Financial Assets and Interest Rates Overview
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Financial Assets and Interest Rates Overview

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Questions and Answers

What happens to bond prices when interest rates increase?

  • Bond prices become volatile
  • Bond prices increase
  • Bond prices remain stable
  • Bond prices decrease (correct)

    • What is meant by 'interest-bearing assets'?

  • Assets that lose value over time
  • Assets that require payment of principal only
  • Assets that do not earn any returns over time
  • Assets that earn interest over time (correct)

    • Which of the following best describes the purchasing power of money?

  • The value of money in relation to other currencies
  • The amount of money needed to purchase a single good
  • The total supply of money in circulation
  • The amount of goods or services an unit of money can buy (correct)

    • Which of the following correctly describes commodity money?

    <p>Money that has intrinsic value outside its labeled value</p> Signup and view all the answers

    What is the primary consequence of inflation on purchasing power?

    <p>It decreases purchasing power</p> Signup and view all the answers

    What element is included in the formula for the nominal interest rate?

    <p>Inflation rate</p> Signup and view all the answers

    Which measure of money supply is considered to have the highest liquidity?

    <p>M1</p> Signup and view all the answers

    Which of the following is NOT a function of money?

    <p>Direct trade of goods/services</p> Signup and view all the answers

    What does the money multiplier effect indicate?

    <p>The relationship between reserve ratio and total money supply</p> Signup and view all the answers

    In terms of stock ownership, what benefit do stockholders receive?

    <p>Dividends from corporate profits</p> Signup and view all the answers

    In the context of fractional reserve banking, what does the term 'reserve ratio' refer to?

    <p>The portion of deposits that a bank must keep on hand</p> Signup and view all the answers

    What is the 'time value of money' concept fundamentally based on?

    <p>The idea that money today is worth more than the same amount in the future</p> Signup and view all the answers

    What is the opportunity cost of holding liquid money?

    <p>The potential interest income lost by not investing</p> Signup and view all the answers

    What challenge does the barter system face that money alleviates?

    <p>Double coincidence of wants</p> Signup and view all the answers

    What happens to acceptability of money during hyperinflation?

    <p>It decreases significantly</p> Signup and view all the answers

    Which statement correctly defines the term 'wealth'?

    <p>The stock of assets owned by an individual or entity</p> Signup and view all the answers

    Which of the following correctly describes the relationship between assets and liabilities?

    <p>Total liabilities must always equal total assets.</p> Signup and view all the answers

    What effect does a decrease in the nominal interest rate have on the opportunity cost of holding money?

    <p>It decreases the opportunity cost.</p> Signup and view all the answers

    Which of the following actions will increase the money supply?

    <p>The government purchasing bonds from commercial banks.</p> Signup and view all the answers

    What is the role of the reserve ratio in a bank's operations?

    <p>It indicates how much money a bank must keep in reserve and not loan out.</p> Signup and view all the answers

    In the loanable funds market, what outcome typically results from an increase in demand for loans?

    <p>Increase in the equilibrium real interest rate.</p> Signup and view all the answers

    What occurs when the Federal Reserve buys bonds from commercial banks?

    <p>The money supply initially increases through the banks' excess reserves.</p> Signup and view all the answers

    How does a higher discount rate influence the banking sector?

    <p>It discourages banks from borrowing and lending.</p> Signup and view all the answers

    What is the initial change in the money supply when the Fed buys $1000 worth of bonds?

    <p>Bank reserves increase by $1000; checkable deposits are unchanged.</p> Signup and view all the answers

    Which of the following factors shifts the money demand curve?

    <p>Changes in the price level.</p> Signup and view all the answers

    In an economic scenario, a government engaging in more borrowing would likely lead to what?

    <p>Decrease in supply and an increase in demand for loans.</p> Signup and view all the answers

    Study Notes

    Financial Assets

    • The financial sector connects borrowers and lenders, including banks, mutual funds, pension funds, and more.
    • Assets can be tangible or intangible and have value.
    • Interest rate is the cost of borrowing money.
    • Interest-bearing assets earn interest over time, like bonds.
    • Personal finance is budgeting, saving, and spending for individuals and families.
    • Investment refers to businesses spending on tools and machinery.
    • Bonds are loans or IOUs that represent debt to repay lenders; bondholders receive interest payments but do not own a portion of the company.
    • Stocks are equities that represent ownership in a corporation; stockholders receive dividends, which are a portion of the company's profits.

    Interest Rates and the Time Value of Money

    • Nominal interest rate is the actual interest rate, and it consists of the real interest rate and inflation.
    • Time value of money: the concept that money today is worth more than money in the future due to its potential earning power.

    The Role of Money

    • Barter system is the direct exchange of goods and services without money.
    • Money is generally accepted as payment for goods and services; it is distinct from wealth and income.
    • Wealth is the total collection of assets, and income is an individual's or household's earnings per unit of time.
    • Commodity money has intrinsic value outside its monetary function, such as gold, silver, or cigarettes.
    • Fiat money has no intrinsic value and serves as money solely by government decree.

    Functions of Money

    • Medium of exchange: money facilitates transactions by acting as an intermediary between buyers and sellers.
    • Unit of account: money provides a common measure of value for goods and services.
    • Store of value: money can hold its purchasing power over time, allowing individuals to save and transfer wealth across time.
    • Bond and interest rates have an inverse relationship: when interest rates rise, bond prices fall.
    • Money's effectiveness depends on collective belief in its value; it should be generally accepted by buyers and sellers, scarce, portable, and divisible.
    • Purchasing power of money is the amount of goods and services that can be purchased with one unit of money.
    • Inflation decreases purchasing power, and hyperinflation significantly reduces its acceptability.
    • Liquidity refers to the ease with which an asset can be accessed and used as a medium of exchange.
    • M1 includes currency in circulation, checkable bank deposits, traveler's checks, and savings accounts - considered the most liquid.
    • M2 (near-money) includes M1 plus saving deposits, time deposits, and money market funds.
    • M2 primarily represents savings.
    • M1 and M2 generally hold little interest.
    • The opportunity cost of holding liquid money is the interest that could be earned by investing it elsewhere.

    Money Multiplier and Fractional Reserve Banking

    • Money multiplier is the ratio of the money supply to the monetary base (1 / reserve ratio).
    • "New money" is created when banks lend out excess reserves, calculated by multiplying the initial loan or excess reserves by the money multiplier.
    • Fractional reserve banking allows banks to hold a portion of deposits as reserves to cover potential withdrawals and loan out the remainder.
    • Reserve ratio is the percentage of deposits that banks must hold as reserves.
    • Bank balance sheets show the financial position of banks, including liabilities (financial obligations) and assets.
    • Liabilities include demand deposits, account investments, and equity.
    • Assets include required reserves, excess reserves, outstanding loans, and investment securities.
    • The total liabilities of a bank must equal its total assets.

    Money Supply and Demand

    • Money supply (MS) is typically represented as a vertical line.
    • Money demand (MD) is a downward-sloping linear curve, indicating that people demand more money when interest rates are low.
    • The opportunity cost of holding money is the interest that could be earned by investing it elsewhere.
    • Shifters of money demand include changes in the price level (direct relationship).

    Monetary Policy and the Federal Reserve

    • Monetary policy attempts to influence the money supply and interest rates to achieve desired macroeconomic goals.
    • The Federal Reserve (Fed) is the central bank of the United States and implements monetary policy.
    • The three main tools of monetary policy are:

    Reserve Requirements Ratio

    • Reserve requirements ratio is a percentage of deposits that banks must hold in reserve.
    • A higher reserve requirement ratio decreases the money multiplier, leading to lower money supply.
    • A lower reserve requirement ratio increases the money multiplier, leading to a higher money supply.
    • The Fed sets the reserve requirement ratio.

    The Federal Funds Rate

    • The Federal Funds Rate is the interest rate that banks charge each other for overnight loans of reserves.
    • The Fed influences the federal funds rate by setting a target rate and using open market operations to achieve it.

    The Discount Rate

    • The Discount Rate is the interest rate that the central bank charges commercial banks for loans.
    • A lower discount rate incentivizes banks to borrow more from the Fed, leading to increased lending and a higher money supply.
    • A higher discount rate discourages banks from borrowing from the Fed

    Open Market Operations

    • Open market operations involve the purchase and sale of government securities by the Fed in the open market.
    • Buying government bonds (securities) from commercial banks increases the reserves of banks and raises the money supply.
    • Selling government bonds (securities) to commercial banks drains reserves from banks and lowers the money supply.

    Monetary Base and Money Supply

    • The monetary base is the sum of bank reserves and currency in circulation.
    • Money supply includes checkable deposits and currency in circulation.
    • The money multiplier amplifies the impact of changes in the monetary base on the money supply.

    The Impact of the Federal Reserve's Actions

    • When the Fed buys 1000ofbonds,bankreservesincreaseby1000 of bonds, bank reserves increase by 1000ofbonds,bankreservesincreaseby1000, but checkable deposits do not change.
    • The 1000increaseinreservesbecomesexcessreserves,whichbanksimmediatelylendouttoconsumers,potentiallyincreasingcheckabledepositsby1000 increase in reserves becomes excess reserves, which banks immediately lend out to consumers, potentially increasing checkable deposits by 1000increaseinreservesbecomesexcessreserves,whichbanksimmediatelylendouttoconsumers,potentiallyincreasingcheckabledepositsby10,000.
    • The Fed's actions can have a substantial impact on the money supply and the economy.

    Government Borrowing and Interest Rates

    • When the government borrows more, it can lead to a decrease in the supply of loanable funds and an increase in demand, potentially pushing up interest rates.

    Relationships Between Interest Rates

    • The nominal interest rate equals the real interest rate plus inflation.
    • A high real interest rate can be beneficial for lenders (more returns) and detrimental for borrowers (higher costs).
    • The loanable funds market models the supply and demand of loans and the equilibrium real interest rate.

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    Description

    This quiz provides insights into financial assets, including tangible and intangible assets, and explores the critical concepts of interest rates and the time value of money. Understand how different financial instruments like bonds and stocks function in the broader financial landscape, along with personal finance principles.

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