present value of expected future dividends.

What is the efficient market hypothesis (EMH)?

Stock prices reflect all available information; future changes are unpredictable.

What happens to stock prices if expected dividends rise?

Prices increase.

Generalized dividend model formula?

P0=∑t=1∞Dt/ (1+ke)^t

Gordon growth model formula?

𝑃0=𝐷1/𝑘𝑒−𝑔 Assumes dividends at a constant rate

Three forms of market efficiency?

Weak, semi-strong, strong.

What is arbitrage?

Exploiting price differences for risk-free profit (eliminated quickly in efficient markets).

What evidence supports EMH?

Stock prices follow a random walk; managers rarely outperform markets long-term.

What anomalies challenge EMH?

Market bubbles, overreactions, and calendar effects (e.g., January effect).

What are the main players in the money supply process?

Central bank (Bank of Canada), banks (deposit institutions), and the public (depositors).

What is the monetary base (high-powered money)?

Currency in circulation + reserves.

What are reserves?

Bank deposits at the central bank + vault cash.

How does the central bank control the monetary base?

Through open market operations and loans to banks.

What are open market operations?

Buying or selling government bonds to influence reserves and money supply.

How do open market purchases affect reserves?

Increase reserves → increase money supply.

How do open market sales affect reserves?

Decrease reserves → decrease money supply.

How do changes in borrowed reserves affect the monetary base?

More borrowing from central bank → larger monetary base.

What happens to the money multiplier when people hold more cash?

It decreases (less money created by banks).

What factors influence the money multiplier?

Required reserve ratio, excess reserves, and currency holdings.

What happens when banks hold more excess reserves?

Money creation decreases.

Midterm 1 Flashcards

(72 cards)