ECONOMICS 0281

MONEY AND BANKING VOCABULARY-PART 1

*01. SPONTANEOUS ORDER: An order created by people who desire to interact on a regular basis. These people will develop rules which govern specific ways of interacting on a trial and error basis. If a rule is good, it will facilitate interactions, reduce the numbers of disputes, and be imitated by other potential users. If a rule is bad, it will increase disputes and therefore be amended or discarded. Good rules will survive and promote mutually beneficial interactions while bad rules generally disappear. As a result, good rules will evolve incrementally over time rather than appear as finished products out of nowhere.

*02. DESIGNED ORDER: An order that is created by third parties to regulate the interactions of other parties. This regulation takes the form of particular rules which are designed to favor some parties at the expense of other parties. Such rules must be imposed because they are not mutually beneficial. Over time, the winners tend to invest resources in maintaining the status quo while the losers tend to invest resources in either circumventing the rules or becoming organized to lobby for a change in the rules that is more favorable to them. As a result, these rules do not evolve incrementally over time but change in highly unpredictable ways, producing short-run stability but long-run instability.

03. WEALTH: All resources owned by an individual, including all assets, (real and financial).

04. INCOME: Flow of earnings (per unit time).

05. MEDIUM OF EXCHANGE: Anything that is used to pay for goods and services.

06. UNIT OF ACCOUNT: Anything used to measure value in an economy.

07. STORE OF VALUE: A repository of purchasing power over time.

08. LIQUIDITY: The relative ease and speed with which an asset can be converted into cash (a medium of exchange).

09. HYPERINFLATION: An extreme inflation (a sustained increase in the general price level) in which the inflation rate exceeds 50% a month.

10. COMMODITY MONEY: Money made up of precious metals or another valuable commodity.

11. FIAT MONEY: Paper currency decreed by a government as legal tender but not convertible into coins or precious metal.

12. PRESENT VALUE: Today’s value of a payment to be received in the future when the interest rate is i.

13. YIELD TO MATURITY: The interest rate that equates the present value of payments received from a credit market instrument with its value today.

14. COUPON BOND: A credit instrument that pays the owner a fixed interest payment every year until the maturity date, when a specified final amount is paid.

15. PAR VALUE/FACE VALUE: A specified final amount paid to the owner of a coupon bond at the maturity date.

16. CONSOL: A perpetual bond with no maturity date and no repayment of principal that periodically makes fixed coupon payments.

17. DISCOUNT BOND: A credit market instrument that is bought at a price below its face value and whose face value is repaid at the maturity date; it does not make any interest payments. Also called a zero coupon bond.

18. INTEREST RATE RISK: The possible reduction in returns that is associated with a change in interest rates.

19. REINVESTMENT RISK: If an investor’s holding period is longer than the maturity of the bond, the investor is exposed to reinvestment risk. This occurs because the proceeds of the short-term bond need to be reinvested at a future interest rate that is uncertain.

20. INFLATION: A sustained rise in the general price level of all goods and services at a constant or increasing rate. This rise in the price level is estimated by an index created from the prices of a sample of items called a market basket.

21. NOMINAL INTEREST RATE: An interest rate that does not take inflation into account.

22. EXPECTED REAL INTEREST RATE: The nominal interest rate adjusted for expected changes in the price level (inflation) so that it more accurately reflects the true cost of borrowing.

23. FISHER EFFECT: The nominal interest rates must be equal to the real interest rate plus the expected amount of inflation. When expected inflation increases, nominal interest rates increase with the real expected interest rate remaining constant.

24. INDEXED BOND: A bond whose interest and principal payments are adjusted for changes in the price level, and whose interest rate thus provides a direct measure of the real interest rate.

25. THE LAW OF DEMAND: The quantity demanded of bonds is inversely related to the price of bonds, all other things held constant.

26. THE LAW OF SUPPLY: The quantity supplied of bonds is directly related to their price, all other things held constant.

27. MARKET EQUILIBRIUM: A situation occurring when the quantity of bonds that people are willing to buy (demand) equals the quantity of bonds that people are willing to sell (supply) at a given price.

28. EXCESS SUPPLY OF BONDS: A situation occurring in which the quantity supplied of bonds is greater than the quantity demanded of bonds.

29. EXCESS DEMAND OF BONDS: A situation occurring in which the quantity demanded of bonds is greater than the quantity supplied of bonds.

30. DEFAULT RISK: The chance that the issuer of a debt instrument will be unable to make interest payments or pay off the face value when the instrument matures.

31. RISK PREMIUM: The spread between the interest rate on bonds with default risk and the interest rate on default-free bonds.

32. JUNK BONDS: Bonds with ratings below Baa (or BBB) that have a high default risk.

33. YIELD CURVE: A plot of the interest rates for particular types of bonds with different terms to maturity.

34. INVERTED YIELD CURVE: A yield curve that is downward sloping.

35. EXPECTATIONS THEORY: The proposition that the interest rate on a long-term bond will equal the average of the short-term interest rates that people expect to occur over the life of the long-term bond.

36. SEGMENTED MARKETS THEORY: A theory of the term structure that sees markets for different-maturity bonds as completely separated and segmented such that the interest rate for bonds of a given maturity is determined solely by the supply and demand for bonds of that maturity.

37. LIQUIDITY PREMIUM THEORY: The theory that the interest rate on a long-term bond will equal the average of short-term interest rates expected to occur over the life of the long-term bond plus a positive term (liquidity) premium.