Econ 330 – Kelly

These are just outlines of potential answers and are not intended to be comprehensive!  To get full credit, you may have been required to write more than is given here!

ID’s:

Liquidity:  the ease of converting an asset into cash (or some other medium of exchange).  Liquidity is a consideration in asset demand; generally speaking, demand increases with an increase in liquidity.
 

Financial intermediation:  the process of transferring funds from savers to borrowers.  Financial intermediaries (banks, S&L’s, credit unions, etc.) accept funds from depositors, and redistribute these funds at a higher interest rate.  The result is reduced transaction costs (gross), increased economic efficiency (as the double-coincidence of wants problem is partially eliminated), and reduced informational asymmetries with better enforcement.
 

Systematic risk:  risk that cannot be diversified away in a portfolio of assets.  Measured by beta.  Associated with macroeconomic phenomena, usually (e.g., business cycles, inflation).
 

Indirect finance:  financing obtained from financial intermediaries, typically through loans, as opposed to primary (i.e., debt, equity) markets.  Largest form of finance, largely due to reduced transaction and informational costs.
 

Short Responses:

An increase in the supply of loanable funds corresponds to an increased demand for bonds.  The demand curve for bonds shifts out, and the supply curve is assumed fixed.  In this case, the price on bonds increases.  The price and interest rate on bonds move inversely, so the interest rate declines.  Intuitively, people have more money to spend, so it costs less to borrow that money.
 

Thirty-year T-Bonds have more interest rate or price risk than T-Bills.  However, T-Bills are reinvested 30+ times over the course of 30 years, and are thus subject to reinvestment risk.  Default risk is essentially identical for the two securities.
 

A reduction in the growth rate of the money supply has an immediate effect, and three longer-term effects.  In the short run, the liquidity effect pushes up interest rates – there are fewer dollars in circulation, so the price of those dollars (the interest rate) increases.  A reduction in the growth rate of the money supply is contractionary, however, so income, prices, and expected inflation typically will decline over time.  The effect of these three changes is to reduce the interest rate from its new, higher, level.  The net change on the interest rate is indeterminate, depending on the strength of the four effects.
 

Excluding tax-deductibility considerations, the cost of borrowing increases one-for-one with the real interest rate.  If actual or expected inflation changes, a 1% increase in the nominal rate does not correspond, necessarily, to a 1% increase in the real rate.  Also, if debt payment are tax deductible, the cost of borrowing increases less that one-for-one with the interest rate.
 

The current yield is an approximation of the yield to maturity, and as such, they are strictly positively correlated.  That is, when one goes up, the other necessarily increases as well.  Depending on the time to maturity of the bond being examined, and the type of bond, the current yield may be a poor approximation of the yield to maturity.  The current yield and yield to maturity move the same direction, but almost never move by the same proportion.
 

Contractional savings institutions are pension funds, insurance companies, etc.  They typically receive periodic payments (e.g., insurance premiums), and have very predictable liabilities.  Because of this predictability, these institutions are less concerned about liquidity than savings institutions.  They are free to purchases long-term assets, which may be relatively illiquid, but pay higher returns than money market instruments.  In other words, they invest in capital market assets.
 
Essays

1.

In some transactions it is correct to assume that all market participants have all the information that is relevant to the object that is transacted. However, this is not always the case. There are some transactions in which more than one party is involved, where one of the parties knows more about the object that will be transacted that the other party. A phenomenon of this kind is known as an “Asymmetric Information” situation.

“Asymmetric Information (AI)” can cause problems before and after the transaction occurs. “Adverse Selection” is the problem created by AI before the transaction occurs while “Moral Hazard” is the problem created by AI after the transaction occurs.

Examples of Adverse Selection could be:

(i) When a firm hires a worker, the firm may know less than the worker does about the worker’s innate ability.
(ii) When an automobile insurance company insures an individual, the individual may know more than the company about her inherent driving skill and hence about her probability of having an accident.
(iii) In the used car market, the seller of a car may have much better information about her car’s quality that a prospective buyer does.
(iv) In the financial markets occurs when the potential borrowers who are the most likely to produce and undesirable outcome are the ones who most actively seek out a loan and thus the most likely to be selected.

Because Adverse Selection problems make it likely that the outcome of transaction to be unsatisfactory to one of the parties, it can cause the market to collapse.

Examples of Moral Hazard could be:

(i) When an owner is not able to observe how hard his manager is working.
(ii) When an insurance company cannot observe how much care is exercised by the insured.
(iii) When a bank has difficulties observing whether the borrower uses the loaned funds for the purpose for which the loan was granted.

As with Adverse Selection, Moral Hazard lowers the probability of the good outcome for one of the parties and therefore reduces the chance that the transaction will actually be performed.

In the context of Financial Markets, Asymmetric Information makes it difficult to direct transactions to occur and makes the Financial Institutions the channel through which most transactions are performed.

2.

Following Chapter 3 in Mishkin’s book the theoretical approach defines money by using economic theory to decide which assets should be included in its measure. Since the key feature of money is that it is used as a medium of exchange, the theoretical approach focuses on this aspect and suggests that only assets that clearly serve as medium of exchange belong in a measure of the money supply. Therefore it only considers currency, checking account deposits and traveler’s checks as money.
However, the fact that other assets can be turned quickly into cash gives rise to ambiguities that have led many economists to define money in a more empirical way, i.e., what to call money should be based on which measure of money works best in predicting movements of variables that money is supposed to explain, like inflation or the business cycle.

The Federal Reserve’s Monetary Aggregates are:
M1 = Currency + Traveler’s Checks + Demand Deposits + Other Checkable Deposits
M2 = M1 + Small-denomination time deposits + Savings deposits and money market deposit accounts + Money Market Mutual Fund Shares (non-institutional)
M3 = M2 + Large-denomination time deposits + Money Market Mutual fund Shares (institutional) + Term Repurchase Agreements + Term Eurodollars
L   = M3 + Short-term Treasury securities + Commercial Paper + Savings bonds + Banker’s acceptances.

The measure of money that you would think is the best is just a personal opinion.

3.

(This question can be interpreted in many ways, so I will provide just one possible correct answer)

                  Period 1 Period 2 Period 3 Period 4 Period 5
Nom. Int. R. 50%        80%       80%         80%    80%
Exp. Inf. R.                  30%       30%         30%    30%

The Formula for the real interest rate is (using the Fisher approximation would be incorrect since the rates are quite high),

r = (1 + i) / (1 + exp. inf) -1

Therefore the real interest rate for the next four years is,

               Period 2 Period 3 Period 4 Period 5
Real Int. R. 38.4%  38.4%   38.4%    38.4%

Since we are talking about an indexed bond, the face value will be adjusted by the inflation rate. Therefore the expected value of the fourth period coupon will be,

C 4 = F V ( 1 + exp. inf. 1) ( 1 + exp. inf. 2) ( 1 + exp. inf. 3) ( 1 + exp. inf. 4) Coupon rate

Therefore, the fourth period expected coupon has to be equal to U$S 219.7.

Regarding the last part of the question, it would be a good measure of the expected return except for the fact that it does not account for the tax problem that inflation brings about.
 

4.

The Demand for a financial asset (which I will call bond onwards) shows the relationship between the quantity demanded and the price (interest rate) when all other economic variables are held constant, i.e., the values of the other variables are taken as given. In the case of a bond, a more formal way to express this locus of points would be:

B d = F (i ; W, Exp. R., Liq., Risk)
 
The interest rate (the relative price for a generic asset) is the opportunity cost of present consumption compared with future consumption. Since an increase in the interest rate implies a higher opportunity cost for current consumption in terms of future consumption, an increase in the interest rate causes an increase in the demand for bonds.

Wealth is the total resources owned by the individual, so an increase in wealth implies that there are more resources available and therefore the quantity of assets demanded increase.

Expected Return measures how much we gain from holding an asset, therefore, an increase in the expected return relative to that of an alternative asset, ceteris paribus, raises the quantity demanded of the asset.

Liquidity measures how quickly an asset can be converted into cash, therefore, the more liquid is an asset relative to alternative assets, ceteris paribus, the more desirable it is, and so the greater will be the quantity demanded.

Risk is measured by the degree of uncertainty that is associated with the return of a given asset. A risk-averse person prefers lower risk, and most people are risk-averse. Therefore, ceteris paribus, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will fall.