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Money and Interest Rates

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Money and Interest Rates
Money and interest rates are important for individuals and businesses making decisions to finance purchases. The following articles deal with assessing conditions to finance purchases and important aspects of policy.
Tom Woodruff has written an interesting and to-the-point article about effects of the Federal Reserve's monetary policy and changes in interest rates.
"A borrower's guide to forecasting interest rates" Retrieved on February 24, 2009.
Economic Focus: "What goes around", The Economist, Retrieved on February 24, 2009.
Read the above articles and write a 4-5 pages that address each of the following questions:
1. What major economic indicators would you examine if you were planning to make a large purchase and needed a loan? For example, think about buying a new car, some business equipment or a house?
2. Describe how the Federal Reserve?s (Fed for short) policy-makers can influence interest rates.
3. Do you think prospects for changes in Fed policy would affect your decision to make a purchase that requires financing? Explain.
4. How can the Fed can influence interest rates in the current economy? What would be your suggestion to stimulate or "fix" the economy?

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1. What major economic indicators would you examine if you were planning to make a large purchase and needed a loan? For example, think about buying a new car, some business equipment or a house?
The major economic indicators that I would examine if I were planning to make a large purchase and needed a loan include the following. I would look at the employment cost index, the quarterly worker productivity report and the gross domestic report. These indicators would give me an idea about the level of inflation in the market. Further, I would take a look at the consumer price index and the producer price index. These would let me know the current levels of inflation. I will examine the producer price index because it helps predict what will happen at the consumer level. In other words it gives you an idea of what interest rates to expect. The basic point is that if the inflation rate is high the interest rate that you need to pay for the car loan will also be high. Thus if the GDP growth rate is high it might indicate that the interest rates may be high. If you want to buy business equipment or a house it is important to look at the interest rates you may expect.
Similarly, if the consumer price index goes up there is also an increase in inflation and the rate of interest that you are likely to get will also increase. On the other hand if there is an increase in productivity the inflationary pressures will be lower and you stand a better change of getting loans at lower rates. Essentially, you need to examine indicators about the amount of money that was saved in the economy, mainly by households. In addition, you need to examine indicators that show the demand for funds by businesses and finally, you need to consider the indicators that show the government's net supply of funds and demand for funds.
2. Describe how the Federal Reserve?s (Fed for short) policy-makers can ...

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1. Compute the annual interest rate or rate of return that you will earn on the following investments:
a. A US T-Bill that has a current price of $930 and will pay $1000 at maturity six months from now.
b. A US T-Bill that has a current price of $950 and will pay $1000 at maturity six months from now.
c. A US Treasury note selling at its maturity value ($1000), paying 9 percent coupon interest per year, and maturing in five years.
d. An acre of vacation property with a current price of $5000 that you expect to be able to sell for $6475 in three years. There are no other expenses or income from this property
e. A preferred stock with a current price of $90 paying $10.80 dividends per share per year forever

2. Compute the annual interest rate for the following investments:
a. A US T-Bill which which matures in ninety-one days with a quoted price of $97.50 per $100 maturity value.
b. A share of common stock purchased one year ago at a price of $42 per share and just sold for $48. No dividends were received.
c. A share of common stock purchased one year ago for $21 and sold yesterday for $18 after receipt of a dividend check for $1
d. A share of common stock purchased for $30 three years ago and just sold for $30. Dividends of $2.10 were received at the end of each of the three years of ownership.

3. Benito Rubio borrowed 5000 bolivars (B) from his older brother in Caracas, Venezuela. Benito promised to repay the loan in two-annual installments of B3000 each. What rate of interest is Benito paying his brother?

4. Determine the annual interest rate on the following debt contracts:
a. A $25,000 mortgage with monthly payments of $209.80 to be paid off in twenty-five years.
b. Solve the problem in (a) considering that the lender is charging a 2 percent fee at the time the loan is taken out so that the actual amount being lent to you is less than $25,000.
c. An installment loan for $2000 that has monthly payments of $66 for the thirty-six months and an additional "balloon" payment of $150 in the last month.

5. You are in the market for a new, high-performance windsurfing board. A dealer offers you financing on the $1500 you need to buy the board at a "low 10 percent annual interest rate" for twenty-four months. Your payments are determined as follows:
a. Annual Interest = 10% of $1500 = $150 per year
Total Due = principal plus 2 years interest
= $1500 + 2($150)
Monthly Payments = $1800 / 24 months
= $75 per month
- This procedure is called "add on" interest. What is the actual annual rate of interest being charged on this loan?

6. You need to borrow $3000 to buy a powerboat. The boat dealer offers (low, low) monthly payments of $99 for thirty - six months with an additional "balloon" payment of $300 in the last month. What annual interest rate is the dealer charging you on the $3000 loan?

7. Four years ago your mother invested $10,000 in the Alpha Mutual Fund to provide money for your college education. All dividends were reinvested in the fund. Now the money is needed. The value of shares in the fund is $14,116. What annual rate of return was earned on the original $10,000 investment?

8. On January 16, 1990, Clara Hatfield invested $2000 in the common stock of Ace Novelties. Ace pays dividends quarterly on April 15, July 15, October 15, and January 15 of each year. Clara sold her stock on July 16, 1991 after receiving $30 dividends each quarter.
a. Suppose that Clara sold her Ace stock for $1820. What annual rate of return did she earn?
b. Suppose that Clara sold her Ace stock for $2000. What annual rate of return did she ear?
c. Suppose that Clara sold her Ace Stock for $2194. What annual rate of return did she earn?

9. In December 1988, exactly four years ago, you purchased shares in a mutual fund for $500. Although all the dividends were reinvested in the fund, you had to pay personal taxes at a rate of 20 percent on the dividends paid into you account each year. The current value of shares you own, including those obtained from dividend reinvestment, is $705.80. If the shares are sold, you will be subject to a capital gains tax of 20 percent (capital gains = proceeds from sale - original cost of all shares). The dividends paid and reinvested are shown below.

a. What is your pretax rate of return to date?
b. If you sell all the shares now, what will be you after-tax rate of return?

Year 1989 1990 1991 1992
Dividends
$ 30.00
$ 32.00
$ 36.00
$ 40.00

10. Your father has asked your advice on the following problem. He has a mortgage loan on the family home that was made several years ago when the interest rate were lower. The loan has a current balance of $40,000 and will be paid off in 20 years by paying $330 per month. He has discussed paying off the loan ahead of schedule with an officer of the bank holding the mortgage. The bank is willing to accept $36,000 right now to pay it off completely.
a. What interest rate, expressed as an annual rate, would your father earn by paying off the loan now rather than making monthly payments for 20 years.
b. Your father is currently earning 9 percent on his investments. Would if be worthwhile paying off the loan if he has the money available?

11. Two years ago Kareem Casey invested $5000 in a savings certificate account with a seven-year (7) maturity and an annual interest rate of 9 percent compounded monthly. Interest rates are higher now and Kareem is considering withdrawing the current balance in the account and investing the money in a higher-yielding asset. However, the bank will deduct a "penalty for early withdrawal" equal to the first six-month' interest paid on the account.
a. What is the current balance in the account
b. What will be the balance at maturity, five years from now, if no withdrawals are made?
c. How much money will Kareem receive if he closes out the account now?
d. What interest rate must Kareem earn on an alternative investment to obtain as much money in five years' time as he would have by keeping the certificate?
e. If Kareem keeps the certificate for one more year, will the interest rate he must earn then to make withdrawal worthwhile be higher, lower, or the same as the rate calculated in d? Why?

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