Money, Banking, and Financial Markets, 6th Edition by Cecchetti, Schoenholtz

TEST BANK for Money, Banking, and Financial Markets, 6th Edition by Cecchetti, Schoenholtz CHAPTER 1 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) Identify which item is not one of the six parts of the financial system. A) financial markets B) central banks C) credit cards D) financial institutions

2) The current mission of which one of the six parts of the financial system involves serving the public at large? A) financial markets B) central banks C) credit cards D) financial institutions

Which one of the following is the central bank of the United States? A) the Bank of America B) the Federal Reserve System C) the U.S. Treasury D) Citibank

An important way that central banks have changed over time is to provide more A) risk. B) money. C) transparency. D) regional reserve banks.

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More of which one of the following is an important key to the financial system? A) risk B) information C) asymmetric trading D) money

Banks and insurance companies are examples of A) central banks. B) regulatory agencies. C) financial institutions. D) financial instruments.

7) Which part of the financial system is used to transfer risk to those who are best equipped to bear it? A) central banks B) regulatory agencies C) financial institutions D) financial instruments

Which part of the financial system provides oversight through enforcement of rules? A) central banks B) regulatory agencies C) financial institutions D) financial instruments

Which of the following is not one of the five core principles of money and banking?

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A) Risk requires compensation. B) Time has value. C) Information is the basis for decisions. D) Stability creates risk.

10)

Investing in financial instruments in today's economy: A) is an activity practiced only by the wealthy. B) involves costly transactions. C) requires a sum of money larger than $100,000 to invest. D) is made easier by the use of mutual funds.

11)

Which of the following is an example of a financial market? A) a local coffeehouse where people regularly buy and sell financial instruments. B) a bank that only accepts deposits and issues loans. C) an electronic network used for buying and selling textbooks. D) a central bank used for raising taxes and borrowing on behalf of the government.

12) Why would a new home buyer be required to purchase fire insurance before a broker transfers funds to the seller? A) Risk requires compensation. B) This provides information to the lender increasing the likelihood that the loan will be repaid. C) Well-developed financial markets promote economic growth. D) Increasing the use of banking services provides stability in the macroeconomy.

13)

The statement "risk requires compensation" implies that people

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A) do not take risk. B) only accept risk when they absolutely have to. C) will only accept risk when they are rewarded for doing so. D) avoid risk at all cost.

14)

Mutual funds have A) been created for very wealthy individuals with a lot of money to invest. B) increased the risks associated with constructing a portfolio. C) reduced the costs associated with gathering information on stocks and bonds. D) increased the transactions costs associated with participating in financial markets.

15) Which one of the following types of action by a central bank could improve the welfare of a society? A) serving the interests of government rather than the public at large B) promoting regulations to slow economic growth C) controlling prices to allocate resources in support of government objectives D) helping to reduce the volatility of business cycles

16)

In the United States, control of the quantity of money is given to the A) president. B) Federal Reserve System. C) Bureau of Printing and Engraving. D) Department of the Treasury.

17)

Financial instruments can transfer

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A) neither resources nor risk between people. B) resources between people but not risk. C) both resources and risk between people. D) risk but not resources between people.

18)

Financial markets

A) lower the cost and increase the speed of buying and selling financial instruments. B) increase the speed of buying and selling, but they also increase the cost since people are earning fees for these transactions. C) are a good example of unregulated markets. D) today offer fewer instruments than they did in the past.

19) Which one of the following parts of the financial system is responsible for making sure that the elements of the system operate in a safe and reliable manner? A) financial markets B) money C) financial institutions D) regulatory agencies

20)

The New York Stock Exchange is an example of a A) financial instrument. B) financial institution. C) financial market. D) bank.

21) When an individual obtains a car loan and makes all of the regular monthly payments, the sum of the payments made will exceed the purchase price of the car. This is due primarily to which core principle? Version 1

A) Risk requires compensation. B) Information is the basis for decisions. C) Markets determine prices and allocate resources. D) Time has value.

22) Car insurance shelters drivers from the possibility of losing all their wealth in the event that they cause an accident in which someone is seriously injured. This best illustrates which core principle? A) Risk requires compensation. B) Information is the basis for decisions. C) Markets determine prices and allocate resources. D) Time has value.

23) A central bank’s pursuit of policies that control inflation and reduce business cycle fluctuations best illustrates which core principle? A) Risk requires compensation. B) Stability improves welfare. C) Markets determine prices and allocate resources. D) Time has value.

24) Which one of the following provides an economy with a foundation for economic efficiency and economic growth? A) high levels of risk in investing B) healthy and constantly evolving financial system C) government that regulates output markets D) tax structure that redistributes income

25)

Most financial markets in the United States operate under a system

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A) without any formal rules or regulations. B) with many rules and regulations to ensure a fair market. C) where the rules and regulations depend on the state in which the financial market is located. D) that is totally controlled by the federal government.

26)

How do financial institutions evaluate the creditworthiness of potential borrowers? A) They offer high interest rates because only the best borrowers will be able to afford

them. B) They gather information regarding the borrowers' finances. C) They do not evaluate creditworthiness because everyone is treated the same. D) They do not evaluate the creditworthiness because they know the borrower will honor his/her obligation to repay the loan.

27)

Stock prices are A) set by the company issuing the stock. B) set by the central bank. C) determined by market transactions. D) unrelated to the value of the company issuing the stock.

28)

The primary function of central banks is to

A) increase risk and volatility to increase compensation. B) control inflation, as well as help reduce the size and frequency of business cycle fluctuations. C) increase the uncertainty that firms face in making investment decisions. D) eliminate the need for banks to collect financial information.

29)

The goal of U.S. monetary policy is best described as

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A) keeping inflation low and stable and growth high and stable. B) determining the denominations of a country's currency. C) one of the most important functions of Congress. D) attempting to keep inflation constant at 0 percent.

30)

Studying money and banking through five core principles is helpful because A) studies have shown students have a difficult time remembering more than five topics. B) everything in economics can be reduced to five core principles. C) money and banking can undergo drastic changes overtime, but the five principles do

not. D) these five principles are understood by everyone.

31) The large regulatory change in U.S. financial markets that followed the Great Recession is known as A) Basel III. B) the Glass-Steagall Act. C) the Gramm-Leach-Bliley Act. D) the Dodd-Frank Act.

32) In 2010, regulators of many nations agreed on a major update of internationally active banks known as

A) Basel III. B) the Glass-Steagall Act. C) the Gramm-Leach-Bliley Act. D) the Dodd-Frank Act.

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SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question. 33) Identify the five core principles of Money and Banking.

34)

Identify the six parts of the financial system.

35) How do the primary functions of financial institutions and regulatory agencies differ in the U.S. financial system?

36) If the U.S. Supreme Court ruled that states could no longer require people to have auto insurance, do you think most people would cancel their policies? Use one of the five core principles to explain your answer.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 37) How do central banks, like the U.S. Federal Reserve, contribute to the welfare of a society?

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38) Which core principle(s) could you use to explain why credit card issuers charge such high rates of interest?

39) Suppose that IBM considers expanding its operations. The expansion will require $400 million for two new factories which the corporation plans to raise by selling stock and bonds. Which of the core principles will come into play as investors decide whether or not to buy the stock and the bonds?

40) A borrower seeking a mortgage today is often presented with the choice between a mortgage with aninterest rate and monthly payment that stays fixed for the duration of the loan, or a mortgage with aninterest rate and monthly payment that can change as other interest rates change. Typically the interest rate on the fixed-rate mortgage is higher. Having learned the five core principles, does this make sense?

41)

Why don’t large financial markets arise by themselves?

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Answer Key Test name: Chap 01_6e 1) C 2) B 3) B 4) C 5) B 6) C 7) D 8) B 9) D 10) D 11) A 12) B 13) C 14) C 15) D 16) B 17) C 18) A 19) D 20) C 21) D 22) A 23) B 24) B 25) B 26) B Version 1

27) C 28) B 29) A 30) C 31) D 32) A 33) (1) Time has value. (2) Risk requires compensation. (3) Information is the basis for decisions. (4) Markets determine prices and allocate resources. (5) Stability improves welfare. 34) They are: money, financial markets, financial instruments, financial institutions, government regulatory agencies, and central banks. 35) Financial institutions, such as banks, securities firms, and insurance companies, provide a myriad of services, including access to the financial markets andcollection of information about prospective borrowers to ensure they are creditworthy. Regulatory agencies provide wide-ranging financial regulation—rules for the operation of financial institutions and markets, and supervision—oversight through examination and enforcement. 36) Probably not. Auto insurance falls under the principle that risk requires compensation. For most people the additional risk they would face of driving without insurance exceeds the cost of the insurance, so they are better off purchasing auto insurance to reduce their risk.

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37) One of the core principles is that stability improves welfare (primarily by reducing risk). One of the functions of a central bank is to try to get rid of the risk that people cannot get rid of on their own, like the risk that comes from economic fluctuations, volatile price level changes or volatility in economic growth. To whatever degree the central bank can smooth these fluctuations, risk can be reduced and the overall welfare of a society can be improved. 38) You could explain the high rates of interest from three principles. First, risk requires compensation, and certainly the credit card issuers are taking a risk when they let people use the cards. There is a risk that some users may not repay the credit card company. Second, you can also justify it from the principle that time has value. The borrowers are using the issuer's funds, and the issuer needs to be compensated for letting the borrower use these funds. Some borrowers do not repay for considerable periods of time. Third, you could also invoke the principle that people use information in making their decisions. Credit card issuers need to acquire information on each applicant before a card is issued and this process is costly. Unfortunately, the applicants who are denied do not get the card, but those who are approved must help cover the information costs.

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39) The five core principles are: (1) Time has value. (2) Risk requires compensation. (3) Information is the basis for decisions. (4) Markets determine prices and allocate resources. (5) Stability improves welfare. Investors considering buying IBM's stock and bonds would surely have principle #2 in mind; they would assess the risk involved in IBM's expansion and want to be compensated for it. This would clearly involve information (principle #3). Principle #1 would come into play with the bonds; are they 1-year bonds? 5-year bonds? The longer the time period involved, everything else constant, the greater the return investors would require. Principles #4 and #5 are not totally irrelevant here, as investors will rely on markets to price the stocks and bonds and will judge IBM's expansion based on the outlook for the economy as a whole (stability). 40) Yes. The lender is shifting risk to the borrower. The risk here is that the lender agrees to a mortgage at (for example) 6% but then over the life of the loan (which can be 10, 25, even 30 years) interest rates in the market go up, putting the lender in the position of being "stuck" with the 6%. If the rate on the mortgage would change with market rates the lender would not have the risk. But remember, risk requires compensation, so to entice the borrower to take on the added risk the lender provides an inducement in the lower rate. A smart borrower will make the decision about whether or not the lower but changeable rate is a good decision based on information about interest rates (information, stability), and the decision may also depend on how long the borrower plans to live in the house (time).

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41) Large financial markets like the New York Stock Exchange, for example, require rules in order to work properly, as well as authorities to police them. Billions of shares of stock change hands every day, and the markets will not function properly without rules and enforcement. For people to be willing to participate in a market, they must perceive it as fair. This creates an important role for the government. Regulators andsupervisors of the financial system make and enforce the rules, punishing people who violate them. When the government protects investors, financial markets work well andhelp promote economic growth.

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CHAPTER 2 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) Which one of the following is not a necessarycharacteristic of money? A) It is a store of value. B) It is a means of payment. C) It has intrinsic value. D) It is a unit of account.

A system of barter A) does not permit the exchange goods and services. B) requires that people do everything for themselves. C) requires exchange of goods and services without money. D) is efficient since people are self-sufficient.

A society without any money A) would have to rely on barter. B) would have no exchange of goods and services. C) would have individuals doing everything for themselves. D) would be more efficient due to more self-sufficiency.

The use of money makes an economy more efficient because A) people spend more time trading and more time producing. B) people can specialize in what they do well. C) with money, people will borrow less. D) money increases in value over time.

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The unit of account characteristic of money A) makes it difficult to compare the relative prices of goods and services. B) refers to how we use money to transfer purchasing power over time. C) means prices are expressed in terms of money. D) means that money finalizes payments.

Without the use of money, workers in an economy would A) become more specialized. B) have to spend a lot less time trading. C) probably specialize less. D) be far more productive.

As an economy without money produces more different types of goods, A) it is more difficult to quote prices. B) the number of relative prices decreases. C) a unit of account is easier to define. D) buyers are more likely to have full information about sellers.

The store of value characteristic of money refers to the fact that A) people save most of their money. B) money allows people to shift purchasing power into the future. C) money is not valuable unless it is stored. D) money is the only way people have to store value.

Stocks and bonds that are held as wealth fulfill which one of the functions of money?

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A) means of payment B) store of value C) unit of account D) medium of exchange

10)

Which best describes money as a means of payment? A) Money provides an immediate double coincidence of wants. B) Money makes sure a double coincidence of wants never occurs. C) Money requires at least two transactions to obtain the double coincidence of wants. D) To obtain a double coincidence of wants without money is impossible.

11) When comparing the exchange of goods and services in a barter economy and an economy that uses money, A) a double coincidence of wants is necessary in the barter economy. B) a double coincidence of wants is more likely to occur in the barter economy. C) transactions are likely to be smoother in the barter economy because goods and services are exchanged directly. D) the money economy requires that sellers have more information about buyers' wants.

12)

In a barter system, people A) have to specialize in order to have goods to trade. B) cannot specialize because they never know what goods will be desired. C) are less likely to specialize as extensively as they would in a monetary economy. D) must be self-sufficient.

13) In a barter economy, prices are stated in terms of relative prices. How many relative prices are in a barter economy where the only goods are oranges, rafts, and flower necklaces?

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A) 3 B) 5 C) 6 D) 9

14) In a barter economy, prices are stated in terms of relative prices. How many prices would a trader of a particular good need to know in a barter economy with 5 goods? A) 5 B) 10 C) 20 D) 50

15) In a barter economy, prices are stated in terms of relative prices. How many prices would a trader of a particular good need to know in a barter economy with 20 goods? A) 190 B) 100 C) 20 D) 40

16) In a barter economy, where prices are stated in terms of relative prices, with n number of goods there will always be A) exactly n relative prices. B) fewer than n relative prices. C) at least n relative prices. D) n/2 relative prices.

17) Which one of the following is the primary source of the high transaction costs associated with a barter system? Version 1

A) The fact that, often times, these exchanges are taxed by governments B) The risk associated with having to carry an inventory of goods to trade C) The high cost associated with finding someone with whom to exchange D) The cost of drawing up complete contracts

18) Suppose that in a barter economy Tom bakes bread and Hans produces chocolates. Tom wants chocolates but Hans doesn't like bread, so Hans is unwilling to trade with Tom. Tom's problem is an example of which problem associated with a barter system? A) too much specialization B) not enough prices C) the law of diminishing returns D) the double coincidence of wants problem

19) Specialization usually increases the output of a country; however, effective specialization requires A) that everyone in the country produce the same thing. B) that workers have very similar skills. C) an effective low-cost means to exchange goods and services. D) a large stock of capital.

20)

Which one of the following is an example of bartering? A) Sue trading candles with Tom for his bread B) Mary paying for her new shoes with her credit card C) John cutting his neighbor's grass in return for a cash payment D) Mrs. Smith giving each of the neighbor children $5.00 after they helped clean up her

yard

21)

Money eliminates the need for

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A) a search for a double coincidence of wants. B) government regulation. C) specialization of labor. D) financial intermediaries.

22)

Money that is used as a means of payment must be A) actual currency. B) coins and currency. C) coins, currency and credit cards. D) anything that is generally accepted as payment for goods and services.

23)

While money is an asset, not all assets are money because A) only money stores value. B) money must work as a means of payment. C) only money is a good asset to hold during times of inflation. D) money must be legal tender.

24)

An advantage that money has over other assets is that it A) increases in value over time. B) has lower transaction costs to use as a means of payment than other assets. C) provides a higher return to the owner. D) is a safer asset to hold during times of inflation.

25)

An individual who stores wealth in art rather than money will find that they

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A) suffer larger real losses during periods of high inflation. B) have far more liquidity than most savers. C) will incur higher transaction costs when they ultimately make purchases. D) will have to resort to barter exchanging the art for desired goods.

26)

Which one of the following best describes how money and wealth are related?

A) Money is wealth but not all wealth is money. B) Money is a means of payment but is not part of wealth. C) Assets that are part of wealth always havea positive return while money does not. D) Wealth is a store of value and a means of payment while money is only a means of payment.

27)

Which one of the following is an example of fiat money? A) silk in China B) butter in Norway C) gold in Venice D) U.S. currency

28) For most of human history, which one of the following has been the most common commodity money? A) silk B) butter C) gold D) U.S. currency

29)

Gold would be a superior commodity money compared to wheat because

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A) wheat has a high value relative to weight, which gold does not. B) it is easier to divide wheat into small units. C) wheat has more practical uses than gold. D) wheat is perishable.

30)

The fact that U.S. currency is legal tender means

A) U.S. currency is good anywhere in the world. B) the only money the government will accept for settlement of debts is U.S. currency. C) private businesses in the U.S. and the U.S. government must accept currency for payment. D) it cannot be backed by gold or other metals.

31)

In comparing money to a U.S. Treasury bond held by an individual, A) the Treasury bond is an asset but money is not. B) money is an asset but the U.S. Treasury bond is a liability of the individual. C) both are stores of value. D) money is a store of value but the U.S. Treasury bond is not.

32)

In comparing money to a U.S. Treasury bond held by an individual, we can say A) both are legal tender. B) both are units of account. C) only the bond is legal tender since it is an obligation of the U.S. government. D) both are stores of value.

33)

In comparing money to a share of Microsoft stock held by an individual, we can say

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A) the share of stock is an asset, but money is a liability. B) only the money is a means of payment, but both are stores of value. C) only the money is a means of payment, but both are units of account. D) both the Microsoft stock and the money are liabilities.

34)

Comparing checks and currency, we can say A) both are money but only currency is legal tender. B) only checks are both money and legal tender. C) a check isn't money but currency is. D) both are money and legal tender.

35) When the Continental Congress issued currency to finance the Revolutionary War, the Continental Congress A) issued too many Continentals, eventually making the currency worthless. B) tied the value of the Continental to gold. C) tied the value of the Continental to French assignats. D) issued too few Continentals which kept them from being widely accepted.

36) During the Civil War, the North issued currency, known as greenbacks. These greenbacks A) are still legal tender in the United States. B) were tied to the value of gold and silver. C) were used by the South to pay for salaries and supplies. D) are a historical example of commodity money.

37)

Most of the non-cash retail payments made each year in the United States are made by

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A) check. B) credit card. C) debit card. D) electronic funds transfers.

38)

All of the following are true about electronic funds transfers except they A) sometimes involve the Federal Reserve sending electronic images of checks to

banks. B) occur when banks or individuals deposit/withdraw from one bank account to another electronically. C) include automated clearinghouse transactions (ACH). D) include credit card payments made online.

39) Carlos pays his cable bill using his bank's internet banking web site to withdraw funds from his checking account. This transaction is a(n) A) automated clearinghouse transaction (ACH). B) digitized-check transaction. C) e-money transaction. D) Fedwire transaction.

40) Consider the path of a paper check as it travels through the check-clearing system. Which step in the process uses money? A) when the consumer hands the check to the merchant B) when the merchant’s bank sends an electronic image of the check to the local Federal Reserve Bank C) when the Federal Reserve credits the merchant’s bank’s reserve account and debits the consumer’s bank’s reserve account D) when the consumer’s bank debits the consumer’s checking account by the amount of the check

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41)

The value of fiat money A) comes from its intrinsic value. B) is worth more as a commodity than its value as money. C) comes from government decree. D) means that it is more desirable than currency.

42)

U.S. currency is A) a commodity money. B) fiat money. C) tied to the value of gold at a fixed rate. D) the only store of value.

43)

One major difference between a debit card and a credit card is that A) only the debit card helps you to build a credit history. B) the debit card has lower minimum monthly payments. C) you do not need to actually have the funds in your account when you use a debit

card. D) debit cards have no late fees.

44)

One major difference between a debit and credit card is A) you can build a credit history with the credit card but not with the debit card. B) you have to pay interest on your purchases if you use a credit card. C) credit cards are money and the debit card is not. D) debit cards charge late fees.

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45)

An asset that is highly liquid

A) physically takes a liquid form, like oil. B) can easily be converted into a means of payment without loss of value. C) is any asset that can be sold. D) must be U.S. currency.

46)

One advantage of using checks over a debit card is that

A) checks can be replaced if lost or stolen, a debit card cannot. B) the bank is responsible if someone steals your checks and uses them; this isn't the case with debit cards. C) a cancelled paper check is the only generally accepted proof of payment. D) the person has "float," meaning time between writing the check and depositing funds to cover it.

47)

Checks and currency function similarly, except that A) currency is a more effective means of payment. B) carrying currency entails greater risk because it cannot be replaced if lost or stolen. C) currency is a better store of value than checking deposits. D) checks are not included in measures of money, whereas currency is.

48)

Apps and smartphone infrastructure such as Apple Pay, Google Pay, PayPal, and Venmo A) reduce the costs and decrease the speed of payments and transfers. B) reduce the costs and increase the speed of payments and transfers. C) increase the costs and decrease the speed of payments and transfers. D) increase the costs and increase the speed of payments and transfers.

49)

Money aggregates can best be defined as a set of measures of the amount of

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A) money that exists at a particular point in time. B) money the Federal Reserve has on deposit as reserves. C) money available to the economy over a year. D) U.S. currency the Bureau of Printing and Engraving has produced.

50)

The money aggregate M1 includes each of the following, except A) currency in the hands of the public. B) other checkable deposits. C) savings deposits. D) demand deposits at commercial banks.

51)

Which one of the following is the largest category of M1? A) currency in the hands of the public B) other checkable deposits C) savings deposits D) demand deposits at commercial banks

52)

The money aggregate M2 includes A) large denomination time deposits. B) stock and bond mutual fund shares. C) institutional money market funds. D) M1.

53)

An automobile is an asset, but it is not liquid because

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A) the owner may need the automobile for transportation. B) the owner may still be making payments on the loan. C) the automobile may not be in good repair. D) the automobile cannot be easily converted into a means of payment without a loss in value.

54)

With inflation, A) you need less money to buy the same basket of goods you bought a month or a year

ago. B) money is more valuable. C) there is too little money in circulation. D) prices, in general, are increasing over time.

55)

Which one of the following lists correctly orders assets from most liquid to least liquid? A) stocks, house, paper currency, savings deposits B) stocks, paper currency, house, savings deposits C) savings deposits, paper currency, house, stocks D) paper currency, savings deposits, stocks, house

56)

Which one of the following assets is the most liquid? A) art B) demand deposits C) houses D) stocks

57)

Which one of the following assets is least liquid?

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A) common stock B) houses C) art D) checking account deposits.

58)

Considering the roughly $1.6 trillion in U.S. currency held by the public, A) over 90 percent of the amount is held in the form of $1 bills. B) more than three-fourths is held in the form of $100 bills. C) over half of the currency held in the form of $20 bills. D) the Federal Reserve distributes the amount equally across all denominations of bills.

59) Ava buys a $2,000 computer using a paper check. At which step does $2,000 get recorded in M1? A) when Ava hands the $2,000 check to the computer merchant B) once the $2,000 is credited to the merchant bank's reserve account and is debited from Ava's bank account C) once the Federal Reserve sends the paper check (or an electronic image) to Ava's bank D) The check is never M1. The $2,000 is M1 both in Ava's bank account and, later, in the merchant's account. It is the deposit balance that is counted.

60) Which statement best summarizes how monetary aggregates are used to understand inflation? A) Economists and policymakers use M1 to understand inflation today. B) M1 and M2 move together so both are good measures to use for understanding inflation. C) In recent years, growth in M2 has stopped being a useful tool for forecasting inflation. D) Especially when inflation is low, M2 is useful for understanding inflation.

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61)

Gross Domestic Product in the United States is roughly A) equal to M1. B) twice as large as M2. C) equal to M2. D) more than five times M1.

62)

M1 is

A) about one-tenth of GDP B) equal to GDP. C) about four times larger than GDP. D) about one fourth the amount of GDP.

63)

Which of the following statements regarding M1 is true?

A) M1 is a more useful measure of the relationship between the money supply and inflation because it includes the most liquid assets. B) M1 is the money supply the Federal Reserve pays the most attention to in conducting monetary policy. C) Beginning in the early 1980s, M1 became less useful than M2 for understanding inflation. D) M1 is the fastest growing of all of the money aggregates.

64)

M1 has decreased in its usefulness in understanding inflation due to

A) the increased use of checks in the economy. B) the introduction of money market mutual fund shares and similar checking substitutes. C) more reliance on the use of currency. D) the increased use of electronic payments.

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65) The introduction of money market substitutes for basic checking accounts was fueled partially by the A) relatively high rates of inflation that existed in the late 1970s and early 1980s. B) reluctance of many retailers to accept checks. C) high number of bank failures that were occurring in the 1970s. D) higher interest rates banks had to pay on checking accounts.

66) A cross-country analysis of money growth supports the conclusion that the correlation between A) the growth rate of the quantity of money and the rate of inflation does not exist. B) the money growth rate and inflation in most countries was positive but very small. C) inflation and money growth in most industrialized countries was actually negative. D) inflation and the money growth rate was positive and relatively strong.

67) A cross-country analysis of money growth shows that the growth rate in the money supply was A) lower in countries with lower inflation rates. B) higher in countries with lower inflation rates. C) lower in countries with higher inflation rates. D) the same whether the countries had high or low inflation rates.

68)

The Consumer Price Index (CPI) is

A) an example of an index that uses variable expenditure weights. B) a fixed-expenditure-weight index used to measure changes in the GDP Deflator. C) a fixed-expenditure weight-index used to measure changes in purchasing power for households. D) the least commonly used measure of inflation.

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69)

The Consumer Price Index (CPI) A) tends to understate the impact of price changes. B) tends to overstate the impact of price changes due to substitution bias. C) is more accurate than the GDP deflator. D) assumes that consumers substitute away from cheaper goods.

70) Assume that people spend 30 percent of their income on food, 45 percent on housing, and 25 percent on transportation. Assume that 2020 is the base year, and use the table below to compute the Consumer Price Index (CPI) for 2021: Year 2020 2021

Price of Food $100 $120

Price of Housing $200 $210

Price of Transportation $100 $150

Cost of the Basket $145 $168

A) 23 B) 100 C) 116 D) 156.5

71)

The Consumer Price Index (CPI)

A) is calculated using a basket of goods and services adjusted annually by government statisticians. B) answers the question, "How much more does it cost today to buy the same basket of goods and services that were purchased at some fixed time in the past?" C) does not suffer from substitution bias because the basket used to measure prices changes every year. D) understates the impact of price changes.

72)

Economists study the link between money and inflation because

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A) they want to understand how to keep inflation low and stable. B) they believe that inflation in the 3–6 percent range is healthy for an economy. C) as prices increase money becomes more valuable. D) the Fed needs to increase the money supply as prices increase.

73)

Inflation refers to growth in an economy’s A) Gross Domestic Product (GDP). B) interest rates. C) money. D) prices.

74)

When the price level increases, the purchasing power of money A) increases by a similar amount. B) stays the same since the purchasing power of money is not impacted by price levels. C) decreases. D) first increases and then decreases as people get used to higher prices.

75)

The purchasing power of money A) rises when inflation rises. B) decreases as the price level decreases. C) decreases with inflation. D) is not impacted by inflation, only by monetary policy.

76)

If you can buy the same goods this year as you bought last year

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A) with less money there must have been deflation. B) with the same amount of money, prices are unstable. C) but it requires more money, there must have been price instability. D) with the same money there must have been deflation.

77) According to the World Bank, in 2017, what fraction of the world’s adults do not have an account at a bank or a mobile money operator? A) zero B) about one-third C) about one-half D) between one-half and two-thirds

78)

In countries with low inflation, A) M2 growth is a very strong forecaster of inflation. B) there tends to be a greater reliance on checks than electronic payments. C) M2 growth is a poor forecaster of inflation. D) money stocks are a larger percentage of GDP.

79)

Sue uses a credit card to purchase a new pair of jeans. Sue is A) using money to buy her jeans. B) creating a liability that she will ultimately have to pay with money. C) using an electronic payment form of money. D) using a form of money included in M2.

80)

The value of money as a means of payment

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A) is independent of changes in the amount of money in the economy. B) is fixed once relative prices are set. C) depends on the amount of money in the economy, among other things. D) depends on whether the majority of M1 is in currency or demand deposits.

81)

The primary concern of current critics of fiat money is that A) fiat money is too costly to produce. B) governments issue too much money, threatening its value. C) fiat money is too easy to counterfeit. D) governments will issue too little, threatening economic growth.

82)

Why would current critics of fiat money urge governments to return to a gold standard? A) They fear that governments will issue too much money. B) They fear that central banks will start making currency out of plastic. C) They believe that politicians need more discretion to make policy time consistent. D) They worry that governments will stop accepting the currency it has issued.

83)

Which function of money has already undergone big changes as technology has evolved? A) means of payment B) store of value C) unit of account D) store of deferred payment

84)

What makes critics of cryptocurrencies say that this is not money?

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A) Users can remain anonymous while making payments. B) Electronic payments are efficient. C) They lack the three key characteristics of money. D) Their value can be undermined by government fiat.

85)

Which one of the following is a drawback to the use of blockchain technology? A) less efficient B) lack of oversight C) less costly D) innovative

86)

A policy is time consistent when A) policymakers have incentives to adhere to a policy decision made today, in the

future. B) policymakers have incentives to make policy decisions in a time-sensitive fashion. C) policymakers consider the future when making current policies. D) the timing of a policy is irrelevant.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question. 87) Consider the following: there are two countries, A and B. Each country has the same resources, and produces the same goods. The residents of country A use money while the residents of country B rely on bartering of goods. Will each country produce the same quantity of output? Explain.

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88) Consider an island where people use sand dollars (shells) as currency. For simplicity, assume that the people consume only one good: fish. a. Currently, there are 400 sand dollars in circulation and there are 200 fish purchased each year. Based on this information, what is the price of fish? b. Suppose that a change in climate leads to new sand dollars washing ashore, leaving a total of 500 sand dollars in the economy. If there are still 200 fish purchased each year, what is the new price of fish? In order to prevent inflation, what would have to happen to the amount of fish purchased each year?

89)

What does it mean to say that an asset is "liquid"?

90)

There are three goods produced in an economy by three individuals. Good apples bread chocolate

Producer orchard owner baker candy maker

If the orchard owner likes only bread, the baker likes only chocolate, and the candy maker likes only apples, will any trade between these three persons take place in a barter economy? Explain.

91) Many college campuses use student ID cards as a way for students to pay for on-campus expenses such as books, photocopies, and food. For convenience, some students will maintain a balance on their ID cards. Are these balances a means of payment? Are they a store of value? Explain why or why not.

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92) Use the information in the table below to answer the questions that follow. Assume that 2020 is the base year and that the market basket includes 5 units of Good A, 15 units of Good B, and 40 units of Good C. Year 2020

Price of Good A $100

Price of Good B $80

Price of Cost of Market Consumer Price Good C Basket Index $240

2021

$150

$80

$300

2022

$200

$120

$360

a. Find the cost of the market basket for each year and fill in the column in the table. b. Find the CPI for each year and fill in the column in the table.

93) Explain why the following statement is true, "money is an asset but not all assets are money."

94)

Explain how money solves the problem of the "double coincidence of wants."

95) Suppose there is an economy that has 100 people each of whom makes a different good, and they use a barter system for exchange. How many relative prices will there be?

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96) Is the characteristic that distinguishes money from other assets its ability to be a store of value?

97)

What distinguishes commodity money from fiat money?

98) During the U.S. Civil War the Confederate government had to resort to printing currency to obtain the goods they needed. Comment on what you think happened to both prices and the value of this currency at the end of the war.

99) You purchase a good by writing a check for $1,000. Considering the financial payments system this check follows, when is the check money? Explain.

100) Explain why credit cards are not considered money even though people seem to use them like money.

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101)

Explain the difference(s) between a debit card and a credit card.

102) Rank the following assets from most liquid to least liquid. a) common stock b) houses c) currency d) art e) savings accounts f) checking account deposits.

103) During what period was money a better store of value: 1960–1980 or 1990–2009? Explain.

104)

What is included in M2 that is not included in M1?

105)

Have the growth rates of M1 and M2 moved together over time? Explain.

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106)

How useful is M2 in tracking inflation? Explain.

107)

Has M2 always been a useful tool for forecasting inflation? Explain.

108) Why do economists claim the Consumer Price Index (CPI) tends to overstate the actual rate of inflation?

109)

What does a CPI of 240 mean?

110) How has the Bureau of Labor Statistics (BLS) changed the calculation of the CPI in order to take substitution bias into account?

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111) What was the double liquidity shock that occurred in the U.S financial system in the summer of 2007?

112)

Why are electronic transactions increasingly taking the place of paper transactions?

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 113) Consider two barter economies: Duos and Varietas. Duos produces two different goods, whereas Varietas produces 80 different goods. Both countries have the same number of people. In which barter economy is it more likely that the means of payment and the units of account would be efficient? How many relative prices are there in Duos compared with Varietas? Which economy would benefit more from adopting money?

114) After the Revolutionary War, the United States monetary system was based on gold. Historically, why did the United States adopt the use of gold as a currency? How does this compare with the currency used today?

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115) Historically, some governments have relied on the revenue generated from printing currency to finance government spending. Give two examples of government's relying on paper currency to finance wartime expenditures. What do you expect happened to inflation rates during these historical episodes?

116) In the chapter you read that it costs the U.S. Treasury's Bureau of Engraving and Printing around 5.5 cents to print a $1 bill, 10.5 cents to print a $20 bill, and a bit over 13 cents to print a $100 bill. It seems the Treasury could generate a nice profit for the government by simply printing currency and using this currency to purchase the goods and services the government needs. In fact, this seems to be a way to eliminate the problem of budget deficits for the U.S. government. Comment on this idea.

117) A famous American has been visiting the same tropical island for 15 years for vacations. When she goes she pays for everything by writing checks drawn on her U.S. bank. The currency the natives use is not U.S. dollars; they use a currency called a fungo. The natives never cash her checks. She is so well known on the island that the natives simply trade her checks among themselves. The question you need to answer, complete with an explanation, is: Who is paying for her vacation? (You can assume her bank would honor the checks if presented for payment even after a considerable period of time has passed.)

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Answer Key Test name: Chap 02_6e 1) C 2) C 3) A 4) B 5) C 6) C 7) A 8) B 9) B 10) A 11) A 12) C 13) A 14) B 15) A 16) C 17) C 18) D 19) C 20) A 21) A 22) D 23) B 24) B 25) C 26) A Version 1

27) D 28) C 29) D 30) C 31) C 32) D 33) B 34) C 35) A 36) A 37) D 38) A 39) A 40) C 41) C 42) B 43) D 44) A 45) B 46) D 47) B 48) B 49) A 50) C 51) A 52) D 53) D 54) D 55) D 56) B Version 1

57) C 58) B 59) D 60) C 61) D 62) A 63) C 64) B 65) A 66) D 67) A 68) C 69) B 70) C 71) B 72) A 73) D 74) C 75) C 76) A 77) B 78) C 79) B 80) C 81) B 82) A 83) A 84) C 85) B 86) A Version 1

87) No, the residents of Country B will definitely spend more of their time transacting, trying to create a double coincidence of wants, and may have to rely on multiple trades to do so. They will also likely specialize less, reducing the gains to the country from specialization. In Country A the residents will be able to transact immediately using money, and will also be able to specialize in what they do well, creating a more efficient economy. 88) a. When there are 400 sand dollars and 200 fish purchased in a year, this implies that each fish costs 2 sand dollars (= 400/200). b. When the number of sand dollars increases to 500, the price of fish will increase to 2.5 sand dollars per fish (= 500/200). In order to prevent this inflation in fish prices, the number of fish would have to be increased to 250. That is, if there are 500 sand dollars and 250 fish, the price of fish would go back to 2 sand dollars per fish (= 500/250). 89) An asset is liquid when it can be converted into a means of payment, quickly, without suffering a loss in value. 90) Yes, but this is a good example of the high transaction costs that can occur in a barter economy due to the double coincidence of wants problem. Any one of the individuals will have to make two trades to get what they want; for example, the baker will have to trade bread with the orchard owner to get apples, to then be able to trade with the candy maker to obtain the chocolate that they really want. 91) The balances on the cards serve as both a means of payment and a store of value. Using the student ID card in this way is an example of a stored-value card, similar to a gift card for a store, or a card used to pay for public transportation. While these stored value cards are not included in the money supply, they are used as a means of payment and a store of value.

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92) a. Cost of Market Basket in 2020 = 100(5) + 80(15) + 240(40) = 11,300 Cost of Market Basket in 2021 = 150(5) + 80(15) + 300(40) = 13,950 Cost of Market Basket in 2022 = 200(5) + 120(15) + 360(40) = 17,200 b. CPI in 2020 = 100 since it is the base year. CPI in 2021 = 13,950/11,300 × 100 = 123 CPI in 2022 = 17,200/11,300 × 100 = 152 Year 2020 2021 2022

Price of Good A $100 $150 $200

Price of Good B $80 $80 $120

Price of Good C $240 $300 $360

Cost of Market Basket $11,300 $13,950 $17,200

Consumer Price Index 100 123 152

93) Money is an asset because it represents something of value to the owner. But not all assets can be used as an immediate means of payment. 94) In an economy that does not rely on the use of money, if people are going to specialize at all they have to resort to barter, which is the exchange of one good or service for another. In the situation of barter, it may be likely that the individual who has what the other person wants will not want what the other person has. In this case multiple trades may be necessary to ultimately obtain what is desired. With the use of money, since everyone generally accepts it, one exchange will suffice. In reality you can say that money creates an immediate double coincidence of wants.

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95) The general formula for the number of prices is n ( n − 1)/2 where n = the number of goods. Since we have 100 people each producing one good, we have 100 goods, so n = 100. Plugging this into our formula, we obtain: 100(99)/2 = 4,950.Therefore, there will be 4,950 relative prices. 96) No; there are many assets that fall into the category of financial assets that are good stores of value, these include bonds and stocks. What distinguishes money is that it is liquid, meaning it can immediately serve as a means of payment. This is not true of other assets, which must be converted to spendable form. Moreover, it can be costly to turn a bond or stock into a means of payment, especially if it must be done on short notice. 97) Commodity money, such as gold or silver, has value even if it is not used as money. For example, gold coins could be melted down and converted to jewelry. Fiat money, such as U.S. paper currency, really has no value other than its use as money. Its value derives from the fact that it is deemed to be legal tender by the U.S. government, along with people's willingness to accept it. 98) While the Confederate government was printing this currency in increasing amounts, the prices in the South undoubtedly were rising. Any time currency is made increasingly available the eventual result will be higher prices. In addition, when the war ended and the Confederate states lost, the currency was basically worthless since there was no government that could guarantee its value. It was probably the case that as it was becoming clearer to people living in Confederate states that the outcome of the war was not going to be in their favor, it would not have been surprising if the people relied less on the currency and more on barter.

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99) The check itself is never money; rather it is the balances on deposit that represent money. Therefore the $1,000 was money when it was in your checking account and that $1,000 will be money again when the Federal Reserve credits the reserve account of the bank receiving the check (and debits your bank's reserve account). 100) A credit card isn't money for a few reasons. One, it is not an asset. The use of a credit card actually creates a liability for the user. A credit card is a promise by a bank to lend the cardholder money with which to make purchases. The store supplying the goods being purchased receives money, but the money that is used does not belong to the buyer. The credit card provides the cardholder with access to someone else's money. 101) A debit card works the same way as a check, in that it provides the bank with instructions to transfer funds from the cardholder's account to the merchant's account. The debit cardholder must have adequate funds in their checking account to cover the purchase. A credit card is a promise by a bank to lend the cardholder money with which to make purchases. The store supplying the goods being purchased receives money, but the money that is used does not belong to the buyer, the credit card provides the cardholder with access to someone else's money. 102) Ranked from most liquid to least liquid: (1) currency; (2) checking account deposits; (3) savings accounts; (4) common Stock; (5) houses; (6) art. 103) The period 1990–2009. During the period 1960–1980, inflation often rose to more than 5 percent; during the period 1990–2000, it rarely did. 104) small denomination time deposits, plus savings deposits and money market deposit accounts and retail money market mutual fund shares

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105) From 1960 to 1980 the growth rates of the two money measures did move together. After 1980 M1 behaved very differently than M2. The main reason for this seems to be the high rates of inflation that began in the late 1970s and fostered innovation into other types of accounts that people could hold to earn a higher return and yet were relatively liquid, such as money market accounts. 106) Empirical research mentioned in the chapter shows that across many countries, high rates of growth in M2 were associated with high rates of inflation and relatively low growth rates in M2 in many countries also were associated with low rates of inflation. For this reason many economists believe that, at least for moderate inflation rates, controlling inflation means controlling the money growth. 107) From 1960 to 1980 it seemed that the growth of M2 was a good tool to forecast inflation, with a two-year lag; in fact the correlation was over 0.5. For the years 1990 to 2016 this does not seem to be the case, in fact the correlation was 0. There is no clear explanation for why the growth of M2 has ceased being a good forecast tool for inflation, but there are some ideas economists are researching. 108) The CPI is measured using a fixed-expenditure-weight index. As a result, when the price of a good included in the index increases, the assumption is that people continue to purchase the same quantity of this item when in reality many consumers (to whatever degree possible) may stop purchasing this item and select a lower-priced substitute. This substitution toward a lower-priced good is not reflected in the reported CPI.

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109) The CPI is designed to answer the following question: How much more would it cost for people to purchase today the same basket of goods and services they bought at some fixed time in the past? A CPI of 240 means that it takes $240 today to buy the market basket that cost $100 in the base year. 110) Substitution bias is an overstatement of inflation by the CPI that comes from the fact that the calculation of the index is based on the assumption of an unchanging market basket of goods and services. Since prices do not all rise at the same rate (and some may not rise or may even fall), people can avoid some inflation by changing their spending pattern, that is, substituting lower-priced goods in place of those whose prices have risen. In order to take this into account, the BLS now changes the weights used in the CPI every two years, and today's CPI is a much more accurate measure of inflation. 111) Investors began to doubt the value of a wide class of securities so market liquidity for those instruments disappeared and financial institutions that held them faced large losses. In turn, funding liquidity for these institutions dried up as the potential losses caused their lenders to be worried about their safety. 112) This is occurring because efficient payments systems continue to evolve and seek easier and cheaper ways to pay for things.

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113) Payments would be far easier and efficient in Duos. With fewer goods to be traded, the likelihood of reaching a double coincidence of wants would be greater. Also, with fewer goods being produced, the need for specialization is not as great as it would be in Varietas. With 80 different goods, people in Varietas are likely to be specialized. Also, with many different goods, the need for information is much greater in Varietas. Duos would have one relative price, 1 = 2(2 − 1)/2. Varietas would have thousands of relative prices: 3,160 = 80(80 − 1)/2. This suggests that quoting prices and recording debts would be easier in Duos. Varietas would benefit more from adopting money, for the reasons cited above. 114) Historically, the United States adopted the use of gold as a currency (or as a way to back paper notes) because people had grown suspicious of the use of fiat money. During the Revolutionary War, the Continental Congress issued Continentals that became worthless with rising inflation. Using gold to back currency gave the public trust in the government's ability and desire to protect its value (e.g., to prevent rising inflation). Today, the currency printed by the United States Treasury Bureau of Engraving and Printing is fiat money. That is, it has little or no intrinsic value. The general public is willing to use this fiat money because it trusts the government's promise to protect its value. People have an expectation that they will be able to use the existing currency to pay for goods and services. 115) The Continental Congress issued continentals in 1775 to finance the Revolutionary War. The French Revolutionary Government issued assignats in 1793. The inflation rates during both historical episodes increased. The money supply is linked to the economy's inflation rate. As the money supply grows at a faster rate, the inflation rate rises.

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116) At first it seems the Treasury could buy one hundred dollars’ worth of goods for an actual cost of less than fourteen cents, the cost of printing the note. Plus the Treasury can avoid having to borrow to finance the difference between tax receipts and expenditures. But what may be profitable for the Treasury can be very harmful to the economy. The printing of this additional currency can have many serious consequences. The additional currency will increase the money supply, which can fuel higher prices, lowering the real purchasing power of money. If the problem becomes large enough it can actually make people reluctant to accept the currency as a means of payment and they would revert to increased use of barter which can make the economy less efficient. 117) Obviously neither the famous American nor her bank is paying for the vacation since the checks are never presented for payment. On the other hand, the famous American is providing the people on the island with additional money, which they seem very comfortable using. As a result, the money supply on the island has increased by the amount of these checks. One result of the added money will be inflation, so islanders will see the real purchasing power of their money decrease, thus their loss in real purchasing power has been used to pay for the famous American's vacations.

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CHAPTER 3 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) A financial intermediary A) is an agency that guarantees a loan. B) is a third party that facilitates a transaction between a borrower and a lender. C) would be used in direct finance. D) must be a depository institution.

Most individuals borrow A) directly without the use of a financial intermediary. B) using a financial intermediary because it lowers the cost of borrowing. C) using a financial intermediary, but would save money if they financed directly. D) without using financial intermediaries, preferring credit cards.

Tom obtains a car loan from Old Town Bank. The car loan is Tom’s A) asset and the bank's liability. B) asset, but the liability belongs to the bank's depositors. C) liability and an asset for Old Town Bank. D) liability and a liability of the bank until Tom pays it off.

The ultimate role of the financial system of a country is to A) provide a place for wealthy households to save. B) be a low-cost source of funds for government. C) facilitate production, employment, and consumption. D) provide jobs in the financial sector.

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5) Susie buys a share of Alphabet stock through her broker, Mr. Diaz, who works for Acme Investing and purchases the stock at the New York Stock Exchange. In this transaction, __________ is a financial instrument, __________ is a financial institution, and __________ represents a financial market. A) Financial Instrument Alphabet stock

Financial Institution Acme Investing

Financial Market New York Stock Exchange

Financial Institution New York Stock Exchange

Financial Market Alphabet stock

Financial Institution New York Stock Exchange

Financial Market Acme Investing

Financial Institution Alphabet stock

Financial Market New York Stock Exchange

B) Financial Instrument Acme Investing

C) Financial Instrument Alphabet stock

D) Financial Instrument Acme Investing

Loans made between borrowers and lenders are A) liabilities to the lenders and assets to the borrowers since the borrower obtains the

funds. B) assets to the lenders and liabilities of the borrowers since the promises are made to the lenders. C) not part of either parties' assets or liabilities until the loans are repaid. D) liabilities to both the lenders and the borrowers.

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Financial instruments are used to channel funds from A) savers to borrowers in financial markets and via financial institutions. B) savers to borrowers in financial markets but not through financial institutions. C) borrowers to savers in financial markets but not through financial institutions. D) borrowers to savers through financial institutions, but not in financial markets.

Loans made between borrowers and lenders are A) usually not taxable at the federal level. B) legal only in the state of origination. C) assets of the lenders. D) assets of the borrowers.

Loans made between lenders and borrowers are A) assets to the borrowers. B) liabilities of the lenders. C) not taxable in the state of origination. D) liabilities of the borrowers.

10)

The process of financial intermediation A) creates a net cost to an economy. B) increases the economy's ability to produce. C) is always used when a borrower needs to obtain funds. D) is used primarily in underdeveloped countries.

11)

Financial intermediaries are

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A) banks. B) firms that provide access to the financial markets. C) insurance companies. D) essential to direct finance.

12)

Financial intermediaries A) can be banks, but not all financial intermediaries are banks. B) must be public corporations. C) are insurance companies. D) are government agencies.

13)

Which one of the following is not a financial intermediary? A) a bank B) an insurance company C) the New York Stock Exchange D) a mutual fund

14)

Mary purchases a U.S. Treasury bond. The bond is a(n) A) asset of the U.S. government as well as an asset for Mary. B) liability of the U.S. government and an asset for Mary. C) liability of the U.S. government as well as a liability for Mary. D) asset for the government but a liability for Mary.

15)

A financial instrument would include

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A) only a written obligation and a transfer of value. B) only a written obligation and a specified date. C) a written obligation, a transfer of value, a future date, and certain conditions. D) a written obligation, a transfer of value, a specific date for payment, and undefined conditions.

16)

Which one of the following is not a financial instrument? A) a share of Microsoft stock B) a U.S. Treasury bond C) an electric bill D) a life insurance policy

17)

Sue has a checking account at the First National Bank. Her checking account is a(n) A) asset to the bank and a liability to Sue. B) asset to Sue and a liability to the bank. C) asset to Sue but actually a liability to the Federal Reserve. D) liability to Sue until she spends the funds.

18)

Financial instruments and money both can function A) as a means of payment and a store of value. B) as a store of value and allow for trading of risk. C) by acting as a means of payment and allow for trading of risk. D) as a store of value even though they do not allow for trading of risk.

19)

Financial instruments are different from money because they

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A) can act as a store of value and money cannot. B) can't be a means of payment but money can. C) can allow for the transfer of risk. D) have greater liquidity.

20)

Juan purchases automobile insurance. The insurance contract is a A) financial instrument. B) form of money. C) transfer of risk from the insurance company to Juan. D) financial intermediary.

21) The listed concepts relate most closely to which part of the financial system? counterparty, asymmetric information, bank loans, options, mortgages, stock A) types of money B) financial instruments C) financial markets D) financial institutions

22) The listed concepts relate most closely to which part of the financial system? risk sharing, centralized exchanges or markets, electronic communication networks, bid price, collateral, ask price A) types of money B) financial instruments C) financial markets D) financial institutions

23) The listed concepts relate most closely to which part of the financial system? insurance companies, pension funds, securities firms, finance companies, direct finance, assets

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A) types of money B) financial instruments C) financial markets D) financial institutions

24) A bank is a financial intermediary that, at a fundamental level, facilitates borrowing and lending between which parties? A) The bank’s depositors are lenders and the bank is the borrower. B) People seeking loans from the bank are the borrowers while the bank is the lender. C) The bank's depositors are the lenders, while those seeking loans from the bank are the borrowers. D) Those seeking loans from the bank are the borrowers while the bank's stockholders are the lenders.

25)

Financial instruments A) are created to transfer risks that are difficult to predict. B) are created to transfer risks that are relatively easy to predict. C) require certainty of an event to be able to transfer risk. D) eliminate the risk from uncertainty, they do not transfer it.

26) Which one of the following has contributed to the standardization of financial instruments? A) rule of 70. B) law of demand. C) economies of scale. D) law of supply.

27)

More detailed financial instruments tend to be

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A) less costly because all possible contingencies are covered. B) more costly because they will cost more to create. C) more desirable than less detailed ones, no matter what the price. D) less costly because they can be standardized more easily.

28)

Many financial instruments are standardized because A) it is believed that most parties to a contract do not read them anyway. B) complexity is costly, the more complex a contract, the more it costs to create. C) the standardization of contracts makes them harder to understand. D) it is required by the government.

29)

A share of Ford Motor Company stock is an example of A) a nonstandardized financial instrument. B) a standardized financial instrument. C) a debt-based financial instrument. D) a financial instrument without risk.

30)

A counterparty to a financial instrument is always the A) issuer of the financial instrument. B) government agency guaranteeing the value of the instrument. C) person or institution that purchases the financial instrument. D) person or institution that is on the other side of the financial contract.

31)

Any entity on the other side of a financial transaction is

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A) the counterparty. B) the borrower. C) assuming all of the risk. D) responsible for providing full information.

32)

The information concerning the issuer of a financial instrument

A) needs to be complete and closely monitored by the buyers of the instrument for change. B) is somewhat non-standardized to minimize the cost of the instrument. C) is usually standardized to the essential information required by the buyers. D) is closely monitored by the buyers of these instruments for change.

33) from

Asymmetric information in financial markets is a potential problem usually resulting

A) borrowers having more information than the lenders. B) lenders having more information than borrowers. C) the fact that people are basically dishonest. D) the uncertainty about Federal Reserve monetary policy.

34) Bond rating agencies rate bonds based on characteristics of the borrower. These agencies are an example of a financial market response designed to A) increase information asymmetry. B) decrease the real return to bondholders. C) provide a lower cost solution to the high cost of information. D) transfer risk from the buyer to the rating agency.

35)

The better the information provided to financial markets, the

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A) less the amount of funds transferred between savers and borrowers. B) greater the amount of funds transferred between savers and borrowers, though risk increases. C) higher the return required by lenders. D) greater will be the flow of funds in these markets.

36)

Financial markets enable the transfer of risk by

A) requiring that risk-averse investors have access to U.S. Treasury bond markets. B) allowing individuals and firms less willing to bear risk to transfer risk to other individuals and firms more willing to bear risk. C) making sure that higher default risk is offset by greater liquidity. D) enabling even unsophisticated investors to purchase highly complex financial instruments.

37)

If a borrower has information that is not available to a prospective lender, there is A) a trading algorithm. B) a transfer of risk. C) information asymmetry. D) liquidity risk.

38)

Disability income insurance is insurance that

A) borrowers can take out in case the company they invest in defaults. B) makes payments of wages to workers when the company they work for is disabled due to a natural disaster. C) makes payments to workers when they are unable to work due to an injury. D) is only available through the government as part of the Social Security System.

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39) The owner of a small business applies for a bank loan and tells the loan officer that the funds will be used to expand inventory for the upcoming holiday season. The small business finds itself in need of additional funds to meet the monthly rent for the next quarter, and the owner uses the loan proceeds to pay the rent. This is an example of A) liquidity risk. B) default risk. C) a lack of diversification for the bank. D) information asymmetry.

40)

A share of Microsoft stock would best be described as which one of the following? A) a derivative instrument B) a means of payment C) an underlying instrument D) a debt instrument

41)

A derivative instrument A) comes into existence after the underlying instrument is in default. B) is a low-risk financial instrument used by highly risk-averse savers. C) gets its value and payoff from the performance of the underlying instrument. D) should be purchased prior to purchasing the underlying security.

42)

A futures contract is an example of A) a derivative instrument. B) an instrument used solely by financial institutions. C) a high-risk security that will only have value if certain events occur. D) a contract that is traded but is not a financial instrument.

43)

The primary use of derivative contracts is

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A) for IRA and other pension plans since they only have value well into the future. B) to shift risk among investors. C) for investors seeking a greater return by taking greater risk. D) to add to the profits an investor obtains through information asymmetry.

44) Considering the value of a financial instrument, the bigger the size of the promised payment the A) less valuable the financial instrument because risk must be greater. B) longer an investor has to wait for the payment. C) more valuable the financial instrument. D) greater the risk.

45) the

Considering the value of a financial instrument, the sooner the promised payment is made

A) less valuable is the promise to make it since time is valuable. B) greater the risk, therefore the promise has greater value. C) more valuable is the promise to make it. D) less relevant is the likelihood that the payment will be made.

46) Considering the value of a financial instrument, the more likely it is the payment will be made the A) more valuable the financial instrument. B) less valuable is the instrument because risk is lower. C) less valuable is the financial instrument because it is highly liquid. D) greater the uncertainty; therefore the less valuable is the financial instrument.

47) Considering the value of a financial instrument, the circumstances under which the payment is to be made influence the value because Version 1

A) we like uncertain payoffs because this adds to the return. B) payments that are made when we need them the most are more valuable. C) the sooner the payment is to be made the better. D) we know when certain events are going to occur and that is when we want the payment.

48) The fundamental characteristics influencing the value of a financial instrument include each of the following except A) the size of the payment promised. B) when the promised payment will be made. C) where the instrument is traded. D) the likelihood of payment.

49)

The value of a financial instrument rises as A) the size of the payment promised decreases. B) the promised payment is made sooner rather than later. C) it is less likely the payment will be made. D) the payments are made when the prospective investor needs them least.

50) Consider the price paid for debt issued by the State of California. Which one of the following would lead to a decrease in the value of State of California bonds? A) The State of California bonds are in small dollar amounts. B) The State of California bonds have a shorter maturity. C) The State of California experiences a fiscal crisis that makes it less likely it will be able to honor its interest payments. D) The State of California pays back its previous bonds ahead of schedule.

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51) Financial instruments used primarily as stores of value include each of the following, except A) bonds. B) futures contracts. C) stocks. D) home mortgages.

52)

Financial instruments used primarily as stores of value would not include A) a car insurance policy. B) a U.S. Treasury bond. C) shares of General Motors stock. D) a home mortgage.

53) Financial instruments used primarily to transfer risk would include all of the following, except A) an insurance contract. B) a futures contract. C) options. D) a bank loan.

54)

Financial instruments used primarily to transfer risk would not include A) a bank loan. B) options. C) an insurance policy. D) home mortgages.

55)

Which type of financial instrument is used mainly to transfer risk?

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A) asset-backed securities B) bonds C) options D) stocks

56)

Financial instruments used primarily as stores of value do not include A) asset backed securities. B) U.S. Treasury bonds. C) a car insurance policy. D) a bank loan.

57)

Which one of the following is a familiar type of asset-backed security? A) shares of stock in corporations B) securities backed by home mortgages C) U.S. Treasury bonds D) movie box-office receipts

58)

Financial markets contribute to all of the following except which one? A) elimination of risk B) providing liquidity C) pooling and communicating information D) sharing of risk

59)

If financial markets did not exist

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A) required returns would be lower since fewer instruments would trade. B) liquidity would diminish and returns would be lower. C) more funds would flow directly between borrowers and savers. D) liquidity would diminish, reducing the flow of funds between borrowers and savers.

60) The high volume of shares of stock that are traded on a normal day on stock markets reflects the A) high transaction costs associated with these financial markets. B) low transaction costs and high liquidity associated with these markets. C) low transaction costs and low liquidity associated with these markets. D) high transactions costs and low liquidity associated with these markets.

61)

The pool of information collected by financial markets is usually A) only available to lenders. B) summarized in the form of a price. C) valuable and not made available until the parties pay for it. D) more than a borrower needs to make a loan.

62)

Financial markets

A) enable buyers and sellers to exchange financial instruments but not risk. B) enable buyers and sellers to exchange risk by buying and selling financial instruments. C) allow the transfer of risk only through derivative securities. D) do not allow for the transfer of risk but do help reduce it.

63)

Commissions paid to a stock broker are an example of

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A) risk transfer. B) transaction costs. C) information asymmetry. D) liquidity.

64)

Brokerage commissions

A) are set by government regulators so they cannot vary across firms for the same services. B) can vary but typically don't because firms tend to set them at the same levels. C) can differ reflecting the different services being offered. D) are always a percentage of the amount of the trade.

65)

A primary financial market is A) a market just for corporate stocks. B) a market only for AAA rated Securities. C) the New York Stock Exchange. D) one in which newly issued securities are sold.

66)

A primary financial market is

A) located only in New York, London, and Tokyo but can handle transactions anywhere in the world. B) one where the borrower obtains funds directly from the lender for newly issued securities. C) a market where U.S. Treasury bonds are traded. D) one that can only deal in the highest investment grade securities.

67)

Newly issued U.S. Treasury Securities are sold

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A) in the primary financial market. B) only to the Federal Reserve who then resells them. C) in the secondary market since bonds cannot be sold in the primary market. D) in secondary markets but only using registered bond dealers.

68) The figure shown here illustrates the flow of funds through financial institutions. The labels for the types of financial institutions and the major actors in this process are missing. Choose the option that identifies the correct labels for the types of financial institutions and where these labels go in the figure.

A) 1. Saver-Lenders and 3. Spender-Borrowers B) 2. Spender-Borrowers and 4. Saver-Lenders C) 1. those that act as Brokers and 3. those that transform Assets D) 2. those that transform Assets and 4. those that act as Brokers

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69) The figure shown here illustrates the flow of funds through financial institutions. The labels for the types of financial institutions and the major actors in this process are missing. Choose the option that identifies the correct labels for the major actors in this process and where these labels go in the figure.

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70) The figure shown here illustrates the flow of funds through financial institutions. The labels for the types of financial institutions and the major actors in this process are missing. Consider the flows of funds and financial instruments in the figure. What is the difference between financial institutions that act as brokers and those that transform assets?

A) Broker institutions facilitate indirect finance while institutions that transform assets facilitate direct finance. B) Broker institutions facilitate direct finance while institutions that transform assets facilitate indirect finance. C) Broker institutions sell stocks, bonds, and insurance policies while institutions that transform assets sell real estate. D) Broker institutions sell real estate while institutions that transform assets sell stocks, bonds, and insurance policies.

71)

Most of the buying and selling in primary markets

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A) is in the public view. B) is highly transparent and closely monitored by the SEC. C) involves an investment bank. D) is done by the Federal Reserve.

72)

Secondary financial markets A) are financial markets for all financial instruments rated less than investment grade. B) are financial markets where existing securities are bought and sold. C) eliminate the transaction costs for buyers and sellers. D) are only for stock.

73)

A collection of assets is known as a(n) A) asset-backed security. B) derivative. C) futures contract. D) portfolio.

74) Which one of the following would not be an example of a secondary financial market transaction? A) You call a broker and purchase 100 shares of McDonald's Corp. stock. B) You go to the bank and purchase a $5,000 certificate of deposit. C) You call a broker and purchase a U.S. Treasury bond. D) You call a broker and purchase a bond issued by General Motors.

75)

Which one of the following is likely to be a primary financial market transaction?

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A) You cash the check your grandmother sent you for your birthday. B) You call a broker and purchase bonds for your retirement fund. C) A city issues bonds to finance new road construction. D) A supermarket needs to borrow the funds for a second location and takes out a loan from a commercial bank to pay for it.

76)

An over-the-counter (OTC) market is A) made up of dealers who only sell government bonds. B) an example of a centralized market. C) made up of dealer who buy and sell only for their own accounts. D) made up of dealers who buy and sell for their customers and for their own accounts.

77)

The New York Stock Exchange (NYSE) originated as A) a decentralized electronic market made up of dealers all over the world. B) an example of a centralized exchange. C) a financial market where nearly 100 million shares of stock are traded every business

day. D) the only centralized stock exchange in the world.

78)

Over-the-counter (OTC) markets A) employ specialists to minimize price volatility. B) are centralized exchanges but you must be a dealer to be part of an exchange. C) only deal in the stocks of companies with over $100 million in capital. D) are networks of security dealers linked electronically.

79)

Which one of the following is not true of over-the-counter markets?

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A) Traders are linked by computer. B) Dealers buy and sell only for their customers. C) Trading does not take place in one physical location. D) Traders are willing to buy and sell stocks and bonds at posted prices.

80)

Equity markets are markets A) of U.S. Treasury bonds. B) for AAA rated bonds. C) for stocks. D) for either stocks or bonds.

81)

Debt instruments that have maturities less than one year are traded in the A) primary market exclusively. B) bond markets exclusively. C) bond market if they are already in existence. D) money market.

82)

Money markets are where trades occur for A) stocks. B) bonds of all maturities. C) derivatives. D) short-term bonds issued by both governments and private companies.

83) All of the following are examples of the types of problems that can exist when trading on decentralized electronic exchanges, except which one?

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A) Customer orders are not executed quickly. B) Not all bid and offer prices are available prior to the trade. C) Systemic fragility and the presence of high frequency traders may reduce liquidity. D) Trading algorithms can inadvertently lead to price volatility.

84)

Well-run financial markets A) keep transactions costs high to benefit brokers. B) prevent the widespread pooling of information. C) ensure that resources are allocated efficiently. D) are usually the result of little or no government regulation.

85)

Countries that lack well-defined property laws and legal structures

A) have large secondary financial markets because the primary markets do not exist. B) will not develop as fast economically as counties with clear property rights and a formal legal system. C) will have much lower transaction costs associated with any level of lending. D) will not have any financial markets at all.

86)

Financial institutions A) raise the level of transaction costs relating to borrowing/lending. B) can lower the information asymmetry involved with borrowing/lending. C) decrease the liquidity to savers. D) are required for all financial transactions.

87)

An insurance company is an example of a financial institution that

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A) transfers risk. B) acts as a broker. C) serves as a depository institution. D) sells derivative securities.

88)

All of the following are depository institutions, except A) commercial banks. B) credit unions. C) insurance companies. D) savings banks.

89)

Which of the following are depository institutions? A) credit unions B) mutual funds C) pension funds D) insurance companies

90)

Nondepository institutions A) do not serve as intermediaries. B) only serve as brokers. C) only transform assets. D) do not accept deposits.

91)

Nondepository institutions would include all of the following except

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A) finance companies. B) pension funds. C) insurance companies. D) credit unions.

92) Small savers would rather use financial institutions than lend directly to borrowers because A) financial institutions will offer the savers higher interest rates than the savers could obtain directly from borrowers. B) lenders wouldn't want to deal with small savers. C) it allows them to diversify risk. D) the liquidity is lower with financial institutions but the return is higher.

93)

Financial intermediaries pool funds of A) many small savers and provide it to a few large borrowers. B) few large savers and provide it to many small borrowers. C) few large savers a few large borrowers. D) many small savers and provide it to many borrowers.

94) Financial intermediaries handle a larger flow of funds than do primary markets mainly because financial intermediaries A) have a government-provided monopoly. B) have government-regulated prices, so there is little competition. C) can lower transaction costs and increase liquidity for savers. D) do not have to worry about information asymmetry.

95)

Derivative markets exist to allow for

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A) the transfer of risk. B) direct transfers of common stocks for bonds. C) cash receipts from the sale of bonds. D) reduced information asymmetry.

96)

Financial intermediaries include each of the following, except A) the New York Stock Exchange. B) credit unions. C) savings banks. D) commercial banks.

97)

Which of the following is not considered to be a shadow bank? A) credit unions B) brokerages C) insurers D) money-market mutual funds

98) As the historical gap between direct and indirect finance has narrowed, the primary distinction between direct and indirect finance today is in who owns the underlying asset. In direct finance, A) the asset holder has a claim on a financial institution while in indirect finance the asset holder has a direct claim on the borrower. B) the lender has a claim on a financial institution while in indirect finance the lender has a direct claim on the borrower. C) the asset holder has a direct claim on the borrower while in indirect finance the asset holder has a claim on a financial institution. D) asset holder has a direct claim on a private sector corporation while in indirect finance the asset holder has a claim on the government.

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99)

Derivatives would include all of the following except A) options. B) U.S. Treasury securities. C) swaps. D) futures.

100) Reasons for the rapid structural change in financial markets in recent years include all of the following except A) globalization. B) technological advances in computing. C) technological advances in communication. D) high real interest rates.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question. 101) How are financial market development and economic growth related?

102)

What are the four characteristics of a financial instrument?

103) Briefly explain one function of financial instruments that can make them very different from money.

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104) Explain why most financial instruments are fairly complex, while at the same time quite standardized.

105) Credit cards usually charge higher rates of interest than most other forms of lending. In terms of information, collateral, and monitoring, how might these higher rates be explained?

106) Why might a life insurance company insist on an individual having a physical exam before agreeing to provide life insurance to the individual?

107) An annuity is a contract that makes monthly payments as long as someone lives. Explain why an individual would want to purchase such a contract. What risk is being transferred?

108)

Why are options referred to as derivative instruments?

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109) What are the four fundamental characteristics that determine the value of a financial instrument?

110) Ceteris paribus, how would each of the four fundamental characteristics that determine the value of a financial instrument need to change to increase the value of a financial instrument?

111) A high-school basketball player decides to bypass college and go right into the NBA (the National Basketball Association). Describe the risk the individual is taking and describe a contract that might transfer the risk.

112) Describe what is likely to happen to the average price of a share of stock if the stock markets decide to close every Friday and Monday to provide workers at the exchanges with longer weekends.

113) Consider a typical individual who owns the following financial instruments: A life insurance policy for $250,000; a certificate of deposit for $10,000; homeowner's and auto insurance policies; $50,000 in a mutual fund, and $150,000 in her pension fund at work. Which of these are instruments used primarily as stores of value and which are being used to transfer risk?

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114) The primary business of Standard & Poor's is the selling of information to investors. Is this an example of a financial intermediary? Explain.

115) Consider a typical individual who owns the following financial instruments: A life insurance policy for $250,000; a certificate of deposit for $10,000; homeowner's and auto insurance policies; $50,000 in a mutual fund, and $150,000 in her pension fund at work. Which of these are instruments used primarily as stores of value and which are being used to transfer risk?

116) Explain how the introduction of asset-backed securities has allowed investors to take advantage of higher returns from loans that most investors could never make on their own.

117) How do financial markets pool and communicate the information regarding issuers of financial instruments in a convenient way?

118) Can a financial instrument be bought and sold in both a primary and secondary financial market? Explain. Version 1

119)

What is the primary distinction between debt/equity markets and derivative markets?

120) Why didn't the over-the-counter (OTC) exchanges suffer the disruption of service that the New York Stock Exchange did after the terrorist attacks of September 11, 2001?

121)

What is the primary distinction between debt/equity markets and derivative markets?

122)

What are some of the advantages of trading in decentralized electronic exchanges?

123)

Why has the pace of structural change in financial markets accelerated in recent years?

124)

What are some of the advantages of trading in decentralized electronic exchanges?

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125) As we saw in the chapter, some financial instruments are used primarily to transfer risk. Explain how a bread maker can use a financial instrument to transfer the following risk: the bread maker has the opportunity to provide bread to a local army base. The base figures they will need 10,000 loaves of bread each week, or roughly 500,000 for a year. The problem is the baker must quote a price for the entire year. The baker would really like to have this contract but he realizes that fluctuating input prices (specifically wheat) could result in significant losses.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 126) Suppose that an internet-based program, Novus, wants to raise $10 million to expand its business operations. Describe how Novus can raise these funds directly through each of the follow options: issuing stock, issuing bonds, or obtaining a bank loan. Compare and contrast these three options.

127) Explain the various ways that financial intermediaries increase the efficiency of an economy.

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128) Compare and contrast financial institutions that act as brokers to those that transform assets. In what sense are both types of institutions financial intermediaries? Provide one example of each type and describe how each functions as a financial intermediary.

129) Trading in electronic exchanges has grown tremendously in recent years. What are some of the disadvantages of trading in decentralized electronic exchanges?

130) Uniqua wants to buy a camper to use when visiting national parks this summer. Her cousin Tyrone recently earned a windfall profit in a business venture with a partner, and Uniqua asked him if she could borrow $5,000 for a down payment on the camper. She proposed paying him 4% interest and paying the loan back over the next two years. Discuss the advantages and disadvantages to Tyrone of choosing to make the loan to Uniqua as opposed to loaning the money to Spectrum Communications, Inc. by buying a $5,000 corporate bond that pays the same amount of interest over that same time period.

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Answer Key Test name: Chap 03_6e 1) B 2) B 3) C 4) C 5) A 6) B 7) A 8) C 9) D 10) B 11) B 12) A 13) C 14) B 15) C 16) C 17) B 18) A 19) C 20) A 21) B 22) C 23) D 24) C 25) B 26) C Version 1

27) B 28) B 29) B 30) D 31) A 32) C 33) A 34) C 35) D 36) B 37) C 38) C 39) D 40) C 41) C 42) A 43) B 44) C 45) C 46) A 47) B 48) C 49) B 50) C 51) B 52) A 53) D 54) A 55) C 56) C Version 1

57) B 58) A 59) D 60) B 61) B 62) B 63) B 64) C 65) D 66) B 67) A 68) C 69) C 70) B 71) C 72) B 73) D 74) B 75) C 76) D 77) B 78) D 79) B 80) C 81) D 82) D 83) A 84) C 85) B 86) B Version 1

87) A 88) C 89) A 90) D 91) D 92) C 93) D 94) C 95) A 96) A 97) A 98) C 99) B 100) D 101) A country's economic growth is linked to financial market development. As the text points out, a country's financial system has to grow as its level of economic activity rises, or the country will stagnate. Economic research has shown that there is strong positive correlation between financial market development and economic growth across countries. 102) (1) A financial instrument is a written legal obligation; (2) a financial instrument transfers something of value to another party; (3) a financial instrument specifies some future date for this transfer to occur; and (4) a financial instrument specifies certain conditions under which payment will be made.

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103) While financial instruments can function as a means of payment and a store of value, similar to money, one function that can make them very different from money is their ability to transfer risk between buyer and seller. A good example of this is the use of a futures contract that guarantees to the seller of the contract a price well into the future. Another common example is an insurance policy that transfers risk from the insured (a homeowner) to the insurer (the insurance company). 104) Most financial instruments are complex in the sense that many possible contingencies are identified and both buyer and seller want to avoid problems that can arise from unforeseen events. To write a complete contract, however, would be very time consuming and expensive. As a result, most financial instruments are standardized because over time many common problems have been identified and worked into the contract, and standardization makes it easier to compare contracts and makes the instruments more liquid. 105) When providing credit cards to customers, banks have the ability to obtain information at the time of application and based on this information they decide to issue or not issue the card. Once issued however, the ability of the bank to obtain further information and monitor the behavior of the individual is limited and before the card issuer can respond the cardholder can incur significant debt. Also, these are basically unsecured loans, meaning there is no collateral for the lender to seize if payment is not made. All of these facts and more make credit card loans risky and demanding of the higher rate.

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106) The life insurance policy is a contract that transfers risk from the buyer to the seller, in this case from the individual to the company. The price of the contract is based upon certain assumptions regarding the general health of the individual and specific information such as gender, age, etc. The company wants to make sure there is not any information hidden (information asymmetry) or any other problems that would significantly alter its decision to provide the coverage or the price of the coverage. 107) An annuity transfers the risk that the buyer will live longer than expected. If an individual had certainty regarding their life expectancy they could plan accordingly and set up a budget that would exhaust their wealth at the time of death. We do not usually have such certainty and the risk is that we may live longer than we expect and could run out of funds before we die. With an annuity, the individual transfers this risk (for a fee) to a company that is pooling many of these individuals and with the "law of large numbers" is better equipped to take this risk. 108) Unlike underlying instruments, such as stocks and bonds, derivatives are instruments where the value and the payoff of the instrument are derived from the behavior of the underlying asset. As an example, suppose Tom has a contract allowing him to purchase 100 shares of stock in ABC Company at a price of $10 per share six months from now. The value of his option contract will increase as the actual price of the ABC stock (the underlying instrument) rises and exceeds $10 per share. 109) The four fundamental characteristics that determine the value of a financial instrument are (1) the size of the payment that is promised; (2) when the promised payment is to be made; (3) the likelihood that the payment will be made; (4) the conditions under which the payment is to be made. Version 1

110) The four fundamental characteristics that determine the value of a financial instrument are (1) the size of the payment that is promised; (2) when the promised payment is to be made; (3) the likelihood that the payment will be made; (4) the conditions under which the payment is to be made. Ceteris paribus, the value of the financial instrument increases if the payment size increases, the payment is promised to be made sooner, there is a higher likelihood that payment will be made, and the conditions under which payment is to be made are clearly spelled out with regular payments. 111) The risks the individual is taking are numerous; one, he may not be as talented as he thinks and does not perform as well as he thinks he will and his value decreases. Perhaps more important, he could suffer a career-ending injury. In either case, by bypassing college he has left himself with fewer options than he might otherwise have. These risks can be transferred through a few different types of contracts. First, he can negotiate a guaranteed contract that will pay him even if he is injured and can't play. The team would likely go along with this if the annual compensation is reduced. The individual could ask for the majority of his first contract to be in a guaranteed upfront payment which can then be used to purchase an annuity to provide income for the rest of his life. The individual could also purchase a disability insurance policy to provide a specified income in the event that he is injured and cannot do his job. 112) The average price of stocks would decrease. The fact that the markets are open less decreases the liquidity of stocks and, as a result, their prices would have to be lower in order to entice savers to hold these instruments.

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113) The life insurance policy and the homeowner and auto insurance policies are instruments being used to primarily transfer risk. The cost of an untimely death or loss resulting from an auto accident or damage to her house is a risk the individual prefers to transfer to someone else. The certificate of deposit andthe balances in her mutual fund and pension are instruments that are serving primarily as stores of value. In these instruments wealth is being accumulated and stored for use at a later time. 114) No. A financial intermediary is involved indirectly in a financial transaction. It matches up the ultimate lenders (savers) with the ultimate spenders (borrowers). The funds flow through the intermediary, which is acting as a "middleman." That is not the case with Standard & Poor's. 115) The life insurance policy, the homeowner and auto insurance policies are instruments being used to primarily transfer risk. The cost of an untimely death or loss resulting from an auto accident or damage to her house is a risk the individual prefers to transfer to someone else. The certificate of deposit, the balances in her mutual fund and pension are instruments that are serving primarily as stores of value. In these instruments wealth is being accumulated and stored for use at a later time. 116) Asset-backed securities are instruments that allow the holder to share in the returns or payments arising from specific assets such as home mortgages or car loans. Investors purchase shares in the revenue that come from the underlying assets. While most investors would not or could not take the risk of making a home mortgage directly, they can purchase these securities and enjoy the higher return offered by home mortgages with less risk than would be the case if they made a home mortgage directly.

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117) Financial markets pool and communicate information about the issuers of financial instruments and summarize this information in the form of a price. For example, any information that says an issuer of a financial instrument is less likely to honor its payment would have the price of the instrument decrease or the required return increases. Any information that places the issuer in a more favorable light would have the opposite effect. 118) The answer is yes and highly likely. When a financial instrument is new, say a newly issued U.S. Treasury bond, it is initially sold in a primary financial market. Perhaps the bond is purchased directly by the Federal Reserve. At some later time, however, the Federal Reserve may decide to sell the bond and this transaction would be a secondary market transaction since the instrument already exists. 119) The market for equities (stocks) and debt (mainly bonds) are markets where the actual claims are purchased or sold for immediate cash payment. On the other hand, in derivative markets, parties and counterparties make agreements that are settled at a later date. 120) The New York Stock Exchange is a centralized exchange, meaning it is one physical location. Since it was located in New York near the World Trade Center it had to close as it was impossible for people to get into the area. The OTC exchange on the other hand is electronic networks where each dealer is linked electronically to other dealers. As a result, the bombing in New York certainly disrupted the ability of some New York dealers to trade, but the remainder of the exchange continued to function.

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121) The market for equities (stocks) and debt (mainly bonds) are markets where the actual claims are purchased or sold for immediate cash payment. On the other hand, in derivative markets, parties and counterparties make agreements that are settled at a later date. 122) Customers can see the orders, the orders are executed quickly, trading occurs 24 hours a day, and costs are low. 123) The pace of structural change has accelerated dramatically in the past few years, driven by (1) ongoing technological advances in computing and communications and (2) increasing globalization. The former dramatically lowered the importance of a physical location of an exchange—as new technology allowed the rapid low‐cost transmission of orders across long distances—while the latter encouraged unprecedented cross‐border mergers of exchanges, integrating larger pools of providers and users of funds. 124) Customers can see the orders, the orders are executed quickly, trading occurs 24 hours a day, and costs are low. 125) The baker could quote a price for bread based on today's price and then purchase wheat a futures contract for wheat at today's price, for delivery one year from now. If actual wheat prices do increase the baker will lose money on the actual baking operations but these losses will be offset by the profits he will earn on the wheat futures contract. If wheat prices end up decreasing, he will suffer losses on the futures contract but will offset these by having higher profits from baking. In this case the futures contract accomplishes exactly what it was supposed to do. It transferred the risk of volatile wheat prices from the baker, who otherwise wouldn't accept the opportunity to provide bread at a guaranteed price for a year, to someone who was more willing to accept this risk. Version 1

126) Novus can issue new stock worth $10 million. Alternatively, it can issue $10 million in bonds. In either of these two cases, Novus will seek out an investment bank to serve as an underwriter (to bring the shares from the primary to the secondary market). If Novus issues stock, it is not obligated to pay dividends to its new stock holders, but if it doesn't it risks reducing the value of its stock. If Novus issues bonds, it must pay interest in regular payments. If Novus goes to a bank for a loan, it will make regular payments that include interest (and possibly parts of the principal amount owed), similar to a bond issue. 127) Financial intermediaries increase an economy's efficiency in a number of ways. First, they provide a means for savers to channel funds to borrowers (spenders). This puts otherwise idle resources to use, increasing an economy's output. While savers theoretically could lend directly to borrowers, the transaction costs as well as the risk would be significantly increased, to the point where these funds may not actually flow. Also, financial intermediaries lower the transaction costs of lending. This includes information gathering as well as monitoring costs. These lower transaction costs allow resources to be used to increase the output of goods and services in the economy.

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128) Financial institutions that act as brokers provide a way for lenders/savers to buy securities from borrowers/spenders. Such institutions make it easier for borrowers and savers to directly access financial markets. Financial institutions that transform assets collect deposits (and payments for insurance policies) to raise funds that are then loaned to borrowers/spenders. These institutions allow borrowers and savers to interact indirectly. Depository institutions accept deposits from savers and issue loans to borrowers. Insurance companies accept premiums from policy holders (savers) and invest these funds in securities. When a policy holder makes a claim (borrower), they receive compensation in the event of a bad event (accident, illness, theft, etc.). Pension funds invest contributions from savers and provide payments to retirees (borrowers). Securities firms provide brokerage services, allowing investors (savers) the ability to buy securities (issued by borrowers) in financial markets. Investment banks serve as underwriters, easing access to markets by bringing securities issued by borrowers into secondary markets for purchase by savers. Mutual funds mainly transform assets, allowing savers to purchase a diverse group of securities (issued by borrowers) with a small initial investment. Finance companies raise funds from buying securities in financial markets and loaning out funds to borrowers. Government-sponsored programs, such as Social Security, provide the same services that pension funds and insurance companies provide privately.

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129) Electronic operations have proven prone to errors that threaten the existence of brokers. In addition, amid the complex system of multiple, imperfectly linked exchanges, new trading patterns have arisen that render the entire system fragile, raising serious worries among investors about the liquidity and value of their stocks. Efforts to speed up electronic trading drain resources from more efficient uses. To see this point, imagine that an HFT firm relocates its computing facilities closer to an exchange so that it can cut the transmission time for orders by a few microseconds (millionths of a second). The goal of the move is to profit by trading an instant faster than competitors when new information such as a stock issuer’s quarterly profit statement or the nation’s monthly employment reportbecomes available. Yet microsecond gains in trading speed likely diminish the willingness of market makers to provide liquidity because they don’t wish to be “picked off” by well-equipped HFTs. Over time, market makers also may be forced to invest heavily to keep up with the faster turnover of stocks, with little gain to the broader economy. Finally, the advent of multiple electronic exchanges and ECNs has not resulted in a single, integrated, and transparent U.S. stock market. 130) The only advantage to making the loan to Uniqua is the emotional payoff of helping his cousin. Disadvantages includethe transaction costs involved in assessing whether Uniqua is likely to repay the loan and the increased risk involved in the loan to Uniqua. Buying the corporate bondis almost certainly less risky. Also, information about Spectrum Communications can be found easily through an internet search or other means of searching publicly available records, so it is easier to assess the risk of buying the bond and the transaction costs are lower.

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CHAPTER 4 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) A promise of a $100 payment to be received one year from today is A) more valuable than receiving the payment today. B) less valuable than receiving the payment two years from now. C) equally valuable as a payment received today if the interest rate is zero. D) not enough information is provided to answer the question.

What links the present to the future in financial markets? A) risk B) information C) interest rates D) stability

The future value of $100 at a 5% per year interest rate at the end of one year is A) $95.00. B) $105.00. C) $97.50. D) 107.50.

Credit A) probably came into being at the same time as coinage. B) predates coinage by 2,000 years. C) did not exist until the Middle Ages. D) first became popular due to the writings of Aristotle.

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Which one of the following expresses 5.65%? A) 0.565 B) 0.00565 C) 5.65 D) 0.0565

Which one of the following expresses 4.85%? A) 0.0485 B) 4.850 C) 0.00485 D) 0.485

Which one of the following expresses 5.5%? A) 0.0055 B) 5.50 C) 0.550 D) 0.0550

If the interest rate is zero, a promise to receive a $100 payment one year from now is A) more valuable than receiving $100 today. B) less valuable than receiving $100 today. C) equal in value to receiving $100 today. D) equal in value to receiving $101 today.

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9) Why is it important to understand present value and future value when studying financial markets? These tools

A) are useful for evaluating risk. B) tell us how to invest in the stock market. C) are useful for analyzing the benefits of hedging investments. D) help us compare the value of a payments made at different points in time.

10) If a saver has a positive rate of time preference then the present value of $100 to be received 1 year from today is A) more than $100. B) not calculable. C) less than 100. D) unknown to the saver.

11)

Ceteris paribus, which increases as interest rates rise—present value or future value? A) both B) neither C) only present value D) only future value

12)

Present value is higher when the future value of the payment is A) higher, the time until payment is shorter, and the interest rate is lower. B) lower, the time until payment is shorter, and the interest rate is higher. C) higher, the time until payment is longer, and the interest rate is lower. D) lower, the time until payment is shorter, and the interest rate is higher.

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13) Which one of the following best expresses the proceeds a lender receives from a one-year simple loan when the annual interest rate equals i? A) PV + i B) FV/ i C) PV(1 + i) D) PV/ i

14) Suppose Tom receives a one-year loan from ABC Bank for $5,000.00. At the end of the year, Tom repays $5,400.00 to ABC Bank. Assuming the simple calculation of interest, the interest rate on Tom's loan was A) $400 B) 8.00% C) 7.41% D) 20%

15) Suppose Mary receives an $8,000 loan from First National Bank. Mary repays $8,480 to First National Bank at the end of one year. Assuming the simple calculation of interest, the interest rate on Mary's loan was A) 8.00% B) $480 C) 6.00% D) 5.66%

16) An investor deposits $400 into a bank account that earns an annual interest rate of 8%. Based on this information, how much interest will he earn during the second year alone?

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A) $25.60 B) $32.00 C) $34.56 D) $64.00

17)

Compound interest means that A) you get an interest deduction for paying your loan off early. B) you get interest on interest. C) you get an interest deduction if you take out a loan for longer than one year. D) interest rates will rise on larger loans.

18)

How does compound interest make your money “work for you”? A) It provides an interest deduction when you pay your loan off early. B) You earn interest on interest in addition to interest on principal. C) It provides an interest deduction if you take out a loan for longer than one year. D) It provides higher interest rates on larger loans with longer time horizons.

19) Which one of the following best expresses the payment a saver receives for investing her money for two years? A) PV + PV B) PV + PV (1 + i) C) PV(1 + i) 2 D) 2 PV(1 + i)

20) Suppose a family wants to save $60,000 for a child's tuition. The child will be attending college in 18 years. For simplicity, assume the family is saving for a one-time college tuition payment. If the interest rate is 6%, then about how much does this family need to deposit in the bank today? Version 1

A) $10,000 B) $21,000 C) $42,000 D) $57,000

21) Which one of the following best expresses the payment a lender receives for lending money for three years? A) 3PV B) PV × (1 + i)3 C) 3PV/(1 + i)3 D) FV/ (1 + i) 3

22) Suppose Paul borrows $4,000 for one year from his grandfather who charges Paul 7% interest. At the end of the year Paul will have to repay his grandfather how much money? A) $4,280 B) $4,290 C) $4,350 D) $4,820

23) Suppose that Stephen Curry, a basketball player for the Golden State Warriors, will become a free agent at the end of this NBA season. Suppose that Curry is considering two possible contracts from different teams as shown in the table. Note that the salaries are paid at the end of EACH year. The interest rate is 10%. Based on this information, which one of the statements below is true?

Signing bonus (paid today) First-year salary Second-year salary Third-year salary

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Contract #1 (Boston) $1 million $2 million $4 million $5 million

Contract #2 (Portland) $1 million $4 million $4 million $3 million

A) Curry should take the Boston contract because it has a higher present value. B) Curry should take the Portland contract because it has a higher present value. C) Curry is indifferent between the two contracts because they are both worth $12 million. D) Curry is indifferent between the two contracts because they are both worth $10.9 million.

24) Farou invests $2,000 at 8% interest. About how long will it take for Farou to double his investment (i.e., to have $4,000)? A) 4 years B) 5 years C) 8 years D) 9 years

25) A lender is promised a $100 payment (including interest) one year from today. If the lender has a 6% opportunity cost of money, they should be willing to accept what amount today? A) $100.00 B) $106.20 C) $96.40 D) $94.34

26) A saver knows that if she put $95 in the bank today she will receive $100 from the bank one year from now, including the interest she will earn. What is the interest rate she is earning? A) 5.10% B) 6.00% C) 5.52% D) 5.26%

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27) Tom deposits funds in his savings account at the bank which is paying 3.5% interest. If he keeps his funds in the bank for one year he will have $155.25. What amount is Tom depositing? A) $151.75 B) $150.00 C) $148.75 D) $147.50

28) Mary deposits funds into a CD at her bank. The CD has an annual interest of 4.0%. If Mary leaves the funds in the CD for two years she will have $540.80. What amount is Mary depositing? A) $520.00 B) $514.50 C) $500.00 D) $512.40

29) Mary deposits funds into a CD at her bank. The CD has an annual interest of 4.0%. If Mary leaves the funds in the CD for two years she will have $540.80. Assuming no penalties for withdrawing the funds early, what amount would Mary have at the end of one year? A) $521.60 B) $490.00 C) $500.00 D) $520.00

30) Sharon deposits $150.00 in her savings account at the bank. At the end of one year she has $156.38. What was the interest rate that Sharon earned?

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A) 4.25% B) 6.38% C) 4.52% D) 5.63%

31) The value of $100 left in a savings account earning 5% a year, will be worth what amount after ten years? A) $150.00 B) $160.50 C) $159.84 D) $162.89

32) The value of $100 left in a certificate of deposit for four years that earns 4.5% annually will be A) $120.00. B) $119.25. C) $117.00. D) $145.00.

33) The future value of $100 that earns 10% annually for n years is best expressed by which one of the following? A) $100(0.1) n B) $100 × n × (1.1) C) $100(1.1) n D) $100/(1.1) n

34) The future value of $200 that is left in account earning 6.5% interest for three years is best expressed by which one of the following? Version 1

A) $200(1.065) × 3 B) $200(1.065)/3 C) $200(1.065) n D) $200(1.065) 3

35) Which one of the following best expresses the future value of $100 left in a savings account earning 3.5% for three and a half years? A) $100(1.035) 3.5 B) $100(0.35) 3.5 C) $100 × 3.5 × (1.035) D) $100(1.035) 3/2

36) Which one of the following best expresses the present value of $500 that you have to wait four years and three months to receive? A) ($500/4.25)(1 + i) B) $500 × 4.25 × (1 + i) C) $500/(1 + i) 4.25 D) ($500/4) × (1 + i) 3

37)

If 10% is the annual rate, considering compounding, the monthly rate is A) 0.0833%. B) 0.833%. C) 0.80%. D) 1.0833%.

38)

What is the future value of $1,000 after six months earning 12% annually?

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A) $1,050.00 B) $1,060.00 C) $1,120.00 D) $1,058.30

39) In reading the national business news, you hear that mortgage rates increased by 50 basis points. If mortgage rates were initially at 6.5%, what are they after this increase? A) 6.55% B) 7.0% C) 11.5% D) 56.5%

40)

One hundred basis points could be expressed as A) 0.01%. B) 1.00%. C) 100.0%. D) 0.10%.

41)

The decimal equivalent of a basis point is A) 0.0001 B) 1.00 C) 0.001 D) 0.01

42)

According to the rule of 72,

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A) any amount should double in value in 72 months if invested at 10%. B) 72/interest rate is the approximate number of years it will take for an amount to double. C) 72 × interest rate is the number of years it will take for an amount to double. D) the interest rate divided by the number of years invested will always equal 72%.

43)

The rule of 72 says that at 6% interest $100 should become $200 in about A) 72 months. B) 100 months. C) 12 years. D) 7.2 years.

44)

What is the present value of $200 promised two years from now at 5% annual interest? A) $190.00 B) $220.00 C) $180.00 D) $181.41

45)

What is the present value of $100 promised one year from now at 10% annual interest? A) $89.50 B) $90.00 C) $90.91 D) $91.25

46)

What is the present value of $500 promised four years from now at 5% annual interest?

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A) $411.35 B) $400.00 C) $607.75 D) $520.00

47)

The higher the future value of the payment the A) lower the present value. B) higher the present value. C) future value doesn't impact the present value, only the interest rate really matters. D) lower the present value because the interest rate must fall.

48)

The shorter the time until a payment the A) higher the present value. B) lower the present value because time is valuable. C) lower must be the interest rate. D) higher must be the interest rate.

49)

The lower the interest rate, i, the A) lower is the present value. B) greater must be n. C) higher is the present value. D) higher is the future value.

50)

Doubling the future value will cause

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A) the present value to fall by half. B) the interest rate, i, to double. C) no change to present value, only the interest rate. D) the present value to double.

51)

Doubling the future value will cause the A) present value to double. B) present value to decrease. C) present value to increase by less than 100%. D) interest rate, i, to decrease.

52)

The present value ( pv) and the interest rate ( i) have A) a direct relationship; as i increases, pv increases. B) an inverse relationship; as i increases, pv decreases. C) an unclear relationship; whether it is direct or inverse depends on the interest rate. D) no relationship.

53)

At any fixed interest rate, an increase in time, n, until a payment is made A) increases the present value. B) has no impact on the present value since the interest rate is fixed. C) reduces the present value. D) affects only the future value.

54)

A change in the interest rate

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A) has a smaller impact on the present value of a payment to be made far into the future than on one to be made sooner. B) will not make a difference in the present values of two equal payments to be made at different times. C) has a larger impact on the present value of a payment to be made far into the future than on one to be made sooner. D) has a larger impact on the present value of a bigger payment to be made far into the future than on one of lesser value.

55)

A monthly growth rate of 0.5% is an annual growth rate of A) 6.00%. B) 5.00%. C) 6.17%. D) 6.50%.

56)

A monthly growth rate of 0.6% is an annual growth rate of A) 7.20%. B) 6.00%. C) 7.60%. D) 7.44%.

57)

A monthly interest rate of 1% is a compounded annual rate of A) 12.68%. B) 10.00%. C) 14.11%. D) 6.00%.

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58) An investment has grown from $100.00 to $130.00 or by 30% over four years. What annual increase gives a 30% increase over four years? A) 7.50% B) 6.30% C) 6.78% D) 7.24%

59) An investment grows from $100.00 to $150.00 or 50% over five years. What annual increase gives a 50% increase over five years? A) 12.00% B) 10.00% C) 9.25% D) 8.45%

60)

The "coupon rate" is

A) the annual amount of interest payments made on a bond as a percentage of the amount borrowed. B) the change in the value of a bond expressed as a percentage of the amount borrowed.. C) another name for the yield on a bond, assuming the bond is sold before it matures. D) the total amount of interest payments made on a bond as a percentage of the amount borrowed.

61)

Higher savings usually requires higher interest rates because A) everyone prefers to save more instead of consuming. B) saving requires sacrifice and people must be compensated for this sacrifice. C) higher savings means we expect interest rates to decrease. D) of the rule of 72.

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62) If a business owner is considering whether to borrow money to purchase a new machine that generates a stream of revenue over time, the decision process involves two primary steps. Which one of the following best summarizes the two steps? A) Calculate the internal rate of return on the investment in the machine and then compare that return to the cost of buying the machine. B) Calculate the internal rate of return on the investment in the machine and then calculate whether the stream of revenue covers the payments on the loan. C) Find out if the bank will approve the loan and then calculate the internal rate of return on the investment in the machine. D) Secure venture capital to finance the purchase of the machine and then pay dividends from the revenue stream generated.

63)

The internal rate of return of an investment is A) the same as return on investment. B) zero when the present value of an investment equals its cost. C) the interest rate that equates the present value of an investment with its cost. D) equal to the market rate of interest when an investment is made.

64) If the internal rate of return from an investment is more than the opportunity cost of funds the firm should A) make the investment. B) not make the investment. C) only make the investment using retained earnings. D) only make part of the investment and wait to see if interest rates decrease.

65) A mortgage, where the monthly payments are the same for the duration of the loan, is an example of a(n)

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A) variable payment loan. B) installment loan. C) fixed payment loan. D) equity security.

66) An investment carrying a current cost of $120,000 is going to generate $50,000 of revenue for each of the next three years. To calculate the internal rate of return we need to A) calculate the present value of each of the $50,000 payments and multiply these and set this equal to $120,000. B) find the interest rate at which the present value of $150,000 for three years from now equals$120,000. C) find the interest rate at which the sum of the present values of $50,000 for each of the next three years equals $120,000. D) subtract $120,000 from $150,000 and set this difference equal to the interest rate.

67)

Usually an investment will be profitable if A) the internal rate of return is less than the cost of borrowing. B) the cost of borrowing is equal to the internal rate of return. C) it is financed with retained earnings. D) the cost of borrowing is less than the internal rate of return.

68) Data generally show that the lifetime value of a college education is worth the cost. When is the investment in a college education not worth it? A) When a student does not incur debt to go to college B) When a student incurs debt and does not complete a degree program C) When a student incurs debt attending a top-ranked university and earns a degree that is in demand D) When a student incurs debt with a lower real interest rate than the average annual return from earning the degree

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69)

A coupon bond is a bond that A) always sells at a price that is less than the face value. B) provides the owner with regular payments. C) pays the owner the sum of the coupons at the bond's maturity. D) pays a variable coupon rate depending on the bond's price.

70)

The coupon rate for a coupon bond is equal to the A) annual coupon payment divided by the face value of the bond. B) annual coupon payment divided by the purchase price of the bond. C) purchase price of the bond divided by the coupon payment. D) annual coupon payment divided by the selling price of the bond.

71) If a bond has a face value of $1000 and a coupon rate of 4.25%, the bond owner will receive annual coupon payments of A) $425.00. B) $4.25. C) $42.50. D) a value that cannot be determined from the information provided.

72) If a bond has a face value of $1,000 and the bondholder receives coupon payments of $27.50 semi-annually, the bond's coupon rate is A) 2.75%. B) 5.50%. C) 27.5%. D) a value that cannot be determined from the information provided.

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73) Consider a bond that costs $1,000 today and promises a one-time future payment of $1,080 in four years. What is the approximate interest rate on this bond? A) 2% B) 4% C) 8% D) 10.8%

74)

Which one of the following is necessarily true of coupon bonds?

A) The price exceeds the face value. B) The coupon rate exceeds the interest rate. C) The price is equal to the coupon payments. D) The price is the sum of the present value of the coupon payments and the present value of the face value.

75)

The price of a coupon bond will increase as the A) face value decreases. B) yield increases. C) coupon payments increase. D) term to maturity is shorter.

76) Suppose the nominal interest rate on a one-year car loan is 8% and the inflation rate is expected to be 3% over the next year. Based on this information, we know that A) the ex ante real interest rate is 5%. B) the lender benefits more than the borrower because of the difference in the nominal versus real interest rates. C) at the end of the year, the borrower pays only 5% in nominal interest. D) the ex post real interest rate 11%.

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77)

Interest rates that are adjusted for expected inflation are known as A) coupon rates. B) ex ante real interest rates. C) ex post real interest rates. D) nominal interest rates.

78)

The price of a coupon bond is determined by taking the present value of A) the bond's final payment and subtracting the coupon payments. B) the coupon payments and adding this to the face value. C) the bond's final payment. D) all of the bond's payments.

79)

Compounding refers to the A) calculation of after tax interest returns. B) internal rate of return a firm earns on an investment. C) real interest return after taxes. D) process of earning interest on both the principal and the interest of an investment.

80)

The interest rate that equates the price of a bond with the present value of its payments A) will vary directly with the value of the bond. B) should be the one that makes the value equal to the par value of the bond. C) will vary inversely with the value of the bond. D) should always be greater than the coupon rate.

81) A credit card that charges a monthly interest rate of 1.5% has an effective annual interest rate of

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A) 18.0%. B) 19.6%. C) 15.0%. D) 17.50%.

82)

Which formula below best expresses the real interest rate, ( r)? A) i = r − πe B) r = i + πe C) r = i − πe D) πe = i + r

83) A borrower who makes a $1,000 loan for one year and earns interest in the amount of $75, earns what nominal interest rate and what real interest rate if inflation is 2.0%? A) A nominal rate of 5.5% and a real rate of 2.0%. B) A nominal rate of 7.5% and a real rate of 5.0%. C) A nominal rate of 7.5% and a real rate of 9.5%. D) A nominal rate of 7.5% and a real rate of 5.5%.

84)

As inflation increases, for any fixed nominal interest rate, the real interest rate A) also increases. B) remains the same, that's why it is real. C) decreases. D) decreases by less than the increase in inflation.

85) Considering the data on real and nominal interest rates for the United States from 1979 to 2018, we can say that

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A) the real interest rate remains unchanged over time. B) there have been times when the real interest rate has been negative. C) nominal interest rates were higher in 2000 than they had been at any other point in time. D) the inflation rate is always greater than the real interest rate.

86)

Which one of the following statements is most correct?

A) We can always compute the ex post real interest rate but not the ex ante real rate. B) We cannot compute either the ex post or ex ante real interest rates accurately. C) We can accurately compute the ex ante real interest rate but not the ex post real rate. D) We can always compute both the ex post real interest rate and the ex ante real rate accurately.

87) Suppose you are risk-averse, and you received an unexpected bonus at work. Why might a financial advisor recommend that you use the money to pay down some of your debt? A) Debt is bad. B) The recommendation applies if you have credit card debt. C) The return received from paying down debt is nearly always higher than any available riskless return. D) The unexpected bonus cannot be used to open a new investment portfolio if you don’t already have one.

88)

From the Fisher equation we see that the nominal interest rate and expected inflation have A) an inverse relationship. B) a relationship which is direct but less than one-to-one. C) a relationship which is direct and one-to-one. D) no relationship.

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89) If a lender wants to earn a real interest rate of 3% and expects inflation to be 3%, they should charge a nominal interest rate that equals A) at least 0%. B) at least 6%. C) at least 7%. D) more than 7%.

90) If a lender charges a nominal interest rate of 6% and expects inflation to be 3%, they expect to earn a real interest rate of A) 0%. B) 2%. C) 3%. D) 9%.

91)

We should expect a country that experiences volatile inflation to also have A) volatile nominal interest rates. B) volatile real interest rates but stable nominal rates. C) stable nominal interest rates. D) volatile real interest rates.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 92) Larry and Darrell each put $2,000 in the bank on the same day and keep in there for 3 years where the money earns 5% interest every year. Larry leaves his money, including interest, in the bank the whole time. Darrell withdraws the interest earned each year and spends it, but he leaves the whole principal of $2,000 in the bank the whole time. a. Fill in the table, showing how much interest each investor earns annually. b. Explain when simple interest might be a rational choice. Year

Larry’s Interest Earned Darrell’s Interest Earned ($) ($)

Year 1

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Year 2 Year 3 Total Interest Earned Dollar Value of Investment at the End of Year 3 Type of Interest Earned (Simple or Compound?)

93) A lender expects to earn a real interest rate of 4.5% over the next 12 months. She charges a 9.25% (annual) nominal rate for a 12-month loan. What inflation rate is she expecting? If the lender is in a 30% marginal tax bracket, the borrower in a 25% marginal tax bracket, and they both have the same inflation expectations, what are the real after-tax rates each expects?

94) Compute the interest rate for a $1,000 face value a bond that sells for $280 and matures in 20 years. The bond has no coupon payments, only the face value payment.

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95) Compute the future value of $1,000 at a 6 percent interest rate after three different lengths of time. Use 6, 10, and 20 years into the future. Do the amounts increase or decrease over time? Explain.

96) Considering the concept of compounding, explain why in determining the future value of a $100 investment at 5 percent annual interest, you can't simply multiply $100 by (1.10) and get the correct answer.

97) Calculate which has a higher present value: an annual payment of $100 received over 3 years or an annual payment of $50 received over 7 years. In both cases the interest rate is 7% (or 0.07).

98) What is the monthly interest rate if you are asked to convert a 12% annual rate to a monthly rate? (Calculate to 4 decimal places.)

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99) Convert each of the following basis points amounts to percents. a) 412.5 b) 10 c) 125.7 d) 1075 e) 1

100) Using the rule of 72, determine the approximate time it will take $1,000 to double given the following annual interest rates. a) 5.5% b) 10.0% c) 30.0% d) 2.0% e) 4.5%

101) What will be the amount owed at the end of one year if a borrower charges $100 on their credit card and doesn't make any payments during the year (assume the interest rate is 1.5% per month)?

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102) Which investment plan will provide the highest future value: $500 invested at 5 percent annually for four years and then that balance invested at 7 percent annually for an additional three years, or $500 invested at 6 percent annually for seven years?

103) Suppose that you have a winning lottery ticket for $100,000. The State of California doesn't pay this amount up front—this is the amount you will receive over time. The State offers you two options. The first pays you $80,000 up front and that will be the entire amount. The second pays you winnings over a three-year period. The last option pays you a large payment today with small payments in the future. The payment options are detailed in the following table. Amount paid today Amount paid after 1 year Amount paid after 2 years Amount paid after 3 years

Option #1

Option #2

Option #3

$80,000 -

$22,000 $22,000 $22,000 $22,000

$50,000 $12,000 $12,000 $12,000

Compute the present value of each payment option, assuming the interest rate is 12%. Now, compute the present values based on an interest rate of 5%. Compare your answers, explaining why they are different when the interest rate changes. When the interest rate is 5%, the present values are as follows. Present Values (i = 5%) Amount paid today Amount paid after 1 year Amount paid after 2 years Amount paid after 3 years Total Present Value

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Option #1 $80,000 $0 $0 $0 $80,000

Option #2 $22,000 $20,952 $19,955 $19,004 $81,911

Option #3 $50,000 $11,429 $10,884 $10,366 $82,679

104) Briefly discuss the relationship between present value and each of the following. a) future value b) time c) interest rate

105) An investment grows from $2,000 to $2,750 over the period of 10 years. What average annual growth rate will produce this result?

106) Calculate the internal rate of return for a machine that costs $500,000 and provides annual revenue of $115,000 per year for 5 years. You can assume all revenue is received once a year at the end of the year.

107) You win your state lottery. The lottery officials offer you the following options: you can accept annual payments of $50,000 for 20 years or receive an upfront payment of $700,000. Ignoring issues like mortality tables, taxes, etc., and assuming the first payment is made immediately, what market interest rate would make it more attractive to take the upfront payment?

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108) You are considering purchasing a home. You find one that you like but you realize that you will need to obtain a mortgage for $100,000. The mortgage company presents you with two options: a 15-year mortgage at a 6.0% annual rate and a 30-year mortgage at a 6.5% annual rate. What will be the fixed annual payment for each mortgage?

109) A bond offers a $50 coupon, has a face value of $1,000, and has 10 years to maturity. If the interest rate is 4.0% what is the value of this bond?

110) A bond offers a $40 coupon, has a face value of $1,000, and 10 years to maturity. If the interest rate is 5.0%, what is the value of this bond?

111) Suppose a two-year coupon bond has payments of $40 and a face value of $800. The interest rate is 8%. Compute the present value of the coupon payments (PCP) and the principal payment of the bond (PBP). What is the price of this bond (P)? Version 1

112) Suppose you negotiate a one-year loan with a principal of $1000 and the nominal interest rate is currently 7%. You expect the inflation rate to be 3% over the next year. When you repay the principal plus interest at the end of the year, the actual inflation rate is 2.5%. Compute the ex ante and ex post real interest rate. Who benefits from this unexpected decrease in inflation? Who loses?

113) In the data from the text, we observe that countries with high inflation rates tend to have high nominal interest rates. What does this imply, if anything, about real interest rates in countries with very high inflation rates?

114) Explain why an increase in expected inflation will result in an increase in nominal interest rates, holding other factors constant.

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115) Explain why, if real interest rates are so important, we see most interest rates quoted in nominal terms.

116) If a borrower and a lender agree on a long-term loan at a nominal interest rate that is fixed over the duration of the loan, how will a higher-than-expected rate of inflation impact the parties if at all?

117) Explain why countries with high and volatile inflation rates are likely to have volatile nominal interest rates.

118) Use an example to explain why the Fisher equation is not highly accurate at high rates of inflation.

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119) An individual is currently 30 years old, wants to work until the age of 65, and plans on dying at the age of 85. How much will the individual need to have saved by the time he or she is 65 if he or she plans on spending $40,000 per year while retired? You can assume the individual can earn an interest rate of 5.0% and the $40,000 is in addition to any Social Security that may be received.

120) How might the behavior of professional investment managers prior to the financial crisis of 2007–2009 have contributed to the depth of the plunge of corporate and mortgage security prices during the crisis?

121) Explain why an investor cannot simply compare the size of promised payments from different investments, even if the interest rates and other risk factors are the same.

122) Historically, many cultural groups have outlawed usury, or the practice of levying interest on loans. Some groups oppose usury because it exacerbates problems of income inequality (as wealthier individuals can afford to lend to poorer individuals), while others claim investment and loans should be made charitably. Evaluate these arguments against usury based on your knowledge of present value. Do such prohibitions make sense?

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123)

How has Islamic banking redefined lending to deal with Islam's prohibition of usury?

124) Discussions in recent years about the vulnerability of the Social Security System cause some people to feel the payments promised will not materialize. Discuss the possible changes we might observe if this feeling becomes prevalent among today’s workers.

125) During the early 1980s, the U.S. economy experienced an increase in interest rates quoted on U.S. Treasury debt, business loans, and mortgages. At the same time, the inflation rate gradually declined more than expected. What happened to ex ante versus ex post real interest rates during this period? Use the Fisher equation to support your answer.

126) Explain why countries that have volatile inflation rates are likely to have high nominal interest rates.

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127) Explain the suggestion that people may have their own "personal discount rate" and how that may affect decisions about borrowing and other financial matters.

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Answer Key Test name: Chap 04_6e 1) C 2) C 3) B 4) B 5) D 6) A 7) D 8) C 9) D 10) C 11) D 12) A 13) C 14) B 15) C 16) C 17) B 18) B 19) C 20) B 21) B 22) A 23) B 24) D 25) D 26) D Version 1

27) B 28) C 29) D 30) A 31) D 32) B 33) C 34) D 35) A 36) C 37) C 38) D 39) B 40) B 41) A 42) B 43) C 44) D 45) C 46) A 47) B 48) A 49) C 50) D 51) A 52) B 53) C 54) C 55) C 56) D Version 1

57) A 58) C 59) D 60) A 61) B 62) C 63) C 64) A 65) C 66) C 67) D 68) B 69) B 70) A 71) C 72) B 73) A 74) D 75) D 76) A 77) B 78) D 79) D 80) C 81) B 82) C 83) D 84) C 85) B 86) A Version 1

87) C 88) C 89) B 90) C 91) A 92) a. See the following table for the solutions. Year Year 1 Year 2 Year 3 Total Interest Earned Dollar Value of Investment at the End of Year 3 Type of Interest Earned (Simple or Compound?)

Larry’s Interest Earned ($) (2,000) × .05 = $100 (2,100) × .05 = $105 (2,205) × .05 = 110.25 $315.25 $2,315.25

Darrell’s Interest Earned ($) (2,000) × .05 = $100 (2,000) × .05 = $100 (2,000) × .05 = $100 $300 $2,000

Compound

Simple

b. Comparing the answers shown, it is clear that compound interest is preferred when the goal is to save money over time. The savings grow much faster if the interest earnings remain in the account and the investor earns interest on interest over time.Simple interest could be a rational choice for an investor who needs the money earned as annual interest to cover current expenses. Even if the investor spends the interest annually, the principal is untouched—so, there is some savings even though it is not compounding over time. There are opportunity costs for every choice. 93) In the first part, she expected an inflation rate of 4.75%. We obtain this answer using the Fisher equation where i = r + πe. For the second part we need to use a variation of the Fisher equation. The lender receives an after-tax nominal rate of 6.475% from which we subtract the inflation rate of 4.75% and the lender expects a real after-tax rate of 1.725%. The borrower expects to pay an after-tax real rate of 2.188%. Version 1

94) Using a financial calculator and inserting $280 for the present value, $1,000 for the future values, 20 for n, and solving for i, we can compute this to be 6.57%. 95) We can use a calculator and the formula FV = PV(1+i)n to solve this problem. To calculate the future value for six years the formula will be: FV = $1,000(1.06) 6 which equals $1,418.52. Using a similar approach for 10 years: FV = $1,000(1.06) 10 which equals $1790.85. And finally for 20 years: FV = $1,000(1.06) 20 which equals $3207.14. The total increases over time because more interest is earned every time annual compounding occurs. 96) To simply multiply $100 by 1.10 ignores the effect of compounding, which is interest paid on the principal and on the interest earned. That is why the correct formula would be FV =$100(1.05) 2. 97) We can use the present value formula to answer this question. In the case of the $100 payment, the present value = $262.43. In the case of the $50 payments received over 7 years, the present value is $269.46. So, the 7 payments of $50 each have a higher present value. 98) It is not as simple as dividing 12% by 12 and thus obtaining an answer of 1.000%. The monthly rate, im, can be determined by using the following formula: (1 + im)12= (1.12) which we can manipulate to (1 + i m) = (1.12)1/12 which equals 1.0095. Therefore, the monthly interest rate is 0.95%. 99) Since 1 basis point equals .01%, we can determine that: a) 412.5 basis points is 4.125% b) 10 basis points is 0.1% c) 125.7 basis points is 1.257% d) 1075 basis points is 10.75% e) 1 basis point is 0.01% Version 1

100) Since the rule of 72 says if we take 72/i we get the approximate number of years it takes for an amount to double, we can determine the answer for each interest rate. a) 72/5.5 = 13.1 years b) 72/10 = 7.2 years c) 72/30 = 2.4 years d) 72/2 = 36 years e) 72/4.5 = 16 years 101) $119.56. While it is tempting to multiply 1.5 times 12, obtaining 18% and the multiplying this by $100 to determine the interest charge, it would be incorrect since we would be ignoring compounding. The correct answer can be determined by using the following: FV = P V(1 + im) 12. This will be FV = $100(1.015) 12 or $119.56. 102) $500 invested for four years at 5 percent interest and then that balance invested at 7% for three additional years will produce a balance of $744.52 at the end of seven years. The future value of $500 invested for seven years at 6 percent interest is $751.82. 103) When the interest rate is 12%, the present values are as follows. Present Values (i = 12%) Amount paid today Amount paid after 1 year Amount paid after 2 years Amount paid after 3 years Total Present Value

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Option #1 $80,000 $0 $0 $0 $80,000

Option #2 $22,000 $19,643 $17,538 $15,659 $74,840

Option #3 $50,000 $10,714 $9,566 $8,541 $78,822

From the previous computations, when the interest rate is 5%, Option #3 has the highest present value. When the interest rate is 12%, Option #1 has the highest present value. When the interest rate increases from 5% to 12%, the opportunity cost of foregoing future payments is higher. That is, while the winner is waiting to receive their future payments, they are forgoing interest that could be earned on a bank deposit or other investment. When the interest rate is low, this opportunity cost is relatively low, making Option #3 (with larger fixed payments, similar to coupon payments on a bond) more attractive. When the interest rate is relatively high, these future fixed payments have less value, making Option #1 more attractive. 104) Holding time and interest rate constant, any percentage change in the future value will cause the same percentage change in the present value. Holding the future value and the interest rate constant, an increase in the time until payment reduces the present value and any decrease in time increases the present value. Holding future value and time constant, an increase in the interest rate reduces the present value and a decrease in the interest rate increases the present value. 105) First, we determine the overall percentage change in the investment is 37.5%, [(2,750 − 20000/2000] × 100 = 37.5. Next, we ask what annual growth rate over 10 years produces this result. We can determine this by using the following: (1 + i) 10 = (1.375). With a little manipulation, this turns into the following: i = (1.375) 1/10 − 1 so, i = .03236. Thus, an annual growth rate of 3.24% produces this result. Notice this is different than the answer you would obtain by simply dividing 37.5% by 10.

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106) To solve this, we equate the cost of the machine to the sum of the present value for each annual payment and solve for the interest rate. Using a financial calculator or a spreadsheet we obtain an internal rate of return of 4.85%. 107) Using a financial calculator or a spreadsheet we can equate the $700,000 to the sum of the present value flow of receiving $50,000 a year for the next 20 years, and the internal rate of return is 4.121%. If you are confident that you can earn an average annual return greater than 4.121% a year over the next 20 years, the upfront payment may be the option to select. 108) Using a financial calculator or a spreadsheet we can determine the 15-year mortgage will require annual payments of $10,296.28; the 30year mortgage will require annual payments in the amount of $7,657.74. 109) Realizing that the price of the bond is the sum of the present value of all payments, we simply calculate the present value of each payment and sum these. With the help of a financial calculator or a spreadsheet if necessary, we see the value of the bond is $1,081.10. 110) Realizing that the price of the bond is the sum of the present value of all payments, we simply calculate the present value of each payment and sum these. With the help of a financial calculator or spreadsheet if necessary, we see the value of the bond is $922.78. 111) The present values are: PCP = $40/(1 + 0.08) + $40/(1 + 0.08) 2 = $37.04 + $34.29=$71.33 PBP = $800/(1 + 0.08) 2 = $685.87 P = PCP + PBP = $71.33 + $685.87 = $757.20 The price of the bond is equal to the present value of future payments on the bond. The future payments include the $40 coupon payments paid over two years (with a present value of $71.33) and the $800 face value payment (with a present value of $685.87). The price of the bond is, therefore, the sum of these two amounts, $757.20.

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112) The ex ante real interest rate is 4% (= 7%− 3%). The ex post real interest rate is 4.5% (=7%− 2.5%). The unexpected decrease in inflation benefits the lender because they receive a higher real interest rate than what was expected. The borrower loses because their real interest rate is higher than expected. 113) The higher nominal interest rates are simply a reflection of high inflation rates. The real interest rates in these countries could be equal to (or even less than) those in low-inflation countries. 114) This follows from the Fisher equation that says the nominal interest rate equals the sum of the real interest rate and the expected rate of inflation. So, for any given real interest rate, an increase in the expected rate of inflation will cause the nominal interest rate to increase. 115) It is almost impossible to quote real interest rates ex ante. For any given nominal interest rate, the real interest rate is the nominal interest rate less the rate of inflation. The problem is no one knows what the rate of inflation will be exactly. As a result, it is easier to quote nominal interest rates. 116) A higher-than-expected rate of inflation will benefit the borrower who will end up paying a lower real interest rate than planned, and so will be better off. The lender, on the other hand, will end up receiving a real interest rate that is less than what was planned so the lender will be harmed. 117) Using the Fisher equation (that says the nominal interest rate equals the sum of the real interest rate and the expected rate of inflation), a country where inflation is volatile will have lenders adding a high expected inflation component, thus raising the nominal interest rate. The higher volatility of nominal interest rates is directly the result of the volatility in the inflation rate. Version 1

118) Consider a lender who loans $100 for a year, in an environment of 10% inflation. If the lender wants to earn a real interest rate of 2%, the Fisher equation says he/she should charge a nominal interest rate of 12.0%. The reality is, however, that the lender wanted to have 2% more purchasing power at the end of the loan. Since inflation also impacts the interest earned, we can calculate the actual interest rate they need to charge by realizing that if the lender wanted $2.00 more purchasing power per hundred dollars loaned, we can take $102 and multiply this by 1 + the rate of inflation or 1.1. $102 × 1.1 = $112.20. Thus they really need to charge a nominal interest rate of 12.2% or slightly more than the 12.0% of the Fisher equation 119) We can use a financial calculator to determine that in order to determine that the individual will need to amass a fund of $498,488 at the time they plan on retiring to obtain $40,000 a year for 20 years. Now since the individual has 35 years to amass this fund, this will require them to set aside $5,519 each year for 35 years. 120) With market interest rates low and stable, investment managers may have been trying to generate high interest payments by taking greater risks in a search for yield. When the risk came to fruition during the financial crisis the prices of the riskier securities fell disproportionately.

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121) The key here is time. Payments that are promised at different times are not equal in value; we could say they are really different units of value. We employ the concept of present value to allow us to make comparisons of promised payments that are due at different time periods. We know that payments that are promised sooner are worth more, other factors held constant (for example interest rates), than payments we have to wait for longer. This is seen from the present value formula. So, a saver who is going to make a thorough comparison of different investments must consider the timing of the payments and convert all future payments to present value amounts so they can be compared in the same units. 122) Prohibitions on interest payments (or usury) are problematic when we apply the concept of opportunity cost. For every dollar that is lent, the lender gives up the use of these funds that could go elsewhere. For example, the funds could be used for consumption, or for earning return on some other investment (such as a bank deposit or bond). If usury is outlawed, then there is no incentive to lend, outside of the perceived benefit the lender receives from charitable contributions to their colleagues.

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123) Islamic banking has found alternative mechanisms for encouraging the flow of funds from savers to borrowers through banks that pay no interest on deposits or loans. This provides savers with access to their liquid assets, while capturing the lower transactions costs and risk sharing associated with depository institutions and other financial intermediaries. On the lender side, the bank is entitled to a share of the gains the borrower generates from the loan (i.e., from investing in capital or some other physical asset), or purchases goods on behalf of the borrower. Since the bank benefits from economies of scale, it is able to generate profits by negotiating lower prices (or lower per-unit cost) than an individual could. 124) If people working now begin to question the viability of Social Security and yet if they want to retire at the planned age and keep their lifestyle during retirement, they will have to increase saving now. The idea is that people will need to build a larger fund at the time of retirement and to do this will require they decrease their current consumption. If people do not alter their saving, they either believe that Social Security will honor their payments and/or they plan on reducing their consumption during retirement. 125) The Fisher equation is: i = r+ πe. The Fisher equation can be used to compute the ex ante real interest rate. The ex post real interest rate is computed using actual inflation in place of expected inflation. If nominal interest rates increase and the inflation rate decreased, this implies the ex post real interest rate must have decreased. If inflation declined more than expected, this would imply that the ex post real interest rate exceeded the ex ante real interest rate.

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126) You could argue that volatile inflation means the inflation rate changes, but it doesn't always mean it increases. The rate could also decrease, and then the average rate may not be that bad. So why is the nominal interest rate higher? The answer can be found in the positions of the party and counterparty to any agreement. For example, in a country where inflation is low, a change of 1 percentage point, say from 1% to 2%, can benefit one party and harm the other party, but the harm/benefit is somewhat minimal. In a country where inflation may average 4% (for example), but is highly volatile, the volatility can cause the rate to change by a larger amount (more percentage points), meaning the potential harm can be much larger. To compensate for this risk, the nominal interest rates will have to be higher. 127) A good illustration of this comes from the story of the downsizing by the Defense Department in the 1990s. Military personnel were offered a choice between an annual payment and a lump sum, and were given information about how to calculate the present value of the annual payment using a 7% discount rate. The evidence suggests that most people put excessive weight on a "bird in the hand," meaning the "sure thing" of the lump-sum payment, suggesting that for most people their "personal discount rate" is higher. For the military personnel, it seemed to be much higher than 7%. This explains why people are more likely to choose lump-sum payments and to borrow at high rates of interest (for example, the rates on credit card balances). Most people seem to be extremely impatient, even to their own financial detriment.

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CHAPTER 5 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) Which one of the following would not be included in a definition of risk? A) Risk is a measure of uncertainty. B) Risk can always be avoided at no cost. C) Risk has a time horizon. D) Risk usually involves some future payoff.

Why is measuring and assessing risk important in the study of financial markets?

A) Risk must be avoided at all costs. B) Positive payoffs always outweigh losses. C) Measuring risk is necessary in calculating a fair price for transferring risk. D) It led to the discovery that changes in risk do not affect demand for financial instruments.

All other factors held constant, an investment with A) more risk should offer a lower return and sell for a higher price. B) less risk should sell for a lower price and offer a higher expected return. C) more risk should sell for a lower price and offer a higher expected return. D) less risk should sell for a lower price and offer a lower return.

Uncertainties that are not quantifiable A) are what we define as risk. B) are factored into the price of an asset. C) cannot be priced. D) are benchmarks against which quantifiable risks can be assessed.

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When measuring the risk of an asset

A) one must measure the uncertainty about the size of future payoffs. B) it is necessary to incorporate uncertainties that are not quantifiable. C) one must remember that the concept of risk applies only to financial markets, not to financial intermediaries. D) one cannot use other investments to evaluate the asset's risk.

Risk A) cannot be quantified. B) is best measured relative to a benchmark. C) doesn’t exist if there is a single random event. D) can be measured without knowing all of the possible outcomes.

Which one of the following is true?

A) Investments with higher risk generally have a higher expected return than risk-free investments. B) Investments that pay a return over a longer time horizon generally have less risk. C) Investments with a greater variance in the size of the future payoff generally pay a lower expected return. D) Risk-free investments are the best benchmark for measuring the risk of all investment strategies.

8) How can investors make decisions about financial instruments that involve future payoffs?

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A) There is no uncertainty in market economies. B) This can be done only when the future payoffs are certain. C) Prices are determined by supply and demand which is always certain. D) Investors can use probabilities and risk measurement procedures to account for all possibilities.

9) Carolina is considering a $500 investment which will pay off $750 with a 30% probability, $600 with a 20% probability, and $350 with a 50% probability. Which of the following tables correctly summarizes her probabilities and payoffs? A) Possibilities 1 2

Probability 0.5 0.5

Payoff $750 $350

Probability 0.33 0.33 0.33

Payoff $750 $600 $350

Probability 0.3 0.2 0.5

Payoff $750 $600 $350

Probability 0.3

Payoff $500

B) Possibilities 1 2 3

C) Possibilities 1 2 3

D) Possibilities 1

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2 3

10)

0.2 0.5

$500 $500

Inflation presents risk because A) inflation is always present. B) inflation cannot be measured C) there are different ways to measure it. D) there is no certainty regarding what inflation will be in the future.

11)

If the probability of an outcome equals one, the outcome A) is more likely to occur than the others listed. B) is certain to occur. C) is certain not to occur. D) has unquantifiable risk.

12)

If a fair coin is tossed, what is the probability of coming up with either a head or a tail? A) ½ or 50 percent B) zero C) 1 or 100 percent D) This is unquantifiable.

13)

If the probability of an outcome is zero, you know the outcome is A) more likely to occur. B) certain to occur. C) less likely to occur. D) certain not to occur.

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14)

The expected value of an investment A) is what the owner will receive when the investment is sold. B) is the sum of the payoffs. C) is the probability-weighted sum of the possible outcomes. D) cannot be determined in advance.

15) If an investment will return $1,500 half of the time and $700 half of the time, the expected value of the investment is A) $1,250. B) $1,050. C) $1,100. D) $2,200.

16)

Another name for the expected value of an investment would be the A) mean value. B) upper-end value. C) certain value. D) risk-free value.

17) If an investment has a 20% (0.20) probability of returning $1,000, a 30% (0.30) probability of returning $1,500, and a 50% (0.50) probability of returning $1,800, the expected value of the investment is A) $1,433.33. B) $1,550.00. C) $2,800.00. D) $1,600.00.

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18) Suppose that Fly-By-Night Airlines, Inc. has a return of 5% twenty percent of the time and 0% the rest of the time. The expected return from Fly-By-Night is A) 10%. B) 0.1%. C) 0.2%. D) 1.0%.

19) An investor puts $1,000 into an investment that will return $1,250 one-half of the time and $900 the remainder of the time. The expected return for this investor is A) $1,075. B) 5.0%. C) 7.5%. D) 15.0%.

20) An investor puts $2,000 into an investment that will pay $2,500 one-fourth of the time; $2,000 one-half of the time, and $1,750 the rest of the time. What is the investor's expected return? A) 12.5% B) $250.00 C) 6.25% D) 3.125%

21)

Risk-free investments have rates of return A) equal to zero. B) with a standard deviation equal to zero. C) that are uncertain, but have a certain time horizon. D) that exhibit a large spread of potential payoffs.

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22)

An investment with a large spread between possible payoffs will generally have A) a low expected return. B) a high standard deviation. C) a low value at risk. D) both a low expected return and a low value at risk.

23) An investment pays $1,500 half of the time and $500 half of the time. Its expected value and variance respectively are A) $1,000; 500,000 dollars B) $2,000; (250,000 dollars) 2 C) $1,000; 250,000 dollars D) $1,000; 250,000 dollars 2

24) An investment pays $1,200 a quarter of the time; $1,000 half of the time; and $800 a quarter of the time. Its expected value and variance respectively are A) $1,000; 20,000 dollars 2 B) $1,050; 20,000 dollars 2 C) $1,000; 40,000 dollars 2 D) $1,000; 80,000 dollars 2

25) An investment pays $1,000 three quarters of the time, and $0 the remaining time. Its expected value and variance respectively are A) $1,000: 62,500 dollars 2 B) $750; 46,875 dollars C) $750; 62,500 dollars D) $750; 187,500 dollars 2

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26)

The standard deviation is generally more useful than the variance because A) it is easier to calculate. B) variance is a measure of risk, and standard deviation is a measure of return. C) standard deviation is calculated in the same units as payoffs and variance isn't. D) it can measure unquantifiable risk.

27)

Given a choice between two investments with the same expected payoff most people will A) choose the one with the lower standard deviation. B) opt for the one with the higher standard deviation. C) be indifferent since the expected payoffs are the same. D) calculate the variance to assess the relative risks of the two choices.

28) An investment will pay $2,000 half of the time and $1,400 half of the time. The standard deviation for this investment is A) $90,000. B) $300. C) $1,700. D) $30.

29) An investment will pay $2,000 a quarter of the time; $1,600 half of the time and $1,400 a quarter of the time. The standard deviation of this asset is A) $600. B) $1,650. C) $47,500. D) $217.94.

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30) Investment A pays $1,200 half of the time and $800 half of the time. Investment B pays $1,400 half of the time and $600 half of the time. Which one of the following statements is correct? A) Investment A and B have the same expected value, but A has greater risk. B) Investment B has a higher expected value than A, but also greater risk. C) Investment A and B have the same expected value, but A has lower risk than B. D) Investment A has a greater expected value than B, but B has less risk.

31) Investment A pays $1,200 half of the time and $800 half of the time. Investment B pays $1,400 half of the time and $600 half of the time. Which one of the following statements is correct? A) Investment A and B have the same expected value, but A has greater risk. B) Investment B has a higher expected value than A, but also greater risk. C) Investment A has a greater expected value than B, but B has less risk. D) Investment A and B have the same expected value, but B has greater risk.

32) Luis is a risk-averse investor who is considering Proposal A and Proposal B. Each proposal requires the same amount of investment and has equivalent expected values. However, the distribution of possible payoffs for Proposal A is more spread out than the distribution of possible payoffs for Proposal B. Based on this information, Luis should choose A) Proposal A. B) Proposal B. C) either since they are equivalent. D) neither there is too much risk involved.

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33) The following figure illustrates two different options for investing $1,000 where the expected value is equal for both. Which one is riskier?

A) Case 1 B) Case 2 C) The risk is equal between the two cases. D) More information is needed to compare the risk.

34)

The greater the standard deviation of an investment, the A) lower the return. B) greater the risk. C) lower the risk. D) lower the risk and return.

35)

The difference between standard deviation and value at risk is

A) nothing, they are two names for the same thing. B) value at risk is a more common measure in financial circles than is standard deviation. C) standard deviation reflects the spread of possible outcomes, whereas value at risk focuses on the value of the worst outcome. D) value at risk is expected value times the standard deviation.

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36) A $600 investment has the following payoff frequency: a quarter of the time it will be $0; three quarters of the time it will pay off $1,000. Its standard deviation and value at risk, respectively, are A) $750; $600. B) $433; $600. C) $0; $1,000. D) $433; $1,000.

37) A $500 investment has the following payoff frequency: half of the time it will pay $350 and the other half of the time it will pay $900. Its standard deviation and value at risk, respectively, are A) $275; $150. B) $625; $275. C) $275; $350. D) $125; $500.

38)

The measure of risk that focuses on the worst possible outcome is called A) expected rate of return. B) risk-free rate of return. C) standard deviation of return. D) value at risk.

39)

Leverage A) reduces risk. B) is synonymous with risk-free investment. C) increases expected rate of return. D) leads to smaller changes in the investment's price.

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40) Which one of the following is least likely to use value at risk as an important factor in their investment decision? A) an individual considering a mortgage to buy his first home B) a family considering purchasing health insurance C) a policy maker considering regulation of depository institutions D) a mutual fund manager choosing the allocation of investments in the fund's portfolio

41) Comparing a lottery where a $1 ticket purchases a chance to win $1 million with another lottery in which a $5,000 ticket purchases a chance to win $5 billion, we notice many people would participate in the first but not the second, even though the odds of winning both lotteries are the same. We can perhaps best explain this outcome by the A) higher expected value for the lottery paying $1 million. B) higher expected value for the lottery paying $5 billion. C) lower value at risk for the lottery paying $1 million. D) higher value at risk for the lottery paying $1 million.

42)

Leverage A) increases expected return while lowering risk. B) increases risk. C) lowers the expected return and lowers risk. D) lowers the expected return and increases risk.

43)

Leverage A) increases expected return and increases risk. B) increases expected return and reduces risk. C) decreases expected return but has no effect on risk. D) decreases expected return and increases risk.

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44) Which one of the following investment strategies involves generating a higher expected rate of return through increasing risk? A) diversifying B) hedging risk C) leverage D) value at risk

45)

A risk-averse investor, compared toa risk-neutral investor, A) will never take a risk, while the risk-neutral investor will. B) needs greater compensation for the same risk versus the risk-neutral investor. C) will take the same risks as the risk-neutral investor if the expected returns are equal. D) needs less compensation for the same risk versus the risk-neutral investor.

46)

A risk-averse investor will A) always accept a greater risk with a greater expected return. B) only invest in assets providing certain returns. C) never accept lower risk if it means accepting a lower expected return. D) sometimes accept a lower expected return if it means less risk.

47)

A risk-averse investor will

A) never prefer an investment with a lower expected return. B) always prefer an investment with a certain return to one with the same expected return but that has any amount of uncertainty. C) always require a certain return. D) always focus exclusively on the expected return.

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48) Consider a game where a fair coin is flipped, and, if you call the correct outcome, the payoff is $2,000. A risk-neutral gambler would pay up to what amount to enter this game? A) more than $1000 but less than $2000 B) up to $2,000 C) up to $1,000 D) more than $1,500

49) Professional gamblers know that the odds are always in favor of the house (casinos). The fact that they gamble says they are A) irrational. B) risk-neutral. C) risk-averse. D) risk seekers.

50)

The risk premium for an investment A) is negative for U.S. treasury securities. B) is a fixed amount added to the risk-free return, regardless of the level of risk. C) increases with risk. D) is zero (0) for risk-averse investors.

51)

A risk-averse investor compared to a risk-neutral investor would A) offer the same price for an investment as the risk-neutral investor. B) require a higher risk premium for the same investment as a risk-neutral investor. C) place more focus on expected return and less on return than the risk-neutral investor. D) place less focus on expected return than the risk-neutral investor.

52) When considering different investments, a risk-averse investor is most likely to focus on purchasing Version 1

A) investments with the greatest spread in the expected rate of return. B) investments that offer the lowest standard deviation in the investments' expected rates of return for any given expected rate of return. C) only risk-free investments. D) investments with the lowest risk premium, regardless of the expected rate of return.

53)

How are expected returns generally related to risk premiums? A) Higher expected returns are associated with higher risk premiums. B) Lower risk premiums are associated with higherexpected returns. C) Lower expected returns are associated with higher risk premiums. D) Expected returns are not associated with risk premiums.

54) The fact that over the long run the return on common stocks has been higher than that on long-term U.S. Treasury bonds is partially explained by the fact that A) a lot more money is invested in common stocks than U.S. Treasury bonds. B) There are regulations on the interest rates U.S. Treasury bonds can offer. C) The risk premium is higher on common stocks. D) Risk-averse investors buy more common stock.

55) of

When the home construction industry does poorly due to a recession, this is an example

A) systematic risk. B) idiosyncratic risk. C) risk premium. D) unique risk.

56)

Unique risk is another name for

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A) market risk. B) systematic risk. C) the risk premium. D) idiosyncratic risk.

57) High oil prices tend to harm the auto industry and benefit oil companies; therefore, high oil prices are an example of A) systematic risk. B) idiosyncratic risk. C) neither systematic nor idiosyncratic risk. D) both systematic and idiosyncratic risk.

58)

Changes in general economic conditions usually produce A) systematic risk. B) idiosyncratic risk. C) risk reduction. D) lower risk premiums.

59) of

Unexpected inflation can benefit some people/firms and harm others. This is an example

A) systematic risk. B) unmeasured risk. C) idiosyncratic risk. D) zero risk since the effects balance.

60)

Diversification is the principle of

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A) eliminating risk. B) reducing the risk we carry to just two. C) holding more than one asset to reduce risk. D) eliminating investments from our portfolio that have idiosyncratic risk.

61)

Diversification can eliminate A) all risk in a portfolio. B) risk only if the investor is risk averse. C) the systematic risk in a portfolio. D) the idiosyncratic risk in a portfolio.

62)

An investor practicing hedging would be most likely to

A) avoid the stock market and focus on bonds. B) purchase shares in General Motors and buy U.S. Treasury bonds. C) purchase shares in General Motors and Amoco oil. D) put their invested funds in CDs.

63)

Hedging is possible only when investments have A) opposite payoff patterns. B) the same payoff patterns. C) payoffs that are independent of each other. D) the same risk premiums.

64) An investor who diversifies by purchasing a 50–50 mix of two stocks that are not perfectly positively correlated will find that the standard deviation of the portfolio is

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A) the sum of the standard deviations of the two individual stocks. B) greater than the sum of the standard deviations of the individual stocks. C) greater than the standard deviation from holding the same balance in only one of these stocks. D) less than the standard deviation from holding the same balance in only one of these stocks.

65)

Which one of the following statements is false? A) Diversification can reduce risk. B) Diversification can reduce risk but only by reducing the expected return. C) Diversification reduces idiosyncratic risk. D) Diversification allocates savings across more than one asset.

66)

Systematic risk A) is the risk eliminated through diversification. B) represents the risk affecting a specific company. C) cannot be eliminated through diversification. D) is another name for risk unique to an individual asset.

67) The Russian wheat crop fails, driving up wheat prices in the United States. This is an example of A) idiosyncratic risk. B) diversification. C) systematic risk. D) quantifiable risk.

68) If the returns of two assets are perfectly positively correlated, an investor who puts half of their savings into each will Version 1

A) reduce risk. B) have a higher expected return. C) not gain from diversification. D) reduce risk but lower the expected return.

69)

In order to benefit from diversification, the returns on assets in a portfolio must A) be perfectly positively correlated. B) be perfectly negatively correlated. C) be positively correlated but not perfectly. D) have the same idiosyncratic risks.

70)

The main reason for diversification for an investor is to A) gain from higher returns that accompany a higher number of investments. B) take advantage of the fact that returns on assets are not perfectly correlated. C) lower transaction costs. D) gain from the greater returns that come from greater risk.

71)

If ABC Inc. and XYZ Inc. have returns that are perfectly positively correlated,

A) adding XYZ Inc. to a portfolio that consists of only ABC Inc. will reduce risk. B) adding ABC Inc. to a portfolio that includes only XYZ Inc. will increase risk. C) adding XYZ Inc. to a portfolio that consists of only ABC Inc. will neither increase nor decrease the risk of the portfolio. D) adding XYZ Inc. to a portfolio that consists of only ABC Inc. will neither increase nor decrease idiosyncratic risk but will lower systematic risk.

72) that

If an investment offered an expected payoff of $100 with $0 variance, you would know

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A) half of the time the payoff is $100 and the other half it is $0. B) the payoff is always $100. C) half of the time the payoff is $200 and the other half it is $0. D) half of the time the payoff is $200 and the other half it is $50.

73)

The fact that not everyone places all of their savings in U.S. Treasury bonds indicates that

A) most investors are not risk averse. B) many investors are actually risk seekers. C) even risk-averse people will take risk if they are compensated for it. D) most people are risk-neutral.

74)

Hedging risk and spreading risk are two ways to A) increase expected returns from a portfolio. B) diversify a portfolio. C) lower transaction costs. D) match up perfectly positively correlated assets.

75)

Sometimes spreading has an advantage over hedging to lower risk because A) it can be difficult to find assets that move predictably in opposite directions. B) it is cheaper to spread than hedge. C) spreading increases expected returns, hedging does not. D) spreading does not affect expected returns.

76)

Spreading risk involves:

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A) finding assets whose returns are perfectly negatively correlated B) adding assets to a portfolio that move independently. C) investing in bonds and avoiding stocks during bad times. D) building a portfolio of assets whose returns move together.

77) Investing in a mutual fund made up of hundreds of stocks of different companies is an example of all of the following except A) spreading risk. B) diversifying. C) risk reduction. D) increasing the variance of a portfolio.

78)

An automobile insurance company that writes millions of policies is practicing a form of A) mutual fund. B) hedging risk. C) spreading risk. D) eliminating systematic risk.

79)

An automobile insurance company, on average, charges a premium that A) equals the expected loss from each driver. B) is less than the expected loss from each driver. C) is greater than the expected loss from each driver. D) equals 1/(expected loss) of each driver.

80)

The variance of a portfolio of assets

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A) decreases as the number of independent assets increases. B) increases as the number of independent assets increases. C) approaches 0 as the number of independent assets decreases. D) approaches 1 as the number of independent assets increases.

81)

A worker who holds all of his wealth in his company’s stock is in danger of A) not spreading risk. B) hedging risk. C) “blowing up.” D) innovating.

82) During the Great Moderation, aggregate income was stable while the volatility of household income actually rose. What type of risk increased for households? A) inflation risk B) systematic risk C) idiosyncratic risk D) interest rate risk

83)

In investment matters, generally young workers compared to older workers will A) minimize expected return and focus more on variability. B) be less risk-averse. C) have equal concern for expected return and variability. D) be more risk-averse.

84)

One can spread risk in a portfolio by:

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A) increasing the number of assets with independent returns B) decreasing thethe number of assets with independent returns C) increasing the number of assets with correlated returns D) owning all of one type of asset

85) The expected return from a portfolio made up equally of two assets that move perfectly opposite of each other would have a standard deviation equal to A) 1.0. B) −1.0. C) 0.0. D) 0.5.

86)

An individual who is risk-averse A) never takes risks. B) accepts risk but only when the expected return is very small. C) requires larger compensation when the risk increases. D) will accept a lower return as risk rises.

87) A portfolio of assets has lower risk than holding one asset but the same expected return and higher transaction costs. The portfolio is A) attractive to people who are risk-averse and risk-neutral, but not to risk seekers. B) attractive to investors who are risk-neutral. C) not attractive to investors who are risk-neutral. D) attractive to investors who are risk seekers.

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SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question. 88) Carolina is considering a $500 investment that will pay $750 with a 30% probability, $600 with a 20% probability, and $350 with a 50% probability. Construct a table showing her probabilities and payoffs and solve for the expected value of her investment option.

89) An individual faces two alternatives for an investment. Asset A has the following probability return schedule: Probability of Return (Yield) % return .25 11.0 .20 10.5 .20 9.5 .15 9.0 .10 6.5 .10 -1.0

Asset B has a certain return of 8.0%. If the individual selects asset A, does she violate the principle of risk aversion? Explain.

90) An individual faces two alternatives for an investment. Asset A has the following probability of return: Probability of return .25 .20 .20 .15 .10 .10

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Return (Yield) % 15.0 12.0 10.0 9.0 7.5 0.0

Asset B has a certain return of 10.25%. If this individual selects asset A, does it imply that she is risk-averse? Explain.

91) risk.

Explain why returns on assets compensate for systematic risk but not for idiosyncratic

92) Consider the following two assets with probability of return = Pi and return = Ri. a. Calculate the expected return for each and the standard deviation. b.Which assetcarries the greatest risk? Why? Asset A Pi 0.40 0.50 0.10

Asset B Ri 12.0% 8.5% -2.0%

Pi 0.20 0.50 0.30

Ri 11.5% 10.0% 0.0%

93) Consider the following two assets, each costing $500, with the probabilities of return and payoffs illustrated in the following table. Construct a chart for each asset illustrating the probabilities on the vertical axis. Which asset carries more risk? How can you tell? Asset A Probability 0.50 0.50

Payoff $1,000 $2,000

Asset B Probability 0.02 0.48 0.48 0.02

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Payoff $100 $1,000 $2,000 $2,900

94) Sufia is preparing a report for next week’s planning meeting and, based on the research, she assigns the following probabilities to next year's sales: Scenario 1 2 3 4

Probability 0.10 0.25 0.30 0.35

Sales ($ Millions) $16 $15 $14 $13

a. Find Sufia’s expected value for next year’s sales. b. Find the variance and standard deviation.

95)

Explain why a riskier asset offers a higher expected return.

96) What is the expected value of a $100 bet on a flip of a fair coin, where heads pays double and tails pays zero?

97) An individual owns a $100,000 home. She determines that her chances of suffering a fire in any given year to be 1/1000 (0.001). She correctly calculates her expected loss in any year to be $100. Explain why this really is nota good way to measure her potential for loss.

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98) Identify at least three possible sources for a risk an individual may face in planning for retirement.

99)

What is the probability of tossing a pair of dice once and getting a 1? How about a 7?

100) If there are 1,000 people, each of whom owns a $100,000 house, and they each stand a 1/1,000 chance each year of suffering a fire that will totally destroy their house, what is the minimum that they would have to pay annually for fire insurance?

101) Calculate the expected value, the expected return, the variance, and the standard deviation of an asset that requires a $1,000 investment but will return $850 half of the time and $1,250 the other half of the time.

102) Explain the following: Risk results from the fact that more outcomes could happen than will happen.

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103) Calculate the expected value of an investment that has the following payoff frequency: a quarter of the time it will pay $2,000, half of the time it will pay $1,000, and the remaining time it will pay $0.

104) Consider the following two investments. One is a risk-free investment with a $100 return. The other investment pays $2,000 20% of the time and a $375 loss the rest of the time. Based on this information, answer the following: (i) Compute the expected returns and standard deviations of these two investments individually. (ii) Compute the value at risk for each investment. (iii) Which investment will risk-averse investors prefer, if either? Which investment will risk-neutral investors prefer, if either?

105) Compute the expected return, standard deviation, and value at risk for each of the following investments Investment (A): Pays $800 three-fourths of the time and a $1,200 loss otherwise. Investment (B): Pays $1,000 loss half of the time and a $1,600 gain otherwise. State which investment will be preferred by each of the following investors, and explain why. (i) a risk-neutral investor (ii) an investor who seeks to avoid the worst-case scenario. (iii) a risk-averse investor.

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106) You do some research and find, for a driver of your age and gender, the probability of having an accident that results in damage to your automobile exceeding $100 is 1/10 per year. Your auto insurance company will reduce your annual premium by $40 if you will increase your collision deductible from $100 to $250. Should you? Explain.

107)

What would be the standard deviation for a $1000 risk-free asset that returns $1,100?

108) You buy an asset for $2,500. The asset will return $3,300 half of the time and $2,700, the other half. The expected return is 20% (a gain of $500) and the standard deviation is 12% ($300). How would using $1,250 of borrowed funds change the expected return and standard deviation specifically?

109) What would be the impact of leverage on the expected return and standard deviation of purchasing an asset with 10% of the owner's funds and 90% borrowed funds?

110)

Why isn't it correct to say that people who are risk-averse avoid risk?

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111) Briefly explain the difference between idiosyncratic risk and systematic risk. Provide an example of each.

112) Explain why a company offering homeowners insurance policies would want to insure homes across a wide geographic area.

113) Use the concept of risk to explain why the popularity of mutual funds rapidly increased as consumers learned about this type of investment.

114) Considering leverage, can you explain why a mortgage lender would want borrowers to have larger down payments, and when the borrower doesn't have the larger down payment, then the mortgage lender may require mortgage insurance?

115) You study horse racing avidly and discover for this year's Kentucky Derby you think you have the field pretty well figured out. In fact, you calculate the expected return and it is the same as the expected return you are getting from the stock market. Is this investment in the race valuable to you?

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116) Consider an individual who plans to buy a new home. He has two options: (i) pay for mortgage insurance (that insures the lender in case the borrower defaults), or (ii) pay the lender a higher interest rate for the mortgage. Describe how these two options are related to the concept of risk premium and the lender's aversion to risk. Why does the interest rate on the mortgage differ in these two options?

117) How are the decisions of government policy makers, such as the Federal Reserve, related to risk and an individual investor's portfolio?

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 118) Apply the definition of risk provided in the textbook to an individual's decision to purchase a car insurance policy. Suppose that the individual has two possibilities: no accident ($0 gain/loss) and accident (-$30,000 loss). If the probability of an accident is lower than the probability of an accident occurring (say the probability of an accident is 10%), then why do people buy car insurance? How is this related to the concept of value at risk and the time horizon of investment decisions?

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119) What is the difference between standard deviation and value at risk? Consider the difference between purchasing a one-year bank CD compared with purchasing a homeowner's insurance policy. Which scenario do you believe is more likely to consider value at risk over standard deviation? Explain.

120) Explain why insurance companies may find themselves at times having to refuse business.

121) Suppose a saver is looking for the opportunity to make a very large return in a very short period of time. Would you recommend diversification for this individual?

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Answer Key Test name: Chap 05_6e 1) B 2) C 3) C 4) C 5) A 6) B 7) A 8) D 9) C 10) D 11) B 12) C 13) D 14) C 15) C 16) A 17) B 18) D 19) C 20) D 21) B 22) B 23) D 24) A 25) D 26) C Version 1

27) A 28) B 29) D 30) C 31) D 32) B 33) B 34) B 35) C 36) B 37) A 38) D 39) C 40) D 41) C 42) B 43) A 44) C 45) B 46) D 47) B 48) C 49) D 50) C 51) B 52) B 53) A 54) C 55) A 56) D Version 1

57) B 58) A 59) C 60) C 61) D 62) C 63) A 64) D 65) B 66) C 67) A 68) C 69) C 70) B 71) C 72) B 73) C 74) B 75) A 76) B 77) D 78) C 79) C 80) A 81) A 82) C 83) B 84) A 85) C 86) C Version 1

87) C 88) The following table illustrates her probabilities and payoffs. Possibilities 1 2 3

Probability 0.3 0.2 0.5

Payoff $750 $600 $350

Probability × Payoff $225 $120 $175

Expected value = $225 + $120 + 175 = $520 89) Asset A provides an expected return of 8.65%. For the investor the 0.65% premium may be a large enough differential to compensate for the additional risk, so she may still be "risk-averse." 90) Since both assets provide the same expected return, they would be equally attractive to an investor who is risk neutral. An investor who is risk-averse would prefer Asset B, which provides the same expected return but with less risk than Asset A. 91) Idiosyncratic risk can be reduced through diversification. Systematic risk cannot since it affects all assets. 92) For asset A, the expected return = 0.4(12) + 0.5 (8.5) + 0.1(-2.0) = 8.85% For asset B, the expected return = 0.2(11.5) +0.5(10.0) + 0.3(0) = 7.30% For asset A, the standard deviation is 3.98 =

For asset B, the standard deviation is 4.81 =

b. Since asset B has a higher standard deviation than asset A, its return has higher risk.

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93)

Asset B carries more risk. The assets have the same expected value, but the payoffs in asset B are more spread out. The higher variance coincides with higher risk.

94) a. Sufia’s expected value for next year’s sales is (0.1) × (16.0) + (0.25) × (15.0) + (0.3) × (14.0) + (0.35) × (13.0) = $14.1 million. b. Calculating variance starts by computing the difference in each potential sales outcome from $14.1 million, then squaring: Version 1

Scenario 1 2 3 4

Probability 0.1 0.25 0.30 0.35

Deviation from Expected Value (16.0 - 14.1) = 1.9 (15.0 - 14.1) = 0.9 (14.0 - 14.1) = - 0.1 (13.0 - 14.1) = - 1.1

Squared 3.61 0.81 0.01 1.21

Variance then weights each squared deviation by its probability, giving us the following calculation: (0.1) × (3.61) + (0.25) × (0.81) + (0.3) × (0.01) + (0.35) × (1.21) = 0.99 Standard deviation is square root of variance = .9950 95) Due to the higher risk, savers will require a risk premium be added to the risk-free return in order to entice the asset. 96) The expected value of this event is calculated as E.V. = PH (H) + PT (T); where H is the payoff from the coin turning up heads and T is the payoff if the coin turns up tails. PH and PT are the probabilities of the coin turning up heads or tails, respectively. Substituting actual values in the formula reveals: E.V. = 0.5 ($200) + 0.5($0) = $100 97) While all of her calculations may be accurate this individual may be better off considering value at risk, which is the worst outcome. The value at risk from a fire for her in this case is $100,000 which, if suffered, could prove devastating. 98) In planning for retirement an individual faces at least the following uncertainties: Life span, there is uncertainty regarding how long an individual's life will be. Unexpected inflation, no one knows what the inflation rate will be in the future. This makes earning a targeted real return difficult. Health problems or other unforeseen contingencies can use up funds that were being set aside for retirement.

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99) It is impossible to toss two dice and get a 1, since the smallest number you can roll is a 2. So the probability of getting a 1 is 0. On the other hand a seven can be obtained a 6 different ways, and since there are 36 possible outcomes from a single roll of a pair of dice, the answer is 6/36 or 1/6 or 16.7% 100) We can calculate the expected loss for any one individual as: E.L. = 0.001($100,000) + 0.999($0) = $100.00. Since the expected loss for each individual is $100 per year, the minimum that each would have to pay is $100.00 a year. In fact, given the probability of 1 in a 1000 homeowners in this group suffering a fire each year, at $100 each, on average, there should be just enough to compensate the person suffering the fire. 101) Expected value is = 0.5($850) + 0.5($1,250) = $1,050. Expected return = $1,050/$1,000 = 0.05 or 5.0% Variance = 0.5(850 − 1,050)2 + 0.5(1,250 − 1,050)2 = 40,000 dollars2 Standard deviation = the square root of the variance or in this case = $200 102) Risk results from uncertainty, not knowing what will happen. For example, before a coin is flipped we know that there are two possible outcomes, heads or tails. Once the coin is flipped, there will only be one outcome. The risk is in not knowing,a priori, what is going to happen. If there is only one possible outcome, there is certainty and, therefore, no risk. 103) The expected value = ¼($2,000) + ½($1,000) + ¼($0) = $1,000

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104) (i) The expected rate of return is $100 for the risk-free investment. The risk-free investment has a standard deviation of zero because the return is certain. For the risky investment: Expected return = 0.2($2,000) + 0.8(-$375) = $100 Standard Deviation = (ii) The value at risk for the risk-free investment is $100 because it pays a certain return. The value of risk for the risky investment is -$375, this is the maximum amount the investor can lose. (iii) The risk-averse investor will prefer the risk-free investment. The risk-neutral investor will not have a preference between the two investments because they pay the same expected return. 105) Investment (A) Expected return = 0.25(−$1,200) + 0.75($800) = $300 Standard Deviation =

Value at Risk = -$1,200 Investment (B) Expected return = 0.5(−$1,000) + 0.5($2,000) = $500 Standard Deviation =

Value at Risk = -$1,000 (i) The risk-neutral investor is indifferent between these two investments because they pay the same expected return. (ii) The investor who seeks to avoid the worst-case scenario will choose Investment (B) because it has the lower value at risk. (iii) The risk-averse investor will prefer Investment (A) because it has a lower standard deviation. This suggests that there is less uncertainty about the expected return relative to Investment (B).

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106) An increase of a deductible from $100 to $250 exposes you to an out-of-pocket possible loss of $150 when you have an accident. But the chances of incurring this out-of-pocket loss is 1/10 (0.10) each year, so we can calculate the expected loss as E.L. = 0.1($150) + 0.9($0) = $15.00. Since this expected loss is less than the $40 in premium savings it makes good sense to increase the deductible. 107) The standard deviation for this asset would have to be $0. If it is truly risk-free the return is certain, and if the return is certain there is no variance in the return, therefore no standard deviation. 108) Borrowing 50% of the funds needed to purchase the asset is using leverage. It will double the expected return as well as the standard deviation. For example, if the asset returns the $3,300, the lender will have to be repaid $1,250, but this leaves $2,050 for you. If the asset returns $2,700 the lender still needs to be repaid, leaving $1,450 for you. Since each of these outcomes is equally likely, we can calculate the expected return and standard deviation of leverage. Expected value = ½($2,050) + ½ ($1,450) = $1,750. The $1,750 expected value on a $1,250 investment is an expected return of 40%. So the expected return doubled using leverage. The standard deviation can also be calculated: = $300 or 24% of the actual amount invested. So while the expected return doubled, so did the standard deviation. 109) We can use the general formula: Leverage factor = Cost of Investment/ Owner's Contribution to the Purchase In this case the leverage factor would be 10; so the expected return and the standard deviation would both increase by a factor of 10.

110) This statement really isn't correct. A better statement would be that people who are risk-averse need to be compensated to take additional risk. The degree of additional compensation is referred to as the risk premium and this will vary depending on the degree of risk aversion. 111) Systematic risk is risk resulting from something that will impact all firms, such as a general slowdown in the economy. Idiosyncratic risk will impact specific firms or industries, such as a harmful bacterium that is discovered in beef. Version 1

112) One of the lessons from this chapter is the ability to reduce risk through diversification, and one way to effectively diversify is through spreading of risk. Since the homes can be exposed to losses which can hit specific areas, like hurricanes, tornadoes, wild fires, floods, etc. (a form of idiosyncratic risk). An insurance company would not be spreading risk effectively if all or most of the homes they insured were located in one specific area. By insuring homes across a wide geographic area the insurance company can effectively spread risk.

113) The chapter covered the topic of spreading risk and one of the ways for an individual investor to spread risk is to purchase many different financial assets. The problem for any one individual is it could be expensive, both in terms of absolute dollars but also in transaction costs to purchase many different assets. Mutual funds allow individuals to pool their funds and purchase many different assets, thereby achieving most of the benefits of diversification without requiring a lot of funds to invest or high transaction costs. 114) We saw that leverage can do two things for the borrower: it will increase the expected return but it also increases risk. As an example, a homebuyer putting 10% down rather than 20% increases the leverage factor from 5 to 10, this will double the expected return for the borrower but also double the risk. The mortgage lender (the counterparty) is certainly concerned with the risk since the doubling of the risk also works against them. As a result, they would want a larger down payment or insurance protection in the event that the borrower does not meet their obligations. 115) While the opportunity to win at the horse race is present, so is the opportunity to lose your investment. The same situation exists with the stock market. One key difference, however, is the stock market offers the opportunity to diversify risk through spreading; this opportunity does not exist with a single horse race—it will be all or nothing.

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116) In option (ii), the risk premium on the mortgage is positive because the lender realizes there is some risk in the homeowner's ability to repay the loan. Therefore, the borrower will have to pay the risk premium in order to obtain a mortgage from the lender. If the homeowner takes option (i), he pays no premium to the lender. This is because the policy holder is paying someone else to take the risks associated with the mortgage. This is why the borrower will not need to pay a risk premium to the lender in option (i). If the borrower pays a risk premium to the mortgage lender, the lender takes on the risk (option i). If the borrower pays for insurance, then the insurance company takes the risk (option ii). 117) The decisions of government policy makers, such as the Federal Reserve, affect macroeconomic conditions, which in turn, affect the degree of systematic risk in the financial system. When the economy has low GDP growth and/or high inflation, this creates systematic risk that cannot be eliminated through diversification. 118) People buy car insurance in order to share risk with other policy holders. Even the risk-neutral investor would purchase car insurance because the expected return from driving one's car on a regular basis is involves a loss and never a financial gain. Risk-averse investors are willing to pay even more because of the uncertainty in outcomes and the possibility of a large loss. Value at risk refers to the worst possible outcome. This is often something drivers consider because if they drive often, and plan to drive over long periods of time, the probability of observing the worst-case scenario is higher over one's lifetime (compared with a situation where an individual drives for one day only).

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119) Standard deviation measures the uncertainty about a payoff's expected return, whereas the value at risk is the worst possible scenario. The decision to purchase an insurance policy is more likely to consider value at risk. When people decide to purchase insurance, they are more likely to consider the worst-case scenario because the time horizon is an individual's lifetime. For a one-year bank CD, the worst-case scenario is less likely to occur simply because the time horizon is shorter. 120) Insurance companies accept risk from individuals and then spread this risk, a form of diversification. As an example, an insurance company that provides home insurance accepts the risk from an individual and pools these risks in a portfolio of policies. One situation the insurance company must be aware of is accepting too many risks from one area so that the portfolio is not diversified as well as it may be. If the company finds that it has too many homes insured in Florida, say, and not enough in other parts of the country it may leave itself exposed to larger losses due to hurricanes. As a result, the company may deny any more policies from Florida until the percentage of homes in Florida represents the percentage the company predicted in determining its expected return. Also, value at risk issues come into play in these situations. A hurricane or other natural disaster can have a very large impact on one concentrated area and insurance companies must always be aware of the value at risk. If this becomes too large for a certain area or possible event, the company may not accept any additional business from that area. (This is one reason why insurance companies purchase re-insurance.)

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121) An individual looking to make a very large return in a short period of time will not likely benefit from diversification. As we saw from the chapter, one of the benefits of diversification is the reduction in risk that results. But another lesson was that the lower the risk, the lower the return. If an individual is interested in a large, short-term return, they are going to have to be willing to accept a larger risk. In this case the individual is more likely to want to concentrate on one or two assets (or gambles) and put all oftheir eggs in that basket and hope for the best. If it turns out well the actual return is likely to be higher than it would have been under a diversification strategy; however, they are more likely to lose using this approach as well. So while the expected return may be the same, without diversification the risk is far greater which is why the actual return could be larger.

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CHAPTER 6 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) A zero-coupon bond refers to a bond that A) does not pay any coupon payments because the issuer is in default. B) promises a single future payment. C) pays coupons only once a year. D) pays coupons only if the bond price is above face value.

At the most basic level, a bond is

A) a loan that involves that a contract. B) the transfer of funds from a lender to a borrower. C) a financial arrangement that involves the transfer of funds to a government or business entity. D) a financial arrangement that involves the current transfer of resources from a lender to a borrower, with a transfer back at some time in the future.

A consol is A) another name for a zero-coupon bond. B) a bond with a maturity date exceeding 10 years. C) a bond that makes periodic interest payments forever. D) a form of a bond that is issued quite often by the U.S. Treasury.

A pure discount bond is also known as a

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A) consol. B) fixed payment loan. C) coupon bond. D) zero-coupon bond.

The most common form of zero-coupon bonds found in the United States is A) AAA rated corporate bonds. B) U.S. Treasury bills. C) 30-year U.S. Treasury bonds. D) municipal bonds.

Most corporate bonds are A) consols. B) coupon bonds. C) municipal bonds. D) fixed-payment loans.

7) Which one of the following best expresses the formula for determining the price of a U.S. Treasury bill that matures n periods from now per $100 of face value when the interest rate is i? A) $100/(1 + i) n B) $100(1 + i) C) $100/(1 + i) D) 1 + $100/(1 + i) n

Once you buy a coupon bond, which one of the following can change?

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A) coupon rate B) coupon payment C) face value D) yield to maturity

Which one of the following makes fixed payments indefinitely? A) amortized loan B) consol C) coupon bond D) zero-coupon bond

10) A 10-year Treasury note as a face value of $1,000, a price of $1,200, and a 7.5% coupon rate. Based on this information, we know the A) present value is greater than its price. B) current yield is equal to 8.33%. C) coupon payment on this bond is equal to $75. D) coupon payment on this bond is equal to $90.

11) If the annual interest rate is 5% (.05), the price of a one-year Treasury bill per $100 of face value would be A) $95.00. B) $97.50. C) $95.24. D) $96.10.

12)

If the annual interest rate is 5% (.05), the price of a six-month Treasury bill would be

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A) $97.50. B) $97.59. C) $95.25. D) $95.00.

13)

If the annual interest rate is 5% (.05), the price of a three-month Treasury bill would be A) $98.79. B) $95.00. C) $98.75. D) $97.59.

14) Why is the price of a one-year Treasury bill per $100 of face value different from the price of a three-month Treasury bill per $100 of face value if the annual interest rate is the same for both?

A) One is zero-coupon bond and the other is a traditional coupon bond. B) For bond price calculations, n and i must be expressed in the same units of time. C) There is no difference since the annual interest rate is the same for both Treasury bills. D) Bond prices and interest rates move in opposite directions for bonds that are shorter than one year in duration.

15) The relationship between the price and the interest rate for a zero-coupon bond is best described as A) volatile. B) fluctuating. C) inverse. D) non-existent.

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16)

When a loan is amortized, it means the A) borrower is in default. B) principal and interest are paid off by the borrower over the life of the loan. C) interest is due entirely at the maturity date. D) principal in never repaid, only interest.

17)

Most home mortgages are good examples of A) consols. B) zero-coupon bonds. C) coupon bonds. D) fixed-payment loans.

18)

The price of a coupon bond can best be described as the A) present value of the face value. B) future value of the coupon payments. C) future value of the coupon payments and the face value. D) present value of the face value plus the present value of the coupon payments.

19) The difference in the prices of a zero-coupon bond and a coupon bond with the same face value and maturity date is simply A) zero, since they are the same. B) the present value of the final payment. C) the present value of the coupon payments. D) the future value of the coupon payments.

20)

The price ( P) of a consol offering an annual coupon payment ( C) is best expressed by

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A) F/ C. B) C (1 + i). C) C/(1+ i). D) C/ i.

21) If a consol is offering an annual coupon of $50 and the annual interest rate is 6%, the price of the consol is A) $47.17. B) $813.00. C) $833.33. D) $8333.33.

22) Historically, governments might want to reduce interest rates on consols and would then convert them into new consols with the lower interest rate. If the original consol had a coupon of $25 with an interest rate of 4%, and it was converted into a new consol with the same coupon of $25 and an interest rate of 3.5%, how would the price of the consol change? A) It would rise to $625.00. B) It would rise to $714.29. C) It would fall to $625.00. D) It would fall to $714.29.

23)

Yield to maturity

A) is equal to the coupon rate if the bond is held to maturity. B) is the same as the coupon rate. C) will exceed the coupon rate if the bond is purchased for face value. D) is the same as the coupon rate if the bond is purchased for face value and held to maturity.

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24)

When the price of a bond is above face value, the yield to maturity will A) be below the coupon rate. B) be above the coupon rate. C) equal the current yield. D) equal the coupon rate.

25) Which one of the following correctly summarizes the relationship among a bond’s price and its coupon rate, current yield, and yield to maturity? A) If Bond price > Face Value then Coupon rate < Current yield < Yield to maturity. B) If Bond price = Face Value then Coupon rate < Current yield < Yield to maturity. C) If Bond price < Face Value then Coupon rate > Current yield > Yield to maturity. D) If Bond price < Face Value then Coupon rate < Current yield < Yield to maturity.

26) A 15-year bond is currently priced at $900 and pays a semi-annual coupon payment of 8%. The par value is $1,000. What is the yield to maturity? A) 4.62% B) 8.00% C) 9.24% D) 10.00%

27)

When the price of a bond is below the face value, the yield to maturity will A) be below the coupon rate. B) be above the coupon rate. C) equal the current yield. D) equal the coupon rate.

28)

When the price of a bond equals the face value the

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A) yield to maturity will be above the coupon rate. B) yield to maturity will be below the coupon rate. C) current yield is equal to the coupon rate. D) yield to maturity is greater than the current yield.

29)

If the purchase price of a bond exceeds the face value, the yield to maturity A) is greater than the coupon rate because the capital gain is positive. B) will equal the current yield. C) will be less than the coupon rate because the capital gain will be negative. D) will be greater than the current yield.

30)

The current yield of a bond A) is another term for the coupon rate. B) is another term for the yield to maturity. C) equals zero for a zero-coupon bond since these bonds have no coupon payments. D) is the difference between its future value and its present value.

31) A $1,000 face value bond purchased for $965.00, with an annual coupon of $60, and 20 years to maturity has a A) a current yield equal to 6.22%. B) a current yield equal to 6.00%. C) a coupon rate equal to 6.22%. D) a yield to maturity and current yield equal to 6.00%.

32) A $1,000 face value bond purchased for $965.00, with an annual coupon of $60, and 20 years to maturity has a

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A) current yield and coupon rate equal to 6.22% and a coupon rate above this. B) current yield equal to 6.22% and a coupon rate below this. C) coupon rate equal to 6.00% and a current yield below this. D) yield to maturity and current yield equal to 6.00%.

33)

In calculating the current yield for a bond, the A) coupon payment is ignored. B) present value of the capital gain/loss is ignored. C) present value of the final payment is the only important consideration. D) present value of the coupon payments is the only important consideration.

34)

In calculating the current yield for a bond, the A) coupon payment and purchase price is all that is needed. B) present value of the capital gain/loss is ignored. C) present value of the final payment is the only important consideration. D) present value of the coupon payments is the only important consideration.

35)

When the current yield and the coupon rate are equal, the bond is A) purchased at a discount. B) purchased at a price that equals the face value. C) a zero-coupon bond. D) purchased at a price that exceeds its face value.

36)

If a bond's purchase price equals the face value, the

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A) coupon rate equals the current yield, which is less than the yield to maturity. B) current yield equals the yield to maturity, which exceeds the coupon rate. C) coupon rate equals the yield to maturity, which equals the current yield. D) coupon rate does not equal the current yield, which does not equal the yield to maturity.

37) Which one of the following is not a reason why the yield to maturity can differ from the current yield? A) because the yield to maturity considers the capital gain/loss B) because the current yield focuses only on the coupon payment and the purchase price C) because most bonds are not purchased for face value D) because the current yield moves in the opposite direction from price

38) A $1,000 face value bond with one year to maturity that sells for $950 and has a $40 annual coupon has a A) current yield and yield to maturity of 4.00%. B) yield to maturity that equals the current yield. C) coupon rate of 4.00% and a current yield that is below this. D) current yield of 4.21%.

39) A $1,000 face value bond, with an annual coupon of $40, one year to maturity, and a purchase price of $980 has a A) current yield that equals 4.00%. B) coupon rate that equals 4.08%. C) current yield that equals 4.08% and a yield to maturity that equals 6.12%. D) A current yield that equals 4.08% and a yield to maturity that equals 4.0%.

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40) A 30-year Treasury bond as a face value of $1,000 and a price of $1,200 with a $50 coupon payment. Assume the price of this bond decreases to $1,100 over the next year. The oneyear holding period return is equal to A) −9.17%. B) −8.33%. C) −4.17%. D) −3.79%.

41)

Yields on government bonds from different countries A) differ substantially across countries. B) are essentially the same within a narrow range. C) differ but the spreads stay relatively similar. D) are essentially the same as the coupon rates for the bonds.

42)

In reading bond quotes, the A) bid price is usually above the ask price. B) ask price is fixed over the life of the bond. C) ask price is usually above the bid price. D) bid and ask prices must be equal as set forth by SEC regulations.

43)

A bond dealer's spread is A) the asking price less the bid price. B) the difference between the current yield and the yield to maturity. C) the bid price less the asking price. D) usually negative because the dealer makes a profit holding the bonds.

44)

The size of the bond dealer's spread is mainly a function of the

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A) purchase price of the bond. B) current yield. C) liquidity of the bond market. D) face value of the bond.

45)

The larger the bond dealer's spread the A) less liquid is the market for that bond. B) greater is the coupon rate for that bond. C) more liquid is the market for that bond. D) less risk there is for the dealer to hold that bond.

46)

The holding period return on a bond

A) can never be more than the yield to maturity. B) will equal the yield to maturity if the bond is purchased for face value and sold at a lower price. C) will be less than the yield to maturity if the bond is sold for more than face value. D) will be less than the yield to maturity if the bond is sold for less than face value.

47) One characteristic that distinguishes holding period return from the coupon rate, the current yield, and the yield to maturity is A) all of the other returns except the holding period return can be calculated at the time the bond is purchased. B) holding period return will always be the highest return. C) holding period return will usually be less than the other returns. D) only the holding period return includes the capital gain/loss.

48)

Holding period returns occur when the price of a bond

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A) is greater than capital gains which exceed the coupon payment. B) is greater than the coupon payment which exceeds capital gains. C) changes between the time of the purchase and the time of the sale. D) does not change between the time of the purchase and the time of the sale.

49)

Which one of the following best expresses the equation for holding period return? A) current yield + coupon rate B) yield to maturity − current yield C) current yield + capital gain D) coupon rate + capital gain

50)

In considering the holding period return, the longer the term of the bond the A) less important is the capital gain and the more important in the current yield. B) less important is the coupon rate and the more important is the current yield. C) less important is the capital gain. D) more important is the capital gain.

51)

The holding period return has relevance because A) most bonds are held by the original purchaser until maturity. B) most bonds are held by the original purchaser until they mature. C) bonds are frequently traded. D) current yields are not that important to bondholders.

52) Suppose there is a decrease in the price at which a bondholder sells her bond. In this case, the holding period return will

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A) increase, since yields and prices are inversely related. B) decrease, since this lowers the capital gain. C) be negative. D) equal the coupon rate.

53) If a one-year zero-coupon bond has a face value of $100, is purchased for $94, and is held to maturity the A) holding period return will exceed the yield to maturity. B) yield to maturity will exceed the holding period return. C) yield to maturity will be 6.38%. D) holding period return is 6.0%.

54)

Bond prices and yields A) move together in the same direction. B) do not change if the coupon is fixed. C) move together but are inversely related. D) are independent of each other.

55)

As bond prices increase A) the quantity of bonds supplied increases. B) the quantity of bonds supplied decreases. C) the quantity of bonds demanded increases. D) yields increase.

56)

The bond supply curve slopes upward because

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A) as bond prices rise, people holding bonds are more tempted to hold them. B) as bond prices rise, yields increase. C) for companies seeking financing, the higher the price of bonds, the more attractive it is to sell bonds. D) as bond prices rise, yields decrease.

57)

The bond demand curve slopes downward because A) at lower prices the reward for holding the bond increases. B) as bond prices fall so do yields. C) as bond prices fall, bonds are less attractive. D) as bond prices rise, yields increase.

58) If the quantity of bonds supplied exceeds the quantity of bonds demanded, bond prices would A) rise and yields would fall. B) fall and yields would rise. C) rise but yields will remain constant. D) fall and yields would fall.

59) The following equations express Demand and Supply in the bond market where Qd is quantity demanded, Qs is quantity supplied, and P is price per bond. What is the equilibrium price in this market? Demand: Q d = 1,000 – 6P/5 Supply: Qs = P – 100 A) $833.33 B) $500.00 C) $400.00 D) $100.00

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60) The following equations express Demand and Supply in the bond market where Qd is quantity demanded, Qs is quantity supplied, and P is price per bond. At a price of $400 in this market, Demand: Qd = 1,000 – 6P/5 Supply: Qs = P – 100 A) the market clears. B) there is an excess supply of bonds. C) there is an excess demand for bonds. D) the bond market is in equilibrium.

61)

If the quantity of bonds demanded exceeds the quantity of bonds supplied, bond prices A) would rise and yields would fall. B) would fall and yields would increase. C) will rise and yields will remain constant. D) will rise and yields would increase.

62)

If the U.S. government's borrowing needs increase, all other factors constant, the A) demand for bonds will decrease. B) price of bonds will increase. C) supply of bonds will increase. D) yields on bonds will decrease.

63)

If the U.S. government's borrowing needs decrease, all other factors constant, the A) supply of bonds will increase. B) demand for bonds will decrease. C) price of bonds will decrease. D) price of bonds will increase.

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64)

If the U.S. government's borrowing needs increase, all other factors constant, the A) price of bonds will increase. B) supply of bonds will increase. C) demand for bonds will decrease. D) supply of bonds and the demand for bonds will both increase.

65) If the U.S. government's borrowing needs increase, in the bond market this would be seen as the A) bond demand curve shifting right. B) bond supply curve shifting right. C) bond demand curve shifting left. D) bond supply curve shifting left.

66) as

If the U.S. government's borrowing needs increase, in the bond market this would be seen

A) the bond demand curve shifting right. B) a movement up the bond supply curve. C) the bond demand curve shifting left. D) the bond supply curve shifting right.

67)

As general business conditions improve, ceteris paribus, in the bond market A) the bond demand curve would shift left. B) the bond supply curve would shift left. C) bond prices would decrease. D) bond prices would increase.

68)

As general business conditions deteriorate, all other factors constant,

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A) the demand for bonds will decrease. B) the supply of bonds will increase. C) bond prices will decrease. D) bond yields will increase.

69)

As general business conditions improve, all other factors constant, the A) price of bonds will increase. B) yield on bonds will increase. C) bond demand curve shifts right. D) bond supply curve shifts left.

70)

As general business conditions deteriorate, all other factors constant, A) the bond supply curve will shift left. B) there will be a movement down the existing bond supply curve. C) the bond demand curve shifts left. D) the price of bonds will decrease.

71)

When expected inflation increases, for any given nominal interest rate the A) cost of borrowing increases and the desire to borrow decreases. B) real interest rate increases. C) bond supply curve shifts to the left. D) cost of borrowing decreases and the desire to borrow increases.

72) When expected inflation decreases for any given nominal interest rate, all of the following occur except the

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A) real interest rate decreases. B) bond supply curve shifts to the left. C) cost of borrowing increases and the desire to borrow decreases. D) price of bonds increases.

73)

When expected inflation increases, for any given nominal interest rate the A) bond demand curve shifts right. B) bond supply curve shifts right. C) price of bonds increases. D) yield on bonds will increase.

74)

When expected inflation increases, for any given nominal interest rate the A) real cost of repayment for bond issuers increases. B) real return for bondholders increases. C) real cost of repayment for bond issuers decreases. D) bond demand curve shifts right.

75) If the federal government were to offer larger tax breaks on the purchase of new equipment for businesses, all other factors constant, we would expect to see the A) bond demand curve shift right. B) bond supply curve shift left. C) bond supply curve shift right. D) bond demand curve shift left.

76)

Which one of the following would lead to an increase in bond supply?

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A) a decrease in government spending relative to revenue B) an increase in corporate taxes C) a decrease in expected inflation D) an improvement in general business conditions

77)

Ceteris paribus, which one of the following would lead to a decrease in bond demand? A) an increase in expected inflation B) an increase in wealth C) a decrease in risk D) a decrease in liquidity

78)

An increase in the nation's wealth, all other factors constant, would cause the A) bond supply curve to shift left. B) bond demand curve to shift left. C) bond supply curve to shift right. D) bond demand curve to shift right.

79)

An increase in the nation's wealth, all other factors constant, would cause A) bond prices to fall and yields to increase. B) bond prices and yields to increase. C) bond prices to rise and yields to decrease. D) the bond supply curve to shift right.

80)

A decrease in the nation's wealth, all other factors constant, would cause

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A) the bond demand curve to shift left. B) bond prices to rise. C) interest rates to decrease. D) the bond supply curve to shift left.

81)

An increase in expected inflation for any given nominal interest rate will cause the A) bond supply curve to shift to the left. B) bond demand curve to shift to the right. C) price of bonds to decrease. D) price of bonds to increase.

82)

A decrease in expected inflation for any given nominal interest rate will cause A) bond prices to increase and interest rates to decrease. B) bond prices to decrease and interest rates to increase. C) the bond demand curve to shift to the left. D) the bond supply curve to shift to the left.

83)

An increase in expected inflation for any given nominal interest rate will cause A) the real return to bondholders to decrease. B) a movement down the bond demand curve, but no change in the bond demand curve. C) the bond demand curve to shift right. D) the price of bonds to increase.

84) Suppose that the expected return on bonds falls relative to other assets. In the bond market this will result in

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A) the bond supply curve shifting left. B) a movement down the bond demand curve. C) a shift to the left of the bond demand curve. D) an increase in the price of bonds.

85) Suppose that the return on assets other than bonds falls. In the bond market this will result in a(n) A) movement down the bond demand curve. B) shift to the left of the bond demand curve. C) increase in the price of bonds. D) shift to the left of the bond supply curve.

86)

The return on bonds rises relative to other assets; in the bond market this will result in A) the price of bonds falling and the yields increasing. B) a rightward shift in the bond supply curve. C) a shift to the left of the bond demand curve. D) an increase in bond prices.

87)

If interest rates are expected to rise, the bond prices will A) not change until interest rates actually change. B) fall, due to the demand for bonds decreasing. C) rise, as people seek capital gains. D) move in the same direction as the expected change in interest rates.

88)

If interest rates are expected to fall, bond prices will

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A) fall as the demand for bonds decreases. B) remain constant until interest rates actually change. C) fall as people fear capital losses in the future. D) increase due to the demand for bonds increasing.

89) Suppose that general business conditions improve, and at the same time, wealth increases. Based on this information, we know that A) bond prices increase. B) yield to maturity decreases. C) the real interest rate increases. D) the quantity of bonds increases.

90) If the risk on foreign government bonds increases relative to U.S. government bonds, the price of U.S. government bonds should A) not change since U.S. government bonds are free of default risk. B) decrease since people will bail out of all government bonds. C) increase as the demand for these bonds increases. D) not be affected because the two types of bonds are traded in different markets.

91) The demand for U.S. government bonds has been high relative to other bond issues because A) the liquidity of other bond issues is high relative to U.S. government bonds. B) the U.S. bond market has low transaction spreads due to high illiquidity. C) the market for U.S. government bonds has been more liquid than most if not all other bond markets. D) U.S. government bonds have higher default.

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92) Ceteris paribus, a decrease in expected inflation in the bond market will have a relatively large effect on the prices of bonds prices because the bond demand curve A) will shift right as will the bond supply curve. B) will shift right but the bond supply curve shifts left. C) and supply curves will shift left. D) will shift left as the bond supply curve shifts right.

93) Which one of the following statements about the result of a deterioration in business conditions that also causes a decrease in a nation's wealth is false? A) The impact on bond prices will be ambiguous since both the bond demand and supply curves shift left. B) The price of bonds will increase if bond supply decreases more than bond demand. C) Interest rates will increase if bond demand decreases more than bond supply. D) Neither bond demand nor bond supply will shift.

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94) The market for bonds is initially described by the supply of bonds, S 0, and the demand for bonds, D 0, with the equilibrium price and quantity being P 0 and Q 0. An increase in the nation’s wealth, all else constant, would cause the

A) bond supply curve to shift to S 1. B) bond demand curve to shift to D 1. C) bond supply curve to shift to S 2. D) bond demand curve to shift to D 2.

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95) The market for bonds is initially described by the supply of bonds, S0, and the demand for bonds, D0, with the equilibrium price and quantity being P0 and Q0. Suppose that the expected return on bonds falls relative to other assets. In the bond market this will result in the

A) bond supply curve shifting to S 1. B) bond demand curve shifting to D 1. C) bond supply curve shifting to S 2. D) bond demand curve shifting to D 2.

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96) The market for bonds is initially described by the supply of bonds, S0, and the demand for bonds, D0, with the equilibrium price and quantity being P0 and Q0. If the federal government were to offer larger tax breaks on the purchase of new equipment for businesses, all other factors constant, we would expect to see the

A) bond supply curve to shift to S 1. B) bond demand curve to shift to D 1. C) bond supply curve to shift to S 2. D) bond demand curve to shift to D 2.

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97) The market for bonds is initially described by the supply of bonds, S0, and the demand for bonds, D0,with the equilibrium price and quantity being P0 and Q0. If the U.S. government's borrowing needs decrease, all other factors constant,

A) bond supply curve will shift to S 1. B) bond demand curve will shift to D 1. C) bond supply curve will shift to S 2. D) bond demand curve will shift to D 2.

98) Fly-By-Night Inc. issues $100 face value, zero-coupon, one-year bonds. The current return on one-year, zero-coupon U.S. government bonds is 3.5%. If the Fly-By-Night bonds are selling for $92.00, what is the risk premium for these bonds? A) 8.7% B) 1.5% C) 5.2% D) 8.0%

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99)

Default risk is the risk associated with A) the bond issuer not being able to make the promised payments. B) the illiquidity associated with small issues. C) the effect on bond prices caused by changes in market rates of interest. D) changes in the expected inflation rate.

100)

Consider the following bonds. Which is subject to the greatest interest-rate risk? A) a 30-year fixed-rate mortgage (fixed payment loan) B) a consol C) a Treasury bill D) a 20-year corporate bond

101) Consider a zero-coupon bond with a $1,100 payment in one year. Suppose the interest rate decreases from 10% to 8%. The price of this bond A) increases from $1,000 to $1,018. B) increases from $1,000 to $1,375. C) decreases from $110 to $88. D) decreases from $1,210 to $1,188.

102) Consider a one-year corporate bond that has a 20% probability of default. The payoff on the bond is $2,000 if the corporation does not default. The interest rate is 10%. If buyers of this bond are risk-neutral, this bond will sell for A) $400. B) $909.09. C) $1,454.54. D) $1,600.

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103) A student receives a five-year loan to pay for a $2,000 used car. The lender and the student agree to an 8% interest rate on a fixed-rate loan. Expected inflation was estimated to equal 2.5%, but it unexpectedly decreases to 2%. Which one of the following is true? A) The real interest rate decreased. B) The student is made worse off because her real cost of borrowing is higher. C) The lender is made worst off because his real return on the car loan is lower. D) Both the student and the lender benefit.

104)

Which of the following is true of interest-rate risk?

A) It is the risk that the coupon rate for a bond will change, affecting current bondholders' coupon payments. B) It refers to the probability that a borrower will default on debt obligations. C) It is the risk that the face value of a bond will change before maturity. D) Individuals owning long-term bonds are exposed to greater interest-rate risk.

105) U.S. government bonds that provide for bondholders to receive a fixed rate of interest plus the change in the consumer price index were designed to remove A) default risk. B) liquidity risk. C) inflation risk. D) interest-rate risk.

106) The U.S. Treasury issues bonds where the return is indexed to the consumer price index. We should expect that these bonds, relative to other U.S. Treasury bonds, will have

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A) lower price and lower return due to the decreased risk. B) lower price and a lower fixed return since the demand for them should be higher. C) higher price and higher fixed return since we always seem to have some inflation. D) higher price and lower return due to the decreased risk from inflation in holding these bonds.

107)

Inflation risk results from A) risk that the bond’s return differs from the risk-free rate. B) a mismatch between an individual's investment horizon and a bond's maturity. C) the difficulty an investor may face in selling a bond before it matures. D) an investor’s uncertainty about the real value of the payments that occur over time.

108)

Interest-rate risk results from A) bond prices being fixed over the life of the bond. B) a mismatch between an individual's investment horizon and a bond's maturity. C) the fact that most people hold bonds until they mature. D) inflation being uncertain.

109)

Interest-rate risk would not matter to a holder of a A) U.S. government bond. B) U.S. government bond indexed for inflation. C) U.S. government bond who plans on selling it in one year. D) U.S. government bond that plans on holding it until it matures.

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SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question. 110) Suppose a family member approaches you to borrow $2,000 for the down payment on an automobile. You have the cash available in a savings account that currently earns 5% annual interest. You and the family member consider the following repayment options. (i) borrower repays $259 each year over the next ten years (ii) borrower repays $300 each year over the next five years, plus a lump-sum payment of $895 in the fifth year. (iii) borrower repays you $2,100 at the end of one year. For each of the options above, show that the present values of each option are approximately equal. Then, relate each of the options above to the four types of bonds, indicating which option is equivalent to which type of bond. Explain why.

111) Consider a $1,000.00 face value bond with a $55 annual coupon and 10 years until maturity. Calculate the current yield; the coupon rate and the yield to maturity under each of the following: (a) the bond is purchased for $940.00 (b) the bond is purchased for $1,130.00 (c) the bond is purchased for $1,000.00

112) Calculate the holding period return for a $1,000 face value bond with a $60 annual coupon purchased for $970.00 and sold three years later for $1,060.00.

113)

Could the holding period return ever be less than the yield to maturity? Explain.

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114)

Use the example of a consol to show how bond prices and yields are inversely related.

115) Notice the following model of a bond market. In each situation given, explain what happens to the bond price and yield and why.

(a) expected inflation increases (b) the return on bonds rises relative to other assets (c) the federal government deficit increases

116) In 2017, the World Bank launched specialized “pandemic bonds” intended to provide financial support to developing countries facing the risk of a pandemic. The bonds offered investors high interest payments in return for taking on the risk of losing a certain amount or all of their money if pandemics occur. In March 2020, the price of these bonds plunged. Use Supply and Demand in the market for these bonds to illustrate why the price dropped at that time.

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117) Calculate the price of a zero-coupon bond that has an interest rate of 6.65% (.0665), a face value of $100.00 and six months to maturity.

118) Calculate the monthly payment for a 30-year mortgage, where the amount borrowed is $100,000 and the annual interest rate is 6.0%.

119) Calculate the price of a $1,000 face value bond that offers a $45 annual coupon, and has six years to maturity, when the interest rate is 6.0% (0.060).

120) Which bond will have a higher yield to maturity, a $1,000 face value bond with a 5.0% coupon rate that sells for $900; or a $1,000 face value bond with a $50 annual coupon that sells for $1,050? Explain your choice.

121) Compute the change in the price of a five-year (until maturity) $1,000 face value zerocoupon bond that currently yields 7% when expected inflation increases from 3% to 4%.

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122) Suppose that the interest rate on a conventional 30-year mortgage is currently 8%. You receive a call from a mortgage broker who offers you a 30-year adjustable rate mortgage at 2% that is adjusted once each year. Evaluate each mortgage in terms of the following: risk that the monthly payment will change over the next 30 years and interest-rate risk.

123)

Explain the relationship between coupon rate (or coupon yield) and current yield.

124) Explain why the bid-ask spread (which is the difference in price a dealer is willing to buy the bond for and the price at which the dealer sells the bond) on most municipal bonds would be greater than the spread on U.S. Treasury bonds.

125) The U.S. Treasury offers several ways to purchase U.S. government bonds. There are the traditional coupon bonds and Treasury Inflation-Indexed Securities. How do these bonds differ from their traditional counterparts?

126) In the late 1990s, the U.S. government ran a surplus for the first time in decades. It instituted a buyback program, whereby the Treasury bought outstanding government bonds. How would this program affect the bond market price, yield, and quantity of bonds? How might it affect the liquidity of government bonds?

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127) Explain why the holding period return, as an economic measure, does not have the same significance as current yield or yield to maturity.

128) Suppose that a bond is purchased at a discount (meaning that it is sold for less than face value). Could the yield to maturity ever be less than the coupon rate? Could the holding period return be less than the coupon rate? Explain.

129) In mid-2004 there was speculation that the Federal Reserve would be raising interest rates before the end of the year. How would this news affect the bond market and why?

130) Use our model of the bond market (supply and demand) to explain what happens if an economy continued to grow at robust rates for a long period of time.

131) How can a bond mutual fund report a return of over 13% when the coupon rate of the bonds they are holding are just 7% and interest rates are falling?

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132) At the time the government of Bulgrovia issued new bonds, they issued them at a price that reflected the risk-free rate because investors had no concerns regarding default risk, so did not require a risk premium. That risk-free rate was 4%. These bonds currently have one year to maturity and you notice the yield is 20%. Can you calculate the probability that the Bulgrovian government will default?

133) Consider two investors: one is risk-neutral and the other is risk-averse. How do they each assess a risk premium?

134) Explain why two countries with the same average rate of inflation may not present the same inflation risk for holders of those countries' bonds?

135) The text identified the various sources of risk for bonds. Are U.S. Treasury TIPS bonds free from risk? Explain.

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136) If you were going to issue bonds, would you prefer to be in a country where the average inflation rate is 3% inflation but fluctuates wildly, or in a country with a higher, 4% expected inflation rate that is stable (meaning it's always 4%). Explain.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 137) You win your state lottery. The lottery officials offer you the option of taking your winnings in one lump-sum payment, or fixed annual payments for the next 20 years. The sum of the 20 annual payments is larger than the lump-sum payment. Before deciding, what are the key factors you will want to consider that could influence your decision?

138) Consider the factors that affect bond demand and bond supply. Describe how the following are likely to change during a period of robust economic growth: wealth, default risk, and general business conditions. For each, state how the factor is likely to change, and discuss the implications for bond demand/supply, bond price, and yield. Bond prices tend to decrease during periods of high economic growth. What does this reveal about which of these factors is important?

139) Many people are worried that, with the growing number of people that are retiring in the United States, the federal government will need to borrow large amounts of money to finance the Social Security System. If we assume that Social Security taxes and the current eligibility age remain constant, explain the likely impact this will have on bond markets.

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Answer Key Test name: Chap 06_6e 1) B 2) D 3) C 4) D 5) B 6) B 7) A 8) D 9) B 10) C 11) C 12) B 13) A 14) B 15) C 16) B 17) D 18) D 19) C 20) D 21) C 22) A 23) D 24) A 25) D 26) C Version 1

27) B 28) C 29) C 30) C 31) A 32) B 33) B 34) A 35) B 36) C 37) D 38) D 39) C 40) C 41) A 42) C 43) A 44) C 45) A 46) D 47) A 48) C 49) C 50) D 51) C 52) B 53) C 54) C 55) A 56) C Version 1

57) A 58) B 59) B 60) C 61) A 62) C 63) D 64) B 65) B 66) D 67) C 68) A 69) B 70) A 71) D 72) C 73) B 74) C 75) C 76) D 77) A 78) D 79) C 80) A 81) C 82) A 83) A 84) C 85) C 86) D Version 1

87) B 88) D 89) D 90) C 91) C 92) B 93) D 94) B 95) D 96) A 97) C 98) C 99) A 100) B 101) A 102) C 103) B 104) D 105) C 106) D 107) D 108) B 109) D

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110) The present values are calculated as follows: (i) Fixed-payment loan. The borrower repays a loan in fixed annual payments for a pre-determined period of time. Present value of fixed payment loan = Fixed payment/(1 + i) + Fixed payment/(1 + i)2 +… + Fixed payment/(1 + i)n = $259/(1 + 0.05) + $259/(1 + 0.05)2 +… + $259/(1 + 0.05)10 = $2,000 (ii) Coupon bond. The borrower repays the loan in fixed annual payments ("coupons") and pays a one-time lump sum payment in the last year of the loan ("face value"). Present value of coupon bond = PCB = Coupon payment/(1 + i) + Coupon payment /(1 + i)2 +… + Coupon payment /(1 + i)n + Face value/(1 + i)n = $300/(1 + 0.05) + $300/(1 + 0.05)2 + …+ $300/(1 + 0.05)5 + $895/(1 + 0.05)5 = $2,000 (iii) Zero-coupon bond. The borrower repays the principal plus interest in one annual payment, with no intermediate payments. Price of zerocoupon bond = Payment/(1 + i) = $2,100/(1 + 0.05) = $2,000 111) We can use a financial calculator to solve for each of these. The easiest answer is to realize the coupon rate will not change; it is $55/$1,000 or 5.50% (.055). The current yield, which is the coupon divided by the purchase price will vary for each: for (a) the current yield is 5.85%,for (b) it is 4.87%, and for (c) it is 5.50%. The yield to maturity will also vary: for (a) it is 6.33%, for (b) it is 3.90%, and for (c) it is 5.50%. 112) The holding period return is 9.02%. Here we have to consider the present value of the three coupon payments as well as the present value of the capital gain that results from purchasing the bond for $970 and selling it for $1,060. 113) This is possible under the condition that the bond is sold before it matures for an amount less than the face value. If this happened then the holding period return would be less than the yield to maturity. Version 1

114) A consol is a bond that pays a fixed payment forever but does not mature. In calculating the price of a consol we use the formula Price = Coupon/interest rate. This simple formula shows the inverse relationship between price and interest rate since price is on the left and interest rate is in the denominator on the right. 115) (a) If expected inflation increases the demand for bonds will decrease and the supply will increase. Both of these will reinforce each other, causing the bond prices to fall and interest rates to increase. (b) If the return on bonds rises relative to other assets, the bond demand curve will shift to the right, causing bond prices to increase and interest rates to decrease. (c) If the federal budget deficit increases, the bond supply curve will shift to the right, causing the bond prices to fall and interest rates to increase.

116) In March of 2020, the Corona virus erupted into a worldwide pandemic. The likelihood of losing money on the pandemic bonds increased greatly as more and more countries experienced outbreaks. Whole countries attempted to lock down their populations and stop all nonessential business. A recession was impending. As general business conditions worsened, the supply bond supply would shift left—which would increase prices, ceteris paribus. However, as central banks implemented expansionary fiscal policy, inflation fears increased. The increases in expected inflation shifted supply to the right and also shifted demand to the left causing prices to fall. As stock markets plummeted, consumer wealth fell, which also decreased demand. Expected returns on these bonds fell, decreasing demand. Risk soared, which also decreased demand. All of these contributions to decreasing demand for the pandemic bonds led to plunging prices. 117) We can use the formula from the text where Price (P) = Face value/(1 + i) n. In this case, P = $100/(1 + .0665) 0.5, which equals $96.83.

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118) If we use 360 months for the 30 years and convert the 6.0% annual rate to a monthly rate of 0.48676%. This is found by solving (1 + im) = (1.06) 1/12 where im = 0.0048676. Using a financial calculator, we find the monthly payment equals $589.37. 119) Using a financial calculator the price of the bond is $926.24. We insert $1,000 for the face (future) value; $45 for the annual payment, 6.0 for the annual interest rate, 6 for the N (or years) and solve for P (or PV on most calculators). 120) The bond that is selling for $900 will. Both bonds have the same coupon rate, 5%, and they have the same maturity, so the bondholder's returns from the coupons are equal. What differentiates the two is that the bondholder who purchases the bond for $900 will also receive a capital gain, which increases his/her yield to maturity. 121) The bond currently will sell for $712.99. Once the expected inflation increases by 1%, the bondholders would want to keep the same real return, which would drive the bond yield up to 8%. This increase in bond yield will drive the price down to $680.58, or a decrease of more than 4.8% of the bond's price. 122) The fixed-rate mortgage protects the borrower and the lender from any risk that the monthly payment will change. Whether the interest rate increases (reducing the present value to the lender) or decreases (increasing the present value to the lender), the payment is always the same. The risk that the present value of the mortgage will change because of a change in interest rates is the interest-rate risk. The adjustable rate mortgage has no interest-rate risk (because the present value is adjusted), but there is considerable risk that the monthly payment will change.

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123) The coupon rate is simply the annual coupon divided by the face value. The current yield is the annual coupon divided by the price of the bond. The only time these should equal each other is when the price of the bond equals the face value. If the price is greater than the face value the current yield should be less than the coupon rate. If the price of the bond is less than the face value, the current yield should be greater than the coupon rate. 124) Spreads are the difference between the dealer's bid and asked prices. Since dealers are ready to buy or sell the bond, they must carry an inventory, which means they accept risk just like any other bondholder would. One of these risks is liquidity risk, which is the risk of not being able to sell the bond when you would like. Since the market for U.S. Treasury bonds is far more liquid than would be the market for any single municipal bond, the dealer of the municipal bond would face greater liquidity risk and require a larger spread. 125) Inflation-indexed securities protect the borrower against inflation risk. If inflation is higher than expected, this will reduce bond prices for the traditional government bonds, but not the inflation-indexed bonds. 126) The buyback of government bonds would reduce bond supply, increasing the bond price, reducing the yield, and decreasing the quantity of bonds. 127) One of the things economists do is try to explain behavior, or decisions people make. Current yield and yield to maturity are a priori measures, meaning we can calculate these prior to actually making the purchase of the bond. The holding period return cannot be calculated a priori, it is only calculated after the bond is purchased; to a certain degree it represents a "sunk" cost.

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128) If a bond is purchased for less than face value, the yield to maturity will always exceed the coupon rate. For the yield to maturity to be less than the coupon rate the price of the bond would have to exceed the face value. On the other hand, the holding period return could be less than the coupon rate. Even if a bond is purchased for less than face value, there is no guarantee it will sell before the maturity date for an amount that is at or above the face value; in fact it could sell for an amount well below the actual purchase price. 129) The speculated increase in interest rates by the Federal Reserve would cause the value of bonds to decrease. As we saw in the text, an increase in the expected future interest rate makes bonds less attractive. This will lower the demand for bonds, causing bond prices to decrease and yields to increase. Moreover, the change in bond prices and yields will occur before the actual interest rate changes since existing and prospective bondholders will act on their expectations. 130) Growth in the economy should result in greater supply of bonds, the bond supply curve shifting right, as more firms seek resources to finance expansion and inventories. The increase in supply by itself would result in lower bond prices and higher interest rates. From the demand side, the robust economy should also cause an increase in wealth. The increases in wealth would cause bond demand to increase (the curve shifts right), which would drive up bond prices and decrease interest rates. The net effect will be determined by which shift is larger. If supply shifts by an amount greater than demand, the bond prices will fall and yields will rise. On the other hand, if demand increases by more than supply, the bond prices will rise and yields will fall.

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131) The bond mutual fund is advertising its holding period return. As illustrated in the text, if a 20-year, 7-percent coupon bond with a face value of $100 is sold before maturity when interest rates have fallen to 6.5%, the price of that bond will rise to $106.50. The $6.50 of capital gain plus the $7.00 coupon payment represent a one-year holding period return of 13.5%. As the text notes, this is why past performance cannot guarantee future returns; if rates rise instead of fall the holding period return will not be as favorable. 132) The simple answer is no. A risk-premium is a measure of the premium required by investors to accept risk; it is not a direct measure of the risk of default. We could only determine this if investors are riskaverse. If that were true then, we can calculate the probability fairly easily by realizing the probability the bond will not default can be expressed by 1.04/1.20, which equals 0.867. If we subtract this from 1.0 we obtain the probability of default, which is 0.133. 133) The risk-neutral investor seeks a risk premium that has the price of the bond (and its subsequent yield) such that the price equals the expected value (the sum of the payoffs times the probabilities). The riskaverse investor would offer a price less than this (and therefore seek a higher yield) since he/she requires additional compensation for risk. Therefore, the risk-averse investor's risk premium would be greater. 134) As the text points out, while the expected (or average) inflation can be the same, the standard deviation around this expected rate presents different amounts of risk. The higher the standard deviation, the greater the risk. For countries where inflation is volatile, the standard deviation around their average expected rate will be greater, and therefore their bonds will present greater inflation risk.

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135) These bonds are free from two of the main sources of risk that make holding bonds risky. U.S. Treasury bonds are free from default risk, and the TIPS bonds also remove the inflation risk. However, the risk still present with these bonds is the interest-rate risk. If the bondholder does not plan on holding these bonds until maturity, changes in the interest rate (specifically increases) can result in capital losses or returns less than expected. 136) Even though the 4% expected rate is higher, it is stable. As we saw, the inflation risk isn't really the risk from inflation; it is the risk that results from unexpected changes in inflation which then can significantly alter the real interest rate, and therefore the real returns bondholders receive. Because bondholders tend to be risk-averse, they would want to be compensated for the inflation risk, and since the inflation risk results from the fluctuations in the rate of inflation, the returns required by bondholders in the country where the average expected rate is 3% but volatile are likely to be higher than the required returns on the bonds in the higher but stable inflation country. This explains, at least partially, why the central banks in many developed countries strive for inflation stability. Stable prices will lead to lower inflation risk and a more efficient bond market.

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137) Although this is certainly a pleasant decision to think about, the options presented do require serious thought. You should start by finding the interest rate that equates the present value of the 20 payments with the lump sum. Next, compare this rate to the interest rate you think you could safely earn on the lump-sum if you invested it. If the market offers a higher interest rate, then this is a reason you may wish to take the lump sum. Although morbid, you should also consider your own life expectancy. If you do not think you are going to live another 20 years, you would certainly want to take your winnings early. Lifestyle is also important as is the degree of risk aversion you exhibit. One advantage to taking the payments over 20 years is that it is a form of expenditure discipline that may prevent you from going through the funds quickly (though it is highly likely that you will find plenty of sources that will loan you funds for the assignment of the winnings to them). If you are a person that benefits from external discipline, the 20-year payout may be more attractive. While this certainly is not an exhaustive list, it does show that many of the factors discussed in the chapter come into play in making a decision such as this one.

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138) (i) Wealth affects bond demand and is likely to increase during an economic expansion. Households experience an increase in the value of their total assets (including stocks, for example). This leads to an increase in bond demand, increase in bond price, and decrease in yield. (ii) Default risk affects bond demand. The risk of default is likely to decrease during an economic expansion because borrowers are more likely to honor their debts. This leads to an increase in bond demand, increase in bond price, and decrease in yield. (iii) General business conditions affect bond supply. These improve during economic booms. This leads to an increase in bond supply, decrease in bond price, and increase in yield. If bond prices tend to decrease during periods of robust growth, this tells us that the improvement in general business conditions has a larger effect on the bond market than changes in wealth or default risk. 139) If the Social Security Administration (SSA) finds that it will need to borrow to finance its obligations this will cause the bond supply to increase, a shift to the right of the bond supply curve. All other factors constant, this will cause bond prices to fall and yields to increase. The yields on all bonds will rise, however, since the U.S. government, and the SSA is a government agency, is usually viewed as the risk-free rate from a default standpoint. Since the yields on these bonds will likely increase, this will cause the yields on all bonds to rise since all other bonds have their respective risk premiums, which are then added to the risk-free return.

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CHAPTER 7 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) The bond rating of a security reflects the A) size of the coupon payment relative to the face value. B) likelihood the lender/borrower will be repaid by the borrower/issuer. C) return a holder is likely to receive. D) size of the coupon rate relative to other interest rates.

The two best known bond rating services are A) the Federal Reserve and Moody's Investment Services. B) the Federal Reserve and the U.S. Treasury. C) Standard & Poor's and the Wall Street Journal. D) Standard & Poor's and Moody's Investment Services.

Investors usually obtain bond ratings from A) private bond-rating agencies. B) the annual tax returns of the issuer. C) the U.S. government from publicly available information. D) public Information made available by the bond issuers.

Which one of the following assigns widely followed bond ratings? A) the Federal Reserve B) the U.S. Treasury C) the New York Stock Exchange D) Standard & Poor's

Which one of the following assigns widely followed bond ratings?

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A) the Federal Reserve B) the Wall Street Journal C) Moody's Investor Service D) NASDAQ

What is the highest bond rating assigned by Standard & Poor’s? A) AA B) EEE C) AAA D) A

The lowest rating for an investment grade bond assigned by Moody's is A) Baa. B) A. C) BBB. D) Aa.

Bonds rated as "highly speculative" are A) rated so because they guarantee high returns for the buyer. B) commonly referred to as junk bonds. C) ranked just above investment grade by Standard & Poor's. D) rated so because they do not have any default risk.

9) Which one of the following would be most likely to earn an AAA rating from Standard & Poor's?

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A) a 10-year bond issued by Canada B) a bond issue by a new vegetarian fast-food chain C) a 10-year bond issued by a state or municipality D) shares of stock in Coca-Cola

10)

Once a bond rating is assigned, it

A) never changes over the life of the bond. B) can change as the financial position of the issuer changes. C) can only change if the rating change is approved by the Securities and Exchange Commission. D) can change on the next bond from the issuer but is fixed for the current bond.

11)

Commercial paper refers to A) the financial publications read by the CEOs of public corporations. B) any debt security with a maturity exceeding one year. C) short-term collateralized securities issued only by corporations. D) unsecured short-term debt issued by corporations and governments.

12)

Most commercial paper is A) issued with maturities exceeding one year. B) issued with maturities between 50 and 75 days. C) used exclusively for short-term financing needs. D) issued by foreign companies doing business in the United States.

13) In 2011, several credit rating agencies around the world downgraded their credit ratings of the U.S. federal government, including S&P. This change in S&P’s rating, specifically, might be illustrated by which one of the following changes?

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A) a change from a rating of C to Ca B) a change from a rating of A to Baa C) a change from a rating of BB to BBB D) a change from a rating of AAA to AA+

14)

If a bond's rating improves, it should cause the bond’s price A) and yield to increase, all other factors constant. B) and yield to decrease, all other factors constant. C) to increase and its yield to decrease, all other factors constant. D) to decrease and its yield to increase, all other factors constant.

15)

If a bond's rating improves, we would expect

A) the demand for this bond to increase, all other factors constant. B) the demand for and the yield of this bond to increase, all other factors constant. C) the demand for this bond to decrease, and its yield to increase, all other factors constant. D) both the demand for and the price of the bond to decrease, all other factors constant.

16)

Bonds issued by the U.S. Treasury are referred to as benchmark bonds because A) they are always purchased for a premium. B) they are highly liquid and virtually free of default risk. C) all bonds from national governments are labeled as benchmark bonds. D) all bonds from the U.S. government have the same rate of interest.

17)

The risk spread is

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A) the difference between a bond's purchase price and selling price. B) the difference between the bond's yield and the yield on a U.S. Treasury bond of the same maturity. C) less than 0 (zero) for a U.S. Treasury bond. D) assigned by a bond-rating agency.

18)

The risk spread A) is also known as the default-risk premium. B) should have a direct relationship with the bond's price. C) should have an inverse relationship with the bond's yield. D) is always constant.

19) In a March, 2020, Moody’s Analytics Report, chief economist Mark Zandi reported that credit spreads in the bond market have sharply widened. This is a signal of A) heightened investor angst. B) positive investor expectations for the future. C) future ratings upgrades for speculative bonds. D) decreasing rates for speculative-grade commercial paper.

20)

All of the following are true about the risk spread except that it should A) be higher for highly speculative bonds than investment grade bonds. B) have a direct relationship with the bond's yield. C) have an inverse relationship with the bond's price. D) have a direct relationship with the bond's price.

21)

The default-risk premium

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A) is negative for a U.S. Treasury bond. B) is also known as the risk spread. C) must always be greater than 0 (zero). D) is assigned by a bond-rating agency.

22)

The default-risk premium A) should vary directly with the bond's yield and inversely with its price. B) is less than 0 (zero) for a U.S. Treasury bond. C) should be lower for a highly speculative bond than for an investment-grade bond. D) should vary directly with the bond's yield and the bond's price.

23)

The risk structure of interest rates says A) the interest rates on a variety of bonds will move independently of each other. B) lower rated bonds will have higher yields. C) U.S. Treasury bond yields always change by more than other bonds. D) interest rates only compensate for risk during recessions.

24) Comparing Moody’s Aaa corporate bond yield to the yield on 10-year U.S. Treasury bonds, the spread increased from 1.14 on January 3, 2020, to 2.81 on March 23, 2020. What does this type of increase signal? A) There is an increase in confidence in the U.S. economy. B) Consumers are less willing to take on riskier investments. C) The economy is heading for an expansion in economic activity. D) Borrowers can pay lower interest rates to get investors to take risks.

25)

U.S. Treasury securities are considered to carry no risk spread because

Version 1

A) they are the closest thing to default-risk free that an investor can obtain. B) the prices of U.S. Treasury bonds never change. C) the yields on U.S. Treasury bonds never change. D) the yields on U.S. Treasury bonds are always low.

26)

The risk structure of interest rates refers to the

A) relationship among the interest rates of bonds with different maturities. B) relationship among the interest rates of bonds from different issuers with the same maturities. C) relationship among the interest rates of bonds from the same issuer but different maturities. D) additional interest required to compensate the buyer for the longer maturity of the bond.

27) pay

A borrower who has to pay an interest rate of 8% rather than 6% due to risk spread will

A) $20 more in interest annually for every $100 borrowed. B) 33.3% higher interest in dollar terms. C) 2% in net interest. D) less interest in total over the life of the loan.

28)

Which one of the following is true? A) Long-term bond yields move together but short-term yields do not. B) Short-term bond yields move together but long-term yields do not. C) U.S. Treasury Bill yields are lower than the yields on commercial paper. D) Long-term bond yields are usually the same as short-term yields.

29)

Taxes play an important role in bond returns because

Version 1

A) all interest from owning bonds is taxed. B) all governments (federal, state, municipal) tax bonds similarly. C) some bond interest is exempt from some government taxation, so after tax returns across bonds can vary considerably. D) only U.S. Treasury bonds are tax-exempt, so investors should always seek higher returns from other bonds.

30)

Municipal bonds are issued by A) cities only. B) the U.S. Treasury, but the proceeds can only be used by cities. C) states and cities, but their interest is taxable only at the federal level. D) states and cities and their interest is exempt from U.S. government taxation.

31) Fatima holds a one-year $200 face value, taxable bond with a coupon rate of 5%. Suppose she faces a tax rate of 20%. How much tax will she pay for income earned on the investment? And, what is the return on the investment when taxes are taken into account? A) She will pay $2 in taxes and earn a return of 4%. B) She will pay $2 in taxes and earn a return of 5%. C) She will pay $10 in taxes and earn a return of 4%. D) She will pay $10 in taxes and earn a return of 5%.

32) An investor in a 30% marginal tax bracket, earning $10 in interest annually for a $100 U.S. Treasury bond A) earns a 10% after-tax return because interest on U.S. Treasury bonds is tax exempt at the federal level. B) earns a 3% return after-tax. C) would be indifferent between this bond and a municipal bond offering $7 annually per $100 of face value, assuming the same default risk and liquidity characteristics. D) earns a 1% return after-tax.

Version 1

33)

The yield on a tax-exempt bond A) equals the taxable bond yield times one minus the tax rate. B) is equal to the yield on a U.S. 30-year bond. C) is called the risk-free yield. D) only applies to foreign bonds because they are exempt from U.S. income taxes.

34) Holding liquidity and default risk constant, an investor earning 6% from a tax-exempt bond who is in a 25% tax bracket would be indifferent between that bond and a taxable bond with a(n) A) 8% yield. B) 4.5% yield. C) 6.25% yield. D) 7.5% yield.

35) Holding liquidity and default risk constant, an investor earning 4% from a tax-exempt bond who is in a 20% tax bracket would be indifferent between that bond and a taxable bone with a(n) A) 7.5% yield. B) 8.0% yield. C) 5% yield. D) 6% yield.

36)

Municipal bonds are usually purchased by investors A) who are retired and have no other taxable income. B) looking for securities to buy for their IRA accounts. C) who live in cities with high municipal tax rates. D) who are in high marginal tax brackets.

37) Suppose the tax rate is 25% and the taxable bond yield is 8%. What is the equivalent taxexempt bond yield? Version 1

A) 2% B) 2.3% C) 6% D) 6.9%

38) In 2003, ratings agencies downgraded bonds issued by the State of California several times. How will this affect the market for these bonds? A) Yields on these bonds will decrease and the yield on Treasury bonds will increase. B) The yield on these bonds will not change, nor will the yield on Treasury bonds. C) The yield on these bonds and on Treasury bonds will both decrease. D) Yields on these bonds will increase.

39)

Tax-exempt bonds

A) generate higher returns for the bondholder when purchased through a tax-exempt retirement account. B) are not affected by changes in yields on taxable bonds. C) are most beneficial to those who pay higher income tax rates. D) include U.S. Treasury securities because the Internal Revenue Service does not charge income tax on interest earned from these bonds.

40) If a local government eliminates the tax exemption on municipal bonds, we would expect to see A) an increase in the yield on taxable bonds. B) a decrease in the gap in yields on taxable and tax-exempt bonds. C) a decrease in the yield on municipal bonds. D) municipal bonds will become more attractive to investors.

41) Which one of the following is not typically used for qualifying mortgages as prime or subprime?

Version 1

A) the borrower’s income B) the borrower’s credit score C) the borrower’s ethnicity D) the loan to value ratio

42) According to the Expectations Theory of the term structure, if interest rates are expected to be 2%, 2%, 4%, and 5% over the next four years, which yield is the closest to the yield on a three-year bond today? A) 2.7% B) 4% C) 4.3% D) 8%

43) Suppose the economy has an inverted yield curve. According to the expectations hypothesis, which one of the following interpretations could be used to explain this? A) Interest rates are expected to fall in the future. B) Investors prefer bonds with less default risk. C) Investors prefer bonds with less interest-rate risk. D) The term spread is positive.

44)

The following figures illustrate which theory concerning interest rates?

Version 1

A) term structure of interest rates B) risk structure of interest rates C) liquidity premium theory D) expectations hypothesis

45)

Which fact about the term structure is the expectations theory unable to explain?

A) why interest rates on bonds with different terms to maturity tend to move together over time B) why yields on short-term bonds are more volatile than yields on long-term bonds C) why longer-term yields tend to be higher than shorter-term yields D) why long-term bond yields are influenced by expected future short-term bond yields

46)

Which fact about the term structure is the expectations theory able to explain?

A) why interest rates on bonds with different terms to maturity tend to move together over time B) why yields on short-term bonds are more volatile than yields on long-term bonds C) why longer-term yields tend to be higher than shorter-term yields D) why long-term bonds usually are less liquid than short-term bonds with the same default risk

47)

The risk spread on bonds fluctuates mainly because A) taxes tend to increase over time. B) bond rating agencies are often inconsistent. C) new information about a borrower’s financial condition becomes available. D) people do not change their attitudes toward risk quickly.

48)

In the fall of 1998 we saw an increase in the risk spread because

Version 1

A) the risk spread always increases as we approach the end of the year. B) the Russian government defaulted on some of its bonds. C) there was an extraordinarily large amount of corporate fraud being reported in 1998. D) there was a significant increase in U.S. income tax rates.

49) As a global pandemic erupted in early 2020, lenders began to reevaluate the relative risk of holding various types of bonds. An important early signal in this type of crisis-induced analysis is A) interest rate spreads. B) tax implications of holding bonds. C) availability of public information about bonds. D) the size of coupon payments relative to the face value of bonds.

50) A company that continues to have strong profit performance during an economic downturn when many other companies are suffering losses or failing should see A) an increase in the yield of their bonds and the price of the bond increases. B) their bond rating maintained or actually increase. C) the demand for their bonds decrease and their yields decrease. D) the demand and price for their bonds decrease.

51)

Bonds with the same tax status and ratings A) always have the same yield. B) can have different yields due to different maturities. C) should sell for the same price. D) will still have different yields depending on their face values.

52)

The U.S. Treasury yield curve

Version 1

A) shows the relationship among bonds with the same risk characteristics but different maturities. B) assumes maturities are constant, and reflects the difference in risk. C) always has a positive slope. D) always has a negative slope.

53) During a recession you would expect the difference between the commercial paper rate and the yield on U.S. T-bills of the same maturity to A) be the same since their maturities are the same. B) increase, reflecting the possibility of higher default risk for commercial paper. C) decrease. D) fluctuate rarely.

54) Which one of the following statements pertaining to the yield curve is false? The yield curve A) usually slopes upwards. B) shows the difference in default risk between securities. C) shows the relationship among bonds with the same risk characteristics but different maturities. D) can be flat or downward sloping depending on market conditions.

55) If the federal government replaced the current income tax with a national sales tax, the price of A) corporate bonds and municipal bonds would rise. B) municipal bonds would rise and corporate bonds would not change. C) corporate bonds would fall while the price of municipal bonds would rise. D) municipal bonds would fall while the price of corporate bonds would rise.

56)

Interest on most bonds issued by states is usually exempt from

Version 1

A) state income tax but not federal. B) from federal income tax but not state. C) both state and federal income taxes. D) from city income taxes.

57)

The term structure of interest rates A) always results in an upward sloping yield curve. B) represents the variation in yields for securities differing in maturities. C) usually results in a flat yield curve. D) usually results in a downward sloping yield curve.

58) Which one of the following statements is not true of the yield curve for U.S. Treasury securities? A) The yield curve usually slopes upward. B) The yield curve usually is inverted. C) The yield curve shows the relationship among securities of different maturities. D) The yield curve can shift over time.

59) In examining the yield curve for U.S. Treasury securities, we find all of the following except which one? A) Long-term yields tend to be higher than short-term yields. B) Interest rates of different maturities tend to move together. C) Long-term rates tend to equal short-term rates. D) Yields on short-term securities are more volatile than yields on long-term bonds.

60)

When the yield curve slope is more upward sloping than usual, people are expecting

Version 1

A) an economic slowdown. B) the U.S. Treasury may default on its obligations. C) the Federal Reserve is going to ease monetary policy. D) a future rise in short-term interest rates.

61)

When the yield curve is downward sloping, A) people are expecting an economic slowdown. B) short-term yields are lower than long-term yields. C) people are expecting higher inflation in the future. D) people could be expecting a tightening in monetary policy.

62) Any theory of the term structure of interest rates needs to explain each of the following, except why A) short-term yields are more volatile than long-term yields. B) the yields of different maturities tend to move together. C) short-term yields are usually higher than long-term yields. D) long-term yields are usually higher than short-term yields.

63)

The expectations hypothesis assumes

A) a high level of uncertainty regarding the future of long-term yields. B) investors know the yields on bonds today and form expectations of the yields on short-term bonds in future time periods. C) securities of different maturities are not perfect substitutes for each other. D) the risk premium increases with longer maturities.

64)

The expectations hypothesis suggests the

Version 1

A) yield curve should usually be downward-sloping. B) yield curve should usually be upward-sloping. C) slope of the yield curve reflects the risk premium associated with longer-term bonds. D) slope of the yield curve depends on the expectations for future short-term rates.

65) The yield on a 30-year U.S. Treasury security is 6.5%; the yield on a 2-year U.S. Treasury bond is 4.0%. These data indicate A) the yield curve is downward-sloping. B) the yield curve is flat since the risk premium needs to be added for longer maturities. C) the yield curve is upward sloping. D) that people expect inflation to decrease in the future.

66) Assume the expectation hypothesis regarding the term structure of interest rates is correct. Then, if the current one-year interest rate is 4% and the two-year interest rate is 6%, then investors are expecting the future one-year rate to be A) 4%. B) 8%. C) 6%. D) 5%.

67) Assume the expectations hypothesis regarding the term structure of interest rates is correct. If the current two-year interest rate is 5% and the current one-year rate is 6%, then investors expect the future one-year rate to be A) 4%. B) 5%. C) 6%. D) 1%.

Version 1

68) Assume the expectations hypothesis regarding the term structure of interest rates is correct. If the current one-year interest rate is 3% and the one-year-ahead expected one-year interest rate is 5%, then the current two-year interest rate should be A) 3%. B) 5%. C) 4%. D) 8%.

69) Assume an investor has a choice of three consecutive one-year bonds or one three-year bond. Assuming the expectations hypothesis of the term structure of interest rates is correct, the A) average interest rate of the three consecutive one-year bonds should be less than the three-year bond to reflect the risk premium. B) interest rate of the three-year bond should equal the average interest rate of thethree one-year bonds. C) three consecutive one-year bonds must have the same interest rate. D) current one-year interest rate must equal the current three-year interest rate.

70)

According to the expectations hypothesis,

A) when short-term interest rates are expected to rise in the future, the long-term interest rates are equal to current short-term interest rates. B) when short-term rates are expected to remain constant in the future, the long-term interest rates are higher than current short-term interest rates. C) short-term bonds are perfect substitutes for long-term bonds. D) expectations of future short-term rates equal estimates of current short-term rates.

71) According to the expectations hypothesis, if investors believed that, for a given holding period, the average of the expected future short-term yields was greater than the long-term yield for the holding period, they would act so as to drive

Version 1

A) down the price of the short-term bond and drive up the price of the long-term bond. B) up the price of the short-term bond and drive down the price of the long-term bond. C) up the prices of both the short- and long-term bonds. D) down the prices of both the short- and long-term bonds.

72)

The expectations hypothesis cannot explain why A) yields on securities of different maturities move together. B) short-term yields are more volatile than long term yields. C) yield curves usually slope upward. D) long-term bonds usually are less liquid than short-term bonds with the same default

risk.

73) Under the expectations hypothesis, a downward-sloping yield curve suggests that investors expect future A) short-term interest rates to fall. B) short-term interest rates to rise. C) long-term interest rates to remain constant. D) short-term interest rates to remain constant.

74)

The expectations hypothesis assumes each of the following, except

A) long-term bond rates are equal to the average of current and expected future shortterm interest rates. B) bonds of different maturities are not perfect substitutes. C) bonds of different maturities have the same risk characteristics. D) bonds of different maturities are perfect substitutes.

75) Suppose that interest rates are expected to remain unchanged over the next few years. However, there is a risk premium for longer-term bonds. According to the liquidity premium theory, the yield curve should be

Version 1

A) upward-sloping and very steep. B) upward-sloping and relatively flat. C) inverted. D) vertical.

76) Suppose the economy has an inverted yield curve. According to the liquidity premium theory, which one of the following interpretations could be used to explain this? A) Interest rates are expected to rise in the future. B) Investors expect an economic slowdown. C) Investors are indifferent between bonds with different time horizons. D) The term spread has increased.

77) The economy enters a period of robust economic growth that is expected to last for several years. How would this be reflected in the risk structure of interest rates? A) an inverted yield curve B) a decrease in the term spread C) a decrease in the interest rate spread D) an increase in yields on tax-exempt bonds

78) If a one-year bond currently yields 4% and is expected to yield 6% next year, the liquidity premium theory suggests the yield today on a two-year bond will be A) more than 4% but less than 5%. B) 5%. C) 4%. D) more than 5%.

79) The addition of the liquidity premium theory to the expectations hypothesis allows us to explain why

Version 1

A) yield curves usually slope upward. B) interest rates on bonds of different maturities move together. C) long-term interest rates are less volatile than short-term interest rates. D) yield curves are flat.

80)

The reason for the increase in inflation risk over time is due to the fact that A) the inflation rate always increases over time. B) we always have inflation. C) it is more difficult to forecast inflation over longer periods of time. D) investors are more focused on nominal returns than real returns.

81) The risk premium that investors associate with a bond increases with all of the following except A) maturity. B) inflation risk increases. C) interest-rate risk. D) an improved bond rating.

82)

Under the liquidity premium theory, a flat yield curve implies A) there is no risk premium for longer-term maturities. B) short-term interest rates are expected to remain constant. C) short-term interest rates are expected to decrease. D) long-term interest rates are higher than short-term interest rates.

83) Under the liquidity premium theory, if investors expect short-term interest rates to remain constant, the yield curve should

Version 1

A) have a positive slope. B) have a negative slope. C) be flat. D) have an increasing slope.

84) Under the expectations hypothesis, if expectations are for lower inflation in the future than what it currently is, the yield curve's slope will A) become more upward-sloping. B) become flat. C) be negative. D) be vertical.

85)

When the growth rate of the economy slows, we would expect

A) the risk to increase for U.S. Treasury securities. B) the risk spread to increase more between U.S. Treasury Securities and Aaa securities than between Aaa and Baa securities. C) the risk spread to increase more between Aaa and Baa securities than U.S. Treasuries and Aaa securities. D) investors to purchase more junk bonds in search of a higher yield.

86)

A flight to quality refers to a move by investors A) away from bonds toward stocks. B) toward securities of other countries and away from U.S. Treasuries. C) toward precious metals and away from U.S. Treasury bonds. D) away from low-quality bonds toward high-quality bonds.

87) As a global pandemic erupts and consumers isolate at home, we would expect the risk spread between Baa bonds and U.S. Treasury securities of the same maturities to

Version 1

A) widen. B) narrow. C) disappear. D) remain relatively constant.

88) We would expect the risk spread between Baa bonds and U.S. Treasury securities of the same maturities to A) widen during periods of economic recession. B) remain relatively constant over the business cycle. C) decrease during economic slowdowns. D) increase during economic growth periods.

89) We would expect the relationship between the risk spread on Baa bonds and U.S. Treasury securities of similar maturities to A) vary directly with economic growth. B) show no variation over the business cycle. C) vary inversely with economic growth. D) be uncorrelated with economic growth.

90)

A flight to quality should result in the A) price of U.S. Treasury Securities rising and the price of corporate bonds rising. B) yield on U.S. Treasury Securities falling and the price of corporate bonds rising. C) yield on corporate bonds falling and the price of U.S. Treasury Securities rising. D) yield on U.S. Treasury securities falling and the price of corporate bonds falling.

91)

When the Russian government defaulted on its bonds in August 1998,

Version 1

A) risk spreads decreased significantly. B) yields on U.S. Treasury securities fell while yields on corporate bonds rose. C) yields on U.S. Treasury securities rose while prices of corporate bonds rose. D) risk spreads did not change.

92)

An inverted yield curve is a valuable forecasting tool because

A) the yield curve usually is inverted so it reflects a growing economy. B) the yield curve seldom is inverted and can signal an economic slowdown. C) investors are expecting higher short-term rates in the future, and this usually signals an economic slowdown. D) inverted yield curves signal better economic times are expected.

93)

The slope of the yield curve seems to predict the performance of the economy usually A) with a three-month lag. B) with a one-year lag. C) within a few weeks. D) with a two-year lag.

94)

A proposed increase in the federal income tax rate should

A) have no impact on the slope of the yield curve since the tax laws impact all maturities the same. B) cause the slope of the yield curve to become negative. C) increase the slope of the yield curve since it increases the risk premium of longer maturities. D) flatten the yield curve.

95) If their only concern were the cost of issuing municipal debt, how would you expect the mayors of most U.S. cities to respond to a revenue-neutral change in the federal income tax that sharply lowered the top marginal tax rate?

Version 1

A) Favorably, since this will significantly increase the demand for municipal bonds. B) Unfavorably, the demand for municipal bonds will fall and their yields will increase. C) Favorably, the price of municipal bonds should increase and their yields fall. D) No reaction, this should have no impact on municipal bonds at all.

96)

The terrorist attack on the World Trade Center on September 11, 2001,

A) triggered a flight to quality in the bond market. B) caused the demand for U.S. Treasury securities to fall and the demand for corporate bonds to rise. C) caused the price of U.S. Treasury securities to fall and the yields on corporate bonds to fall. D) did not have any significant impact since the risk on all bonds increased.

97) Interest rates on short-term U.S. Treasury bills turned negative on March 25, 2020. They inched back up into positive values shortly after, but they remained very low. In the case of negative interest rates, cash deposited at a bank yields a storage charge rather than an opportunity to earn interest income. If the central bank charges banks to store their reserves at the central bank, they are providing an incentive for banks to A) lend more money. B) charge higher interest rates. C) provide less liquidity in the economy. D) restrict loans to preferred customers only.

98) As the COVID-19 pandemic spread in 2020, many countries’ economies headed toward recession. Economic activity ground to a halt in many countries as people stayed home to slow the spread of the virus. What is the expected change in the risk spread when there is an impending recession? The risk spread A) narrows. B) widens. C) is unchanged. D) is not correlated to economic activity.

Version 1

99) As the COVID-19 pandemic spread in 2020, many countries’ economies headed toward recession. Economic activity ground to a halt in many countries as people stayed home to slow the spread of the virus. Using the term spread as an economic indicator, economists would expect the yield curve to A) become inverted as recession hit. B) have inverted approximately a year earlier. C) have become flat as recession hit. D) become inverted approximately a year after recession hit.

100)

Which one of the following suggests troubled economic times ahead? A) increases in the risk spread and an inverted yield curve B) decreases in the risk spread and an inverted yield curve C) increases in the risk spread and an upward-sloping yield curve D) decreases in the risk spread and an upward-sloping yield curve

101)

If the Federal Reserve surprises investors by announcing an easing of monetary policy A) it should have no impact on the slope of the yield curve. B) we should expect the yield curve to possibly become inverted. C) the yield curve would flatten. D) we should expect the yield curve to steepen.

102)

An increased risk of a financial crisis in the euro area should cause the A) demand for all government securities including U.S. Treasury securities to decrease. B) risk spread between U.S. Treasury bonds and other bonds to decrease. C) price of U.S. Treasury bonds to increase and the yield on other bonds to increase. D) price of U.S. Treasury bonds to increase and the yield on other bonds to decrease.

103) A permanent increase of borrowing by the U.S. Treasury to finance growing budget deficits would Version 1

A) result in U.S. Treasury yields being higher than high-grade corporate bonds. B) result in the price of U.S. Treasury bonds rising. C) cause the yield on U.S. Treasury bonds to increase, but still be lower than corporate bonds. D) result in lower yields on corporate bonds.

104)

The presence of a term spread that is usually positive indicates that A) the yield curve always slopes upward. B) bonds of similar risk but with different maturities are not perfect substitutes. C) we should expect the yield curve to usually be flat. D) we should expect the yield curve to usually slope downward.

105)

The interest-rate risk that is associated with bond investing

A) exists even if an investor plans on holding the bond to maturity. B) arises because of a mismatch between the investor's investment horizon and the maturity of the bond. C) is not reflected in the risk premium. D) can be eliminated by holding only consols.

106) Imagine a scandal that finds the officers of bond rating agencies have been taking bribes to inflate the rating of specific bonds. This should A) have no impact on the bond market since bond markets are highly efficient. B) decrease the demand for all bonds. C) increase the demand for U.S. Treasury securities and decrease the demand for corporate bonds. D) decrease the risk spread.

107) Under the expectations hypothesis, bonds of different maturities are assumed to be perfect substitutes because

Version 1

A) the risk premium is assumed to be negative. B) market forces would always have long-term interest rates equal the average of the current and expected short-term rate. C) expectations of future interest rates are uncertain and therefore cannot be included in the analysis. D) bond markets are very liquid.

108) A proposed increase in the federal income tax rates may actually be viewed favorably by many mayors of cities because A) it will allow them to also raise their tax rates. B) it will cause the demand for municipal bonds to increase and their yields to increase. C) people will pay less attention to local taxes. D) it will cause the price of municipal bonds to increase and their yields to decrease.

109) As technology allows information regarding the financial health of corporations to become easier to obtain, we should expect A) the risk spread to decrease. B) the role of bond rating agencies to become more important. C) a decrease in the number of participants in the bond market. D) the risk spread to increase.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 110) What is the main purpose (function) of bond rating services?

111)

Briefly describe the two different types of junk bonds (high-yield bonds).

Version 1

112)

What is meant by a subprime mortgage?

113) If an investor wants to compare commercial paper to a corresponding default-free investment, which security would they use and why?

114) How did asset-backed commercial paper (ABCP) rollover risk contribute to the financial crisis of 2007–2009?

115) An investor sees the current twelve-month rate at 4% and expects the following future twelve-month rate for each of the subsequent years; 4.5%, 5.5% and 6.0%. If this investor views a four-year maturity at 5.65% as equal to four consecutive one-year securities, what is their risk premium?

Version 1

116)

Why do economists pay particular attention to inverted yield curves?

117) If the yield curve is flat, using liquidity premium theory, what do you know about the expected future short-term interest rate?

118) Explain why many mayors of cities facing the need to borrow for infrastructure improvements, may not look favorably on a large federal income tax rate reduction?

119) What is the effective after-tax yield to an investor from a bond paying $70 per $1,000 annually, if the investor is in a 25% marginal tax bracket? Explain.

Version 1

120) Consider the following four investors. Rank each according to who has the most to gain from investing in 30-year tax-exempt municipal bonds. Each investor has $1,000 in a savings account that they plan to use to buy bonds. Explain briefly why you ranked the investors this way. (a) A 20-year-old college student who earns low income through working over summers and breaks. The student plans to graduate next year. (b) The CEO of a large company who is currently in the highest tax bracket. (c) A middle-income household saving up to move into a larger home. (d) A 60-year-old nurse who plans to retire at age 62. He uses a tax-exempt pension fund for all of his savings.

121) Using the information provided and the expectations hypothesis, compute the yields for a two-year, three-year, and four-year bonds. Time today 1 year from today 2 year from today 3 year from today

Expected 1-year Treasury yield 2.5% 3.5% 4% 4.5%

Now, suppose there is a risk premium attached to each bond. These risk premiums are given in the following table. Time one-year bond two-year bond three-year bond four-year bond

Version 1

Risk Premium 0% 0.5% 1% 2%

Using the information above and the liquidity premium theory, compute the yields for a twoyear, three-year, and four-year bonds. How does this yield curve compare to the one you computed using the expectations hypothesis?

122) What is the equivalent tax-exempt bond yield for a taxable bond with an 8% yield and a bondholder in a 35% marginal tax rate? Explain.

123) Assuming the expectations hypothesis is correct, use the information provided below to find the expected one-year interest rate for three years from now. Explain your answer.

124)

Any theory of the yield curve must be able to explain what three general conditions?

125) The usually upward-sloping yield curve indicates that long-term bonds have higher yields than short-term bonds. Why is this?

Version 1

126) Why can't the expectations hypothesis stand alone as an adequate theory to explain yield curves?

127)

What impact should an economic slowdown have on the risk structure of interest rates?

128) During economic slowdowns why would you expect the risk premium to increase the most between U.S. Treasury bonds and junk bonds?

129) When we compare GDP growth over time to the risk spread on Baa bonds compared to 10-year U.S. Treasury bonds for the same time frame, what relationship can be inferred?

Version 1

130) Describe the concept of “flight to quality” in terms of the Russian government default of August 1998.

131)

Why do yield curves usually slope upward?

132)

Explain why an inverted yield curve is a valuable forecasting tool.

133) Why might we expect to see a high correlation between increases in the risk structure of interest rates and the yield curve becoming inverted?

134) Does the expectations hypothesis allow for people to have a preference for longer-term investments? Explain

Version 1

135) Explain why most retired individuals are not likely to be heavily invested in municipal bonds.

136) At the beginning of 2006 the yield curve was usually flat, and sometimes downward sloping (inverted). This raised concerns that a recession might be on the way. But the slope of the yield curve is only part of the story. What else is important?

Version 1

137) Please use the graphs to show what happens to the risk (yield) differential in each situation and why.

Assume the corporate and Treasury bonds have the same maturity; a) If the corporate bonds are default-risk free, what could you tell about the price and yields of each? b) If the corporate bonds are now viewed as having the possibility of default, what happens in each market? c) If the corporate bonds are granted tax-exempt status, what happens in each market? d) If the corporate bonds have a longer maturity than the Treasury bonds what would happen?

138) Under the expectations hypothesis of the term structure of interest rates, explain the impact of a U.S. Treasury decision to phase out the 30-year bond and to only focus on 3-month, 1-year, 5-year, and 10-year bonds?

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139) We have heard the predictions regarding the large number of people that will be retiring over the next 25–50 years and the strain this is going to place on the federal budget. Assuming that federal borrowing will have to increase, what is the likely impact going to be on the risk and term structure (if any) of interest rates and why?

140) The paper-bill spread refers to the interest rate spread between commercial paper and Treasury bills with the same maturity. Is this a risk spread or a term spread? How do you expect the paper-bill spread is related to GDP growth? What is the intuition for this result? What does this imply about the yield curve?

141) Suppose that the Federal Reserve is concerned about rising inflation, so they increase short-term interest rates. How will this affect long-term rates and the yield curve? What does the slope of the yield curve reveal about the effectiveness of the Fed's policy? Explain in the context of the Liquidity Premium Theory.

142) In March of 2020, Argentina’s risk spread increased to levels not seen since 2005 as the coronavirus expanded globally. Why would the global pandemic be accompanied by an increase in the risk spread?

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Answer Key Test name: Chap 07_6e 1) B 2) D 3) A 4) D 5) C 6) C 7) A 8) B 9) A 10) B 11) D 12) C 13) D 14) C 15) A 16) B 17) B 18) A 19) A 20) D 21) B 22) A 23) B 24) B 25) A 26) B Version 1

27) B 28) C 29) C 30) D 31) A 32) C 33) A 34) A 35) C 36) D 37) C 38) D 39) C 40) B 41) C 42) A 43) A 44) D 45) C 46) D 47) C 48) B 49) A 50) B 51) B 52) A 53) B 54) B 55) D 56) C Version 1

57) B 58) B 59) C 60) D 61) A 62) C 63) B 64) D 65) C 66) B 67) A 68) C 69) B 70) C 71) B 72) C 73) A 74) B 75) B 76) B 77) C 78) D 79) A 80) C 81) D 82) C 83) A 84) C 85) C 86) D Version 1

87) A 88) A 89) C 90) D 91) B 92) B 93) B 94) A 95) B 96) A 97) A 98) B 99) B 100) A 101) D 102) C 103) C 104) B 105) B 106) C 107) B 108) D 109) A 110) These companies monitor the status of individual bond issuers and assess the likelihood that a lender/bondholder will be repaid by a borrower/issuer. 111) There are two types of junk bonds; there are the fallen angels, which were at one time investment grade bonds, but their issuer fell on hard times. The second type is original issue junk bonds, which originate as junk bonds because little is known about the issuer. Version 1

112) A subprime mortgage does not meet key standards of credit worthiness. 113) They should use the U.S. Treasury bill. The reason is U.S. Treasuries are the closest thing to default-free and the reason for the Treasury bill is that T-bills, like commercial paper have very short maturities, usually less than 360 days. 114) ABCP creates a mismatch between the long-term maturity of the asset (mortgage) and the short-term maturity of the liability (ABCP). When the ABCP matures, the issuers may have to borrow to meet their payment obligations, which creates rollover risk because of the possibility that the market for borrowing may have dried up. This is exactly what happened in the early days of the financial crisis of 2007– 2009. 115) 0.65% 116) Inverted yield curves can be highly useful for forecasting economic slowdowns. Usually the yield curve turning inverted predicts an economic slowdown, usually with a one-year lag. 117) If the yield curve is flat, the expected future short-term interest rate(s) must be lower than the current short-term rate because liquidity premium theory assigns a positive risk premium to longer maturities, which is why the yield curve usually slopes upward. 118) The interest earned on municipal bonds is exempt from federal income taxes. A reduction in the federal income tax rate decreases the attractiveness of these bonds. As a result of the decrease in demand, their prices will fall and their yields will need to increase to attract investors. 119) 5.25%. The $70 is taxed at 25%; leaving the bondholder with $52.50; which when divided by the $1,000 provides an effective yield of 5.25%

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120) (b), (c), (a), (d) The CEO has the most to gain because she is in the highest marginal tax break. Therefore, she would receive the largest benefit from investing in tax-exempt bonds. Similarly, the middle-income family will benefit, but their savings will not be as significant as those of the CEO. The 20-yearold college student earns low income, so her tax savings are relatively low. Finally, the nurse will receive no benefit from purchasing a taxexempt bond because he uses a tax-exempt pension to purchase his assets. Therefore, he saves nothing from buying a tax-exempt bond in lieu of a taxable bond.

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121) Using the information above and the liquidity premium theory, compute the yields for a two- year, three-year, and four-year bonds. How does this yield curve compare to the one you computed using the expectations hypothesis? Using the expectations hypothesis, the interest rates are as follows. 1-year: 2.5% (given) 2-year: 3% 3-year: 3.33% 4-year: 3.625% Using the liquidity premium theory, the interest rates are as follows. 1-year: 2.5% (given) 2-year: 3.5% 3-year: 4.33% 4-year: 5.625% Using the liquidity premium theory, the yield curve has a steeper positive slope. This is caused by the presence of a risk premium attached to the longer-term bonds. 122) 5.20%. The tax-exempt bond yield = (taxable bond yield) × (1 − tax rate). Substituting, the tax-exempt bond yield = (8%) × (1 − 0.35) = 5.20%

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123) The current four-year interest rate is 5.0% The current one-year interest rate is 4.0%

The expected one-year rate for one year from now is 5.0%

The expected one-year rate for two years from now is 5.5%

The general statement of the expectations hypothesis is that the interest rate on a bond with n years to maturity is the average of n expected future one year interest rates, which is

In this case n = 4 and we know int = 5.0%; using a little algebra allows us to solve for ie1t + 3. In this case 4 × 5 = 20 and subtract the sum of the first three short-term rates, which is 14.5; this leaves us 5.5% as the expected one-year rate for three years from now.

124) (1) The interest rates of different maturities will move together; (2) Yields on short-term bonds will be more volatile than yields on longterm bonds; and (3) Long-term yields are usually higher than short-term yields (the yield curve usually slopes upward). 125) Bondholders face both inflation- and interest-rate risk. The longer the term of the bond, the greater both types of risk. This implies that the risk premium increases with maturity. 126) The expectations hypothesis does a good job of explaining why interest rates of different maturities move together and for explaining why short-term rates are more volatile than long- term rates. What it cannot do is explain why yield curves usually are upward sloping. To use only expectations hypothesis implies that investors usually expect short-term interest rates to rise, which certainly is not the case.

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127) An economic slowdown should increase the risk premium on privately issued bonds since some firms may find it increasingly difficult to meet their financial obligations. It is important to note, however, that a slowdown or recession does not affect the risk of holding government bonds, which is why the risk spread increases for private bonds. 128) While it is true that during economic slowdowns most private bond issuers may feel increased difficulty, it is highly likely that firms that were already in a precarious position regarding their finances (junk bonds) would feel the most difficulty, thus significantly increasing the risk premium on those issues the most. 129) There seems to be an inverse relationship between GDP growth and the size of the risk spread. As GDP growth slows, the risk spread increases and vice versa. 130) The concept of flight to quality implies that during any economic downturn or turmoil in financial markets, investors (savers) will seek out high-quality bonds and shun low-quality bonds. This can have very significant impacts on the prices and yields of high- and low-quality bonds, adding to the volatility of financial markets. This was certainly what was observed when the Russia government defaulted. 131) The upward sloping yield curve is the most common since it includes the risk premium for longer maturities, and the risk premium increases with maturities. So even if investors expected short-term rates to remain constant, we would still observe an upward sloping yield curve. 132) An inverted yield curve is a valuable forecasting tool because it predicts a general economic slowdown. Even if short-term rates were expected to remain constant, the yield curve would slope upward. So an inverted yield curve signals an expected decrease in short-term interest rates.

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133) Both situations, the risk structure of interest rates increasing and the inverted yield curve, usually occur when a tight monetary policy is expected to lead to an economic slowdown. As a result, we would expect to see the risk spread increase in anticipation of economic slowdowns as we would view the inverted yield curve as an omen of an economic slowdown. 134) Not really; a key assumption of the expectations hypothesis is that bonds of different maturities are perfect substitutes, which basically implies that investors are indifferent between different maturities and that the yield of consecutive short-term investments will equal the yield of a long-term investment over the same investment horizon. 135) Most retired individuals are not working and as a result, they may find themselves in a relatively low marginal tax bracket. As a result, the tax-exempt status of municipal bond interest is less beneficial and hence, less attractive to them. 136) A recession is associated both with an inverted yield curve and with an increase in the risk spread. As illustrated in the text, in 2006 Baa bond yields were less than two percentage points above U.S. Treasury yields, well below levels associated with recessions.

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137) a) If corporate bonds are default-risk free, the risk premium would be 0 (zero) so the price and yield should be the same across both bonds. b) If the corporate bonds are viewed as having the possibility of default, then the demand for corporate bonds will decrease, and the demand for Treasury bonds will rise; this will result in the price of Treasury bonds increasing while their yields fall, where in the corporate bond market, the price decreases and the yields increase. c) If corporate bonds are granted tax-exempt status, the demand for these bonds will increase, their price will rise and the yield will fall. In the Treasury bond market, the demand will decrease, so the price will fall and the yield will increase. d) If corporate bonds have longer maturity than the Treasury bonds, the demand for the corporate bonds will decrease since longer maturity bonds carry more risk. This will cause their price to fall and the yield to rise. In the Treasury bond market, the demand will increase, thus the price of the bond will rise and the yield will decrease.

138) This decision should not have any impact in terms of the Expectations hypothesis. A key assumption of the Expectations hypothesis is savers look at all maturities as perfect substitutes because they have certainty regarding the future of interest rates. Thus, the phasing out of the 30-year bond would have no impact on the decisions made by savers.

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139) Increased borrowing by the U.S. Treasury may certainly cause interest rates to increase, however the U.S. Treasury will still be the benchmark bond or the default-free bond. Other bonds will still have their yield calculated by taking the default-free rate (now perhaps higher) and adding the appropriate risk premium to this rate. As a result, greater borrowing by the U.S. Treasury would likely result in an increase in all yields. Regarding the term structure, this may depend on the selection of instruments used by the Treasury. For example, if the Treasury decides to finance the deficit by issuing only long-term (30year) bonds, the price of these bonds will adjust to market forces. In order to attract buyers their price may fall and their yields increase causing the slope of the yield curve to increase. A similar argument could be offered if the Treasury decided to finance the deficit with mainly short-term instruments, in this case the subsequent market forces may cause the slope of the yield curve to decrease. 140) This is a risk spread because it compares the commercial paper yield to a benchmark bond, a U.S. Treasury bill. Since the terms are the same, this is not a term spread. Risk spreads generally increase when GDP growth decreases. This happens because the default risk premium associated with commercial paper increases when economic conditions worsen. This doesn't imply anything about the yield curve per se, because the two bonds have the same terms to maturity. 141) The increase in the short-term rate may cause the yield curve to flatten. In addition to raising short-term rates, the policy will reduce expected inflation, reducing the risk premium associated with longerterm bonds. The more the curve flattens, the greater the confidence of investors that the central bank will limit future inflation.

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142) When the pandemic started, governments advised citizens to isolate to slow the spread of the disease that had no cure or vaccine. This slowed economic activity worldwide. The increase in the risk spread in Argentina is just one example of changes that were occurring worldwide. When the overall growth rate of the economy slows or turns negative, it strains private businesses, increasing the risk that corporations will be unable to meet their financial obligations. The immediate impact of an impending recession, then, is to raise the risk premium on privately issued bonds. The economic slowdown doesn’t affect the risk of holding U.S. government bonds, though, so the spread increases.

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CHAPTER 8 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) Stock ownership A) increases risk in wealth portfolios. B) is not a widely held financial instrument. C) reduces efficient operation of the economy. D) benefits individuals by providing ways to diversify risk.

A share of common stock represents A) equity in a company. B) a loan to a company. C) a share in the company's debts. D) unlimited liability to the owner of the stock.

A share of common stock represents a(n) A) claim from a lender against a borrower. B) share in the company's debts. C) share of ownership of the company. D) unlimited liability to the owner of the stock.

Two characteristics that make owning stock attractive are A) unlimited liability and owners having first claim on assets. B) share prices that are relatively inexpensive and transferable. C) that each share represents a large percentage of ownership and dividends are fixed. D) dividends that are paid before any other distributions are made and transferability of

stocks.

Voting rights in a corporation are held by the

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A) board of directors. B) preferred stockholders. C) corporate bondholders. D) common stockholders.

The fact that common stockholders are residual claimants means the stockholders A) have a claim against the revenue that remains after everyone else is paid. B) receive their dividends before any other residuals are paid. C) are paid any past due dividends before other claims are paid. D) are paid before the bondholders but after any taxes are paid.

7) If a public corporation goes bankrupt and does not have enough assets to pay off all creditors, the stockholders A) are personally liable for the balance. B) who are residual claimants may have to pay in additional capital to cover the obligations. C) receive any dividends due before the other creditors are paid. D) cannot lose more than their investment.

Limited liability means that a stockholder of a corporation A) is liable for the corporation's liabilities, but nothing more. B) cannot receive dividends that exceed his/her investment. C) cannot lose more than their investment. D) is only responsible for any taxes that the corporation may owe but not its other debts.

Comparing home ownership and stock ownership over time,

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A) stock ownership provides a higher financial return, on average, but the home also provides a place to live. B) home ownership provides a higher financial return, on average, but stock ownership provides a share of company ownership. C) stock ownership provides a higher financial return, on average, but home ownership is risk-free. D) home ownership provides a higher financial return, on average, but stock ownership is adjusted for inflation.

10)

Stockholders A) have limited liability and no control over corporate leadership. B) can dislodge the managers of the corporation but not the board of directors. C) have unlimited liability and can dislodge members of the board of directors. D) can dislodge members of the board and have limited liability.

11)

Which one of the following is not a feature of common stock? A) Stockholders receive regular fixed payments on their shares. B) Stockholders have limited liability. C) Stock holders are residual claimants. D) Stockholders have voting rights.

12)

Both bondholders and stockholders A) are claimants. B) have voting rights. C) are shareholders in the company. D) receive fixed payments on their securities each year.

13)

Which one of the following statements is most correct?

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A) Managers, directors, and stockholders almost always share the same interest. B) Interests of managers and directors often conflict with stockholders' interest. C) Interests of managers and stockholders often conflict with directors’ interest. D) Interests of stockholders and directors often conflict with managers’ interest.

14)

Which one of the following stock price indexes is a price-weighted index? A) Dow Jones Industrial Average B) Standard & Poor's 500 Index C) Nasdaq D) Wilshire 5000

15)

An index number is valuable because A) the level of every index number itself provides critical information. B) it is more stable than the data it reflects. C) it provides a meaningful measurement scale to calculate percentage changes. D) it does not require any calculations to compute percentage changes.

16)

The Dow Jones Industrial Average is A) an index made up of the stock prices of the 100 largest corporations in the United

States. B) an index that measures the value of purchasing 100 shares in each of the corporations that make up the index. C) the average price of stock in 30 of the largest companies in the United States. D) the broadest measure of stock market performance.

17)

The Dow Jones Industrial Average is a

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A) simple average. B) price-weighted index. C) value-weighted index. D) total-value index.

18)

The Dow Jones Industrial Average

A) gives equal weight to a change in the price of the stock of any company in the index. B) reflects that a 10% increase in a share of stock selling for $30 will have the same effect on the index as a 10% increase in the price of a stock selling for $60. C) is a value-weighted index. D) gives greater weight to shares with higher prices.

19) If the Dow Jones Industrial Average is currently at 20,000 and the price of one stock included in the index increases by $10, the Dow Jones Industrial Average will A) not change; it is a value-weighted index. B) increase by 5.0%. C) increase by 0.5%. D) increase by 0.05%.

20) If the Dow Jones Industrial Average is at 20,205 and it is up 4% from the previous day, what was the index at the close of the market the previous day? A) 808 B) 19,428 C) 20,236 D) 21,013

21)

The stocks that make up the Dow Jones Industrial Average

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A) are dominated by the automobile industry. B) are the same ones that were originally used to construct the index. C) are not a broad measure of the market since they do not include any technology companies. D) have changed as the structure of the economy has changed.

22) If each company that made up the Dow Jones Industrial Average increased the number of their shares outstanding by 10%, but the share prices did not change, the value of the index would A) not change. B) increase by 10%. C) increase, but by less than 10%. D) decrease since there are more shares outstanding.

23)

The Standard & Poor's 500 Index differs from the Dow Jones Industrial Index because

A) it takes into account the stock prices of 500 of the largest firms, which is less than the DJIA. B) it is a price-weighted index, where the DJIA is a value-weighted index. C) larger firms are less important in the S&P 500 than in the DJIA. D) it takes into account the prices of more stocks and it uses a different weighting scheme.

24)

The Standard & Poor's 500 Index A) gives more weight to large companies than small companies. B) actually includes more than 500 of the largest corporations in the United States. C) is a price-weighted index. D) assigns equal weight to all the prices of all the stocks in the index.

25)

Considering the S&P 500 Index, if each company's stock price increased by 10%, the

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A) weights in the index would remain the same. B) companies with the most shares outstanding would have even greater weight after the increase. C) companies with fewer shares would gain more weight at the expense of the companies with greater shares. D) weights in the index would change to reflect the percentage changes in the prices of the various stocks.

26)

Which one of the following statements is false?

A) A value-weighted index is a better index to use to reflect changes in the economy's overall wealth. B) A price-weighted index is a better index to use to reflect the average change in the price of a typical share of stock. C) The Dow Jones Industrial Average is a price-weighted index. D) The S&P 500 is a price-weighted index.

27)

The Nasdaq Composite Index is A) a value-weighted index. B) a price-weighted index. C) made up of over 5000 companies traded on the NYSE. D) made of mainly older firms and is heavily weighted by manufacturing.

28)

The Nasdaq Composite Index is

A) made up of over 50,000 firms traded on the Over-the-Counter market. B) a price-weighted index. C) made up of mainly newer firms, and heavily influenced by technology and internet companies. D) the most broadly based index in use.

29)

The most broadly based stock index in use is the

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A) Nasdaq Composite Index. B) Wilshire 5000. C) Dow Jones Industrial Average. D) Standard and Poor's 500 Index.

30)

When studying world stock indexes, we observe that A) the S&P 500 is largest in terms of index value. B) most of the world's indexes are price-weighted. C) the indexes are very comparable. D) the indexes are comparable but only in percentage terms.

31)

When comparing stock indexes around the world, we

A) find that a given percentage change across all indexes has the same value. B) observe that they always move together. C) can see that the numeric change in indices allows investors to make easy comparisons of value. D) can examine their respective movements if we look at them as percentage changes.

32) People differ on the method by which stocks should be valued. Some people are chartists, while others are behaviorists. The basic difference between these groups is A) chartists rely on astrological charts to predict stock values, behavioralists rely on psychology. B) behavioralists are finance based, chartists study charts of investor psychology. C) chartists study charts of stock prices; behavioralists focus on investor psychology and behavior. D) chartists and behavioralists are the same in their approach; essentially there aren't any differences.

33)

The dividends that stockholders receive are

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A) fixed by contract and paid annually. B) distributions from profits. C) paid before all other obligations of the company are met. D) always equal to the average amount of interest paid to a bond holder, adjusting for the value of the holdings.

34) An investor starts with a $1,000 portfolio, and it loses 50% over the next year. The following year it gains 50% in value. At the end of two years the investor’s portfolio is worth A) $1,000. B) $500. C) $750. D) $950.

35) An investor starts with a portfolio valued at $500, and it loses 40% over the next 12 months. The following year it has a gain of 30%. At the end of two years the investor’s portfolio is worth A) $390. B) $450. C) $300. D) $410.

36) An investor has a portfolio valued at $1,000. Over the next twelve months it loses 75% of its value. What return is required over the following twelve months to restore the portfolio to its original value? A) 75% B) 200% C) 300% D) 25%

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37) An investor has a portfolio valued at $10,000. Over the next twelve months it loses 50% of its value. What return is required over the following twelve months to restore the portfolio to its original value? A) 100% B) 50% C) 200% D) 25%

38)

The dividend-discount model of stock valuation

A) is an application of the net present value formula. B) takes the net present value of expected dividends and add it to the future sale price of the stock. C) takes the net present value of the expected future price of the stock and adds the annual dividend. D) takes the annual dividend, adds it to the expected future selling price and divides by the number of years to get the current price.

39) A stock has an annual dividend of $10.00 and it is expected not to grow. It is believed the stock will sell for $100 one year from now, and an investor has a discount (interest) rate of 6% (0.06). The dividend-discount model predicts the stock's current price should be A) $94.67. B) $116.00. C) $103.77. D) $106.60.

40) A stock has a current annual dividend of $6.00 per year, and it is expected to grow by 3% (0.03) a year. It is expected that two years from now the stock will sell for $90.00 a share. If the interest rate is 5% (0.05), the dividend-discount model predicts the stock's current price should be

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A) $94.90. B) $93.29. C) $101.30. D) $94.30.

41) A stock currently does not pay an annual dividend, and an investor expects this policy to remain in force. She believes, however, the stock of this company will sell for $110.00 per share four years from now. If she has an interest (discount) rate of 7% (0.07), the dividend-discount model predicts the current price of this stock should be A) You cannot apply the model to this example since it requires a dividend be offered. B) $82.00. C) $83.92. D) $86.35.

42) Next year, the price of a stock is expected to be $2,200 and the stock will pay a $55 dividend. The interest rate is 10%. Based on the dividend-discount model, what is the current price of this stock? A) $1,980 B) $2,000 C) $2,050 D) $2,035

43) The price of a stock is currently $750 and the stock will pay a $43 dividend. The interest rate is 7.5%. Based on the dividend-discount model, what is the expected price of this stock for next year? A) $651.17 B) $657.67 C) $691.17 D) $763.25

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44) A company currently pays a dividend of $4.00 per share. It expects the growth rate of the dividend to be 3% (0.03) annually. If the interest rate is 6% (0.06) what does the dividenddiscount model predict the current price of the stock should be? A) $33.33 B) $66.67 C) $103.33 D) $137.33

45) A company currently pays an annual dividend of $6.50 per share. It expects the growth rate of the dividend will be 2.5% (0.025) annually. If the interest (discount) rate is 5% (0.05), what does the dividend-discount model predict the current price of the stock should be? A) $225.00 B) $257.50 C) $130.00 D) $266.50

46)

The dividend-discount model predicts that stock prices A) should be high when dividends are high. B) will be high when interest rates are high. C) will be higher when the growth rate of dividends is low. D) should be high when dividends are low.

47) Suppose that the current dividend for a stock is Dtoday, the expected dividend growth rate is r, and the interest rate is i. If we ignore risk, which one of the following represents the dividend-discount model formula for the fundamental price of a stock? A) D today/( i + g) B) ( i + g)/ D today C) D today(1 + g)/( i − g) D) D today/( i− g)

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48) Which one of the following statements is not true about how a share of stock resembles a consol? A) Neither the share of stock nor the consol have a maturity date. B) The annual dividend the stock pays resembles the coupon on a consol. C) The prices of both can be computed using a variation of the net present value formula. D) Owners of both are residual claimants.

49)

As a corporation uses more debt financing, the expected return to the stockholders A) decreases, and the standard deviation of the return decreases. B) increases, and the standard deviation of the return decreases. C) increases, and the standard deviation of the return increases. D) decreases, and the standard deviation of the return increases.

50) The fact that many corporations use debt financing as well as equity financing creates all of the following except which one? A) the opportunity for a greater expected return for the stockholders B) greater risk for the stockholders C) leverage for the stockholders D) consistently lower debt-to-equity ratios

51)

Without the stockholders' limited liability, the risk from the use of leverage would A) be significantly less. B) be significantly greater. C) still be the same. D) be irrelevant.

52) Consider the effect of business cycles on bondholders versus stockholders. We expect that business cycles will affect

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A) bondholders and stockholders about the same. B) bondholders more since the amount they receive depends on profits. C) stockholders more since they are residual claimants. D) bondholders more since they do not have any claim to property.

53)

In the event of bankruptcy, stockholders A) are paid before bondholders. B) receive at least their initial investment due to limited liability. C) could lose more than their initial investment. D) are the last to be paid and could end up losing what they have invested.

54)

As a company issues more debt, A) its leverage decreases. B) the share of financing from equity increases. C) the expected return to equity holders falls. D) risk increases.

55)

All other things equal, a decrease in the equity risk premium leads to a(n) A) increase in the required return on stock. B) decrease in the present value of stock. C) increase in the price of equity shares. D) decrease in dividend growth.

56) The basic dividend-discount model is a bit of an oversimplification for valuing stocks because it ignores

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A) expected dividend growth. B) the value of future dividends. C) the risk involved in holding stocks. D) stocks that do not pay dividends.

57) The required stock return an investor seeks can best be represented by which one of the following? A) Risk Premium − Risk-free Return B) Risk-free Return × Risk Premium C) (Risk-free Return + Risk Premium)/(1 + i) D) Risk-free Return + Risk Premium

58) Including risk in the dividend-discount model as shown here, which one of the following will cause an increase in the current price of a stock?

A) a decrease in the risk-free return B) a decrease in the current dividend C) a decrease in the dividend growth rate D) either an increase in the risk-free return or an increase in the current dividend

59) Including risk in the dividend-discount model as shown here, if a company reports that it is going to have a difficult time meeting its debt obligations, you would expect the Ptoday to

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A) fall since the risk-free return will rise. B) rise since the D today will likely fall. C) fall since the risk premium will likely rise. D) remain about the same until the D today actually changes .

60) Including risk in the dividend-discount model as shown here, suppose there is a reduction of the return provided on U.S. Treasury bonds. We should expect the current price of stocks to

A) increase since the risk-free return is now lower. B) decrease since U.S. Treasury bonds are safer. C) increase since the risk premium on the stocks will increase. D) stay the same; there is no effect on stock prices from this reduction.

61) Including risk in the dividend-discount model as shown here, the impact from rapid dividend growth on a stock's current price will be

A) negative, since the company is paying out profits to stockholders. B) positive since rapid dividend growth causes stockholders to expect higher future dividends. C) zero; only current dividends are used to determine the current price of a stock. D) positive, but only if the corporation does not have any debt.

62)

The theory of efficient markets assumes that

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A) prices of bonds, but not stocks, reflect all available information. B) the prices of all financial instruments reflect all available information. C) stock prices are relatively rigid because it takes a while for information to efficiently move through the market. D) the best approach to determining stock prices is to follow the chartists.

63)

The theory of efficient markets implies A) stock prices should be highly unpredictable. B) the price at which stocks currently trade only reflect past information. C) expectations do not play a role in stock prices because this isn't real information. D) the chartists are in fact correct that there are patterns in stock prices.

64)

If the theory of efficient markets holds, then

A) professional fund managers should be able to consistently beat the market average. B) a professional fund manager should really not expect to beat the market average consistently. C) a professional fund manager who beats the market average one year should be expected to beat the market average the next year. D) a professional fund manager who beats the market average one year should be expected to not beat the market average the next year.

65)

The theory of efficient markets A) rules out high returns due to chance. B) says insider information makes markets less efficient. C) allows for higher than average returns if the investor takes higher than average risk. D) assumes people have equal luck.

66)

The notion that stock prices reflect all current available information

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A) makes the risk of holding stocks greater. B) indicates that mutual fund managers will not, on average, outperform market averages. C) says stock prices should be more rigid than they are. D) makes it easier to predict the movements in the price of a stock.

67)

People who claim to have the ability to accurately predict the future prices of stocks A) are strong advocates of the theory of efficient markets. B) should be looked at with skepticism, unless they have information not available to

others. C) are unusually lucky, and should be listened to intently. D) are always psychologists.

68) In the first calendar quarter, a company issues a surprising report saying that it expects profits to rise in the fourth quarter. The theory of efficient markets says we should expect the price of the company's stock to A) rise in the fourth quarter when the higher profits are actually seen. B) fall immediately as stockholders will be disappointed about having to wait until the fourth quarter for higher profits. C) rise immediately on the expectation of higher profits in the future. D) rise around the third quarter since this information will take time to disseminate.

69)

According to the theory of efficient markets,

A) investors use rules of thumb to make choices about which stocks to buy and sell. B) investors are able to use forecasts based on the dividend-discount model to generate above-average returns. C) a portfolio manager who charges no commission should not, on average, outperform an individual investor with access to the same funds. D) the stock price should remain constant.

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70) According to the theory of efficient markets, mutual fund managers may be expected to earn above-average returns if they A) take on less risk. B) have access to illegal, private information. C) participate in efficient markets. D) have learned from investing in the same stocks repeatedly.

71) Stocks appear to present risk, yet many people have substantial parts of their wealth invested in them. This behavior could be explained by the fact that A) people are irrational in their investment behavior, only focusing on positive outcomes. B) people are not very risk-averse and do not require a risk premium for stocks. C) investing in stocks over the long run is not as risky as short-term holdings of stocks. D) people are not efficient users of information.

72)

Professor Jeremy Siegel, of the University of Pennsylvania, did research showing that

A) owning stocks over the long run produces returns below the risk-free return. B) if an investor owns stocks for a very short time the risk is greater than if the stocks are held for a long time. C) the return on the S&P 500 for a 25-year period often produces returns below zero. D) bonds really are less risky to hold over the long term.

73) Professor Jeremy Siegel, of the University of Pennsylvania, conducted research that showed that A) over the long run, stocks have been less risky than bonds. B) over the long run, bonds have been less risky than stocks. C) over the long run, bonds frequently outperform stocks. D) investors should only own stocks for short periods of time to maximize returns.

74)

Mutual funds are characterized by the fact that they all

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A) have the same management fee set by regulation. B) require the same minimum investment of $10,000. C) provide some degree of diversification. D) provide the same degree of liquidity.

75)

Management fees for mutual funds are A) fixed by regulation. B) fixed by regulation and can vary by the size of the fund. C) usually a percentage of the gains the fund achieves. D) usually a percentage of the funds under management.

76)

Management fees for mutual funds are A) different across funds and can significantly impact the return to an investor. B) fixed by regulation. C) fixed by regulation but can vary by the size of the fund. D) usually a percentage of the return achieved by fund managers.

77)

Index funds are often preferred to other mutual funds because A) they offer greater diversification. B) they are managed better. C) they have greater liquidity. D) on average they have lower management fees.

78)

When stock prices reflect fundamental values, A) all investors will have positive returns. B) the allocation of resources will be more efficient. C) all companies will have an easier task of obtaining financing for investment projects. D) the overall level of the stock market should move higher.

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79) The fact that returns from the stock market are less volatile over long periods of time suggests that A) investors are more risk averse over the long run. B) stock markets are efficient. C) people get comfortable with the stocks they own. D) stock market bubbles have become more common.

80)

Stock market bubbles are

A) the increase in a stock's price resulting from reported higher profits by a firm. B) persistent and expanding gaps between stocks' actual prices and the prices warranted by the fundamentals. C) synonymous to stock market crashes. D) those periods of time when the overall level of the stock market is rising at a slow rate reflecting market fundamentals.

81)

Stock market bubbles are similar to global pandemics in that both typically lead to A) stock market crashes. B) an efficient allocation of resources. C) patterns of stable returns from the stock market. D) equalizing of actual stock prices and prices warranted by the fundamentals.

82)

Stock market bubbles typically lead to all of the following except A) an efficient allocation of resources. B) stock market crashes. C) patterns of volatile returns from the stock market. D) gaps between actual stock prices and those warranted by the fundamentals.

83)

Which one of the following could cause a stock market bubble?

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A) changes in the real interest rate B) better enforcement of insider trading laws C) investor euphoria D) changes in dividends

84)

Stock market bubbles are costly for the economy because they A) imply that the actual stock price is equal to the fundamental value of the stock. B) hurt consumers more than corporations. C) lead to a reduction in real investment in both the short term and long term. D) lead to a misallocation of resources in both the short term and long term.

85)

Companies whose stocks increase the most during a stock market bubble will A) have a difficult time raising investment capital. B) tend to underinvest. C) usually rebound faster once the bubble bursts. D) find it difficult to put their capital to profitable use after the bubble bursts.

86)

The stock market bubble of the late 1990s and early 2000s A) saw internet and computer technology companies over-invest. B) saw an efficient allocation of resources toward the high-growth computer/internet

sector. C) was a good example of the theory of efficient markets. D) was an example that not all bubbles burst.

87)

Stock market bubbles impact consumers by encouraging

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A) greater consumption and greater saving. B) greater consumption and less saving. C) more work and delaying retirement. D) less investment in home ownership and more in stocks.

88) In April of 2020, Wall Street’s three major stock indexes fell more than 4% on the day that President Donald Trump offered a dire warning about the expected death rate to come from the coronavirus. Trump warned Americans of a “painful” two weeks to come. Why would this affect the stock market? A) As the global pandemic spread, fundamental values fell. B) Companies did not need financing during the global pandemic. C) The prediction created pessimism, which led to a collapse in investment. D) This was a coincidence, and the stock market fall was not actually related to Trump’s warning.

89) In early 2020, the U.S. stock market experienced one of its fastest bear market declines ever. The DJIA fell more than 35% in a single month. According to Professor Jeremy Siegel, once that happened, investors should have

A) continued to hold stocks for the long run. B) moved investments out of the stock market. C) switched to investing in bonds, which are less risky. D) let year-to-year fluctuations in stock values guide investing.

90)

A good outcome from the internet bubble of the late 1990s was

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A) that people learned they should not invest in dotcom companies. B) that start-up companies found they could bypass venture capitalists and raise funds directly from the capital markets. C) the discovery that stock market bubbles do not have to result in an inefficient allocation of resources. D) the discovery that the theory of efficient markets doesn't always hold and consistently better-than-market returns are achievable.

91) In early 2020, a global pandemic erupted, and the values of stock market indices worldwide plummeted. Global travel, a variety of events, and social gatherings screeched to a halt as countries attempted to isolate and stop the spread of COVID-19. Even so, every company was not simultaneously a loser. There are typically some stocks that benefit, depending on the type of crisis, or at least don’t get hit as hard as others. Which one of the following is the most likely to have benefited during the 2020 global pandemic? A) Clorox Co. B) Boeing Co. C) Walt Disney Co. D) Norwegian Cruise Line Holdings, Ltd.

92)

The Nasdaq Composite Index is A) composed of mainly newer, smaller firms. B) a price-weighted index. C) made up of over 5000 companies traded on the NYSE. D) composed of mainly older firms and is heavily weighted by manufacturing.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 93) Explain why being a residual claimant can increase the risk from owning stocks.

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94)

Does the concept of limited liability make owning stocks more or less attractive? Explain.

95) Explain why the willingness to purchase stocks is influenced heavily by shareholders' legal rights with respect to control of the corporation.

96) Why isn't the actual level of an index, for example the Dow Jones Industrial Average, very useful on its own?

97) Suppose a price-weighted index is made up of two stocks, A and B. The price of A equals $30 and the price of B equals $70. What is the current value of this index? Also, what is the percentage change in the index resulting from a 10 % increase only in the price of A? What is the percentage change in the index resulting from a10% increase only in the price of B?

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98) Why might the Dow Jones Industrial Average have a value over 20,000 when the 30 stocks that make up the index all have values less than $200 per share?

99)

What are two major differences between the Standard & Poor's 500 Index and the DJIA?

100)

Consider the following information on the stock market in the small country of Utopia.

Company ABC LMN XYZ

Shares Outstanding Price, beginning of year 500 5,000 15,000

$100 $25 $5

Price, end of year $95 $50 $6

a. Compute a price-weighted stock price index for the beginning of the year and the end of the year. Find the percentage change.\ b. Compute a value-weighted stock price index for the beginning of the year and the end of the year. Find the percentage change.

101) There is a value-weighted index made up of two companies, A and B. Company A has a stock price of $25 per share, and there are 10,000 shares outstanding. Company B has a stock price of $100 per share and has 1,000 shares outstanding. What is the percentage change in the index from a 10% increase in the share price of company A? What is the percentage change in the index from a 10% increase in the share price of company B? Version 1

102)

Compare/contrast the Nasdaq Composite Index with the Dow Jones Industrial Average.

103)

Why must caution be employed in comparing stock indexes across countries?

104) Briefly explain the different focuses of valuing stocks taken by behavioralists, chartists, and fundamentalists.

105) Considering the different focuses of valuing stocks taken by behavioralists, chartists, and fundamentalists, which would you say is most consistent with your own views? Explain the different views as part of justifying your answer.

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106) Many small companies currently pay no dividends to their shareholders. Based on the dividend-discount model, how is it possible for these stocks to sell for a positive price?

107) What price would an individual be willing to pay today for a stock he/she expects can be sold for $200 one year from now, if the individual has a discount rate of 6% (.06) and the stock pays an annual dividend of $7.50?

108) What price would an individual be willing to pay today for a stock that is expected to sell for $100 two years from now and which pays an annual dividend that is $6.00? Assume the individual has a discount rate of 8% (0.08).

109) What price would an individual would be willing to pay for a stock that currently pays a $5.00 annual dividend if the individual expects the dividend to grow by 4% (0.04) per year and the individual has a discount rate of 6.0% (0.06)?

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110) After one year, a company will pay $20 in dividends. It commits to paying $21 two years from the current date. This growth rate in dividends is expected to continue indefinitely. The interest rate is 8%. Compute the current price of this stock, using the dividend-discount model.

111) Identify the ways in which a bondholder's rights differ from those of a stockholder. In what ways do they differ when a firm is bankrupt?

112) Suppose a firm needs $1,000 to obtain a new machine for its business. It can either issue stock or bonds, or some combination of both. If it issues bonds, it will have to pay $8.00 in interest for every $100 borrowed. Finally, assume the company will earn $150 in good years and $75 in bad years, with equal probability. Determine the payment to the equity holders under the following three scenarios: (i) the first is the firm uses 0% debt financing, (ii) the second is the firm uses 50% debt financing, and (iii) the third finds the firm using 80% debt financing. For each scenario, determine the expected equity return (%).

113) An investor makes a $1,000 investment in the stock of ABC Inc. Over the next year the investment decreases by 60%. What percentage increase is required in the following year to get back to $1,000?

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114) The investment you made in a mutual fund one year ago lost 50% of its value over the past year. What percentage increase is needed in the fund to restore your portfolio to the level it was one year ago?

115) After one year, a company will pay $5 in dividends. It commits to paying $5.30 two years from the current date. This growth rate for dividends is expected to continue indefinitely. The U.S. Treasury bond yield is 8% and the equity-risk premium is equal to 2.5%. Compute the required stock return and current price of this stock, using the dividend-discount model.

116) What are the two components that make up the return an investor requires from a stock? Briefly explain each of these components.

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117) Discuss the effects on the current price of a stock from each of the following. a) an increase in the growth rate of the dividend b) a decrease in the risk-free interest rate c) an increase in the equity-risk premium d) a decrease in the annual dividend Use the dividend-discount model to explain your answers.

118) Why does the theory of efficient markets imply that stock price movements are unpredictable?

119) Is the efficient markets hypothesis (EMH) responsible for the financial crisis of 2007– 2009?

120) What possibilities exist to explain the claim made by many professional portfolio managers that they can exceed the average stock market return year after year?

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121) Use the theory of efficient markets to explain why it may be difficult for professional portfolio managers who have an exceptional year to continuously outperform the market average.

122) You hear someone claim that stocks are less risky than bonds. What possible evidence could this person offer for such a claim?

123) Use the five issues an investor should consider when purchasing stock to explain the popularity of mutual funds.

124) Explain how a well-functioning stock market contributes to the efficiency of the economy.

125) Explain at least two reasons an investor may want to consider an index fund over a managed (mutual) fund.

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126) Discuss the inefficiencies that can be caused by stock market bubbles, especially focusing on firms and consumers.

127) Both euphoria and depression are contagious. Use the example of a global pandemic such as COVID-19 to explain how depression can become contagious with respect to worldwide stock markets.

128) Do the voting rights possessed by common stockholders ensure that managers and directors have the same objectives as stockholders? Explain.

129) Use the characteristics of common stocks to explain the following statement: One of the benefits from stock ownership is the unlimited upside potential and the limited downside.

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130) XYZ Inc. announces plans to finance the expansion of the firm by issuing hundreds of millions of dollars of bonds. Discuss how the current stockholders of XYZ Inc. will feel about this plan.

131) Discuss how changes in economic conditions are likely to affect the equity-risk premium and stock prices. Considering the risks associated with investing in stocks (over short periods of time), what types of investments would you expect investors to buy during an economic recession?

132) You are a top Treasury official for a developing country who has been asked for advice on how best to open the nation's stock market to foreign investment. Previously, the government did not permit foreigners to purchase domestic stock. Now, the government has a plan to create two markets: one for domestic residents and one for foreign investment. What are the potential drawbacks of this system, compared to allowing both domestic and foreign investors to trade in the same market? What are the larger implications for economic efficiency? How might the government be able to address these issues?

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133) Discuss whether the economy would be more or less efficient if public corporations issued fewer shares of stock.

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Answer Key Test name: Chap 08_6e 1) D 2) A 3) C 4) B 5) D 6) A 7) D 8) C 9) A 10) D 11) A 12) A 13) B 14) A 15) C 16) C 17) B 18) D 19) D 20) B 21) D 22) A 23) D 24) A 25) A 26) D Version 1

27) A 28) C 29) B 30) D 31) D 32) C 33) B 34) C 35) A 36) C 37) A 38) A 39) C 40) B 41) C 42) C 43) D 44) D 45) D 46) A 47) C 48) D 49) C 50) D 51) B 52) C 53) D 54) D 55) C 56) C Version 1

57) D 58) A 59) C 60) A 61) B 62) B 63) A 64) B 65) C 66) B 67) B 68) C 69) C 70) B 71) C 72) B 73) A 74) C 75) D 76) A 77) D 78) B 79) B 80) B 81) B 82) A 83) C 84) D 85) D 86) A Version 1

87) B 88) C 89) A 90) B 91) A 92) A 93) The stockholders, being residual claimants, get what is left after everyone else has been paid. While this can be substantial during good years, it also means that during bad years the stockholders may get nothing, and if the corporation does poorly for a number of years, the stockholders' investments can be lost. 94) Limited liability makes owning stocks (equities) more attractive. Basically, limited liability means that an investor can only lose what they paid for the stock (invested) in the first place. This clearly makes stock ownership more attractive. 95) Shareholders' legal rights include the ability to elect and dislodge the board of directors of a corporation. The board can also dislodge managers and officers who are performing poorly. The ability of stockholders to influence these choices enhances the attractiveness of owning shares and therefore increases the willingness of individuals to purchase stocks. 96) For many indexes, the real value is to be able to compute percentage changes in the index over time. For example, the level of the Consumer Price Index by itself conveys little information, but percentage changes in the CPI allow us to measure the rate of inflation. Similarly, in the case of the Dow Jones Industrial Average, the percentage changes are useful in measuring the performance of the stocks (on average) that make up this index.

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97) The current value of the index is 50. This is determined by taking the current stock prices and dividing by two, similar to the construction of the DJIA. If the price of A increases by 10% this raises the price of A to $33 and the value of the index to 51.5, for an increase of 3%. If only the price of stock B increases by 10%, the price of B will rise to $77, and the index will have a value of 53.5, for an increase of 7%. 98) The DJIA accounts for stock splits over the years, which are reflected in the average but not in the current price of the stock, and the companies included in the index change periodically. 99) The S&P 500 Index differs from the DJIA in (1) that the S&P 500 is constructed from the 500 largest firms in the U.S. economy, where the DJIA uses 30 of the largest firms. Also, (2) the S&P is a value-weighted index, meaning it reflects the total value of owning the entirety of the 500 firms. By contrast, in the DJIA the higher-priced stocks carry more weight because it is a price-weighted average. The S&P 500 gives more weight to the larger firms than the DJIA does.

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100) a. For a price-weighted index, find the cost of buying one share of each company at the beginning of the year: $100 + $25 + $5 = $130 then divide by the number of stocks (3) to find the index = 130/3 = 43.33 The cost of buying one share of each company at the end of the year: $95 + $50 + $6 = $151 then divide by the number of stocks (3) to find the index = 151/3 = 50.33 Percentage change = 100[(50.33 − 43.33)/43.33] = 16.16% b. The percentage change in a value-weighted index is given by the percentage change in the sum of the values of the companies. At the beginning of the year the value of the companies is the following: 500(100) + 5,000(25) + 15,000(5) = $250,000 At the end of the year the value of the companies is the following: 500(95) + 5,000(50) + 15,000(6) = $387,500 Percentage change = 100[(387,500 − 250,000)/250,000] = 55%

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101) The value of company A is $250,000, which we obtain by taking the share price of $25 and multiplying that by 10,000 shares outstanding. The value of company B is $100,000, which we obtain by taking the share price of $1,000 and multiplying by 1,000 shares outstanding. A 10% increase in the share price of A results in a market value of $275,000, which is a 10% increase. The index however is constructed from the value of both companies, and the total value increases from $350,000 to $375,000, for a percentage change of 7.14%. When the share price of B increases by 10%, the new market value of the entire company is $110,000, ($110 × 1000), this increases the value of the index to $360,000 from $350,000, or 2.86%. 102) The Nasdaq is a value-weighted index, where the DJIA is a priceweighted index. Also, the Nasdaq is made up of many smaller, newer companies, recently dominated by technology and internet companies, where the DJIA includes 30 of the largest firms in the United States. 103) Since stock indexes are made up of different companies and can be composed in different ways, comparing indexes in terms of their levels is really useless, much as it really is of little value to just look at the level of various indexes. What can be important and interesting is to compare percentage changes in the various indexes and to see how they correlate or move together. 104) The behavioralists estimate the value of stocks based on their perceptions of investor psychology and behavior. Chartists look for patterns in the price movements of a stock. And others focus on the financial statements, where they determine a stock's fundamental value from current assets and estimates of future profitability.

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105) Answers will vary for the normative question, but students should include the following information as part of the answer: The behavioralists estimate the value of stocks based on their perceptions of investor psychology and behavior. Chartists look for patterns in the price movements of a stock. And others focus on the financial statements, where they determine a stock's fundamental value from current assets and estimates of future profitability. 106) According to the dividend-discount model, the current price is equal to the present value of future dividends to be paid on the stock. Therefore, while these small companies don't currently pay dividends, investors may still buy stocks in these companies based on the expectation that they will pay dividends in the future. 107) We can use the following formula to determine the price of the stock today:

Based on the information provided in the question, the Dnextyear = $7.50; the Pnextyear = $200; and the i = 0.06. With these values plugged into the equation, we determine the Ptoday to be $195.75. 108) We can use this formula from the chapter to determine the price of the stock today:

Based on the information provided in the question, the Dnext year and Din two years will = $6.00. The Pin two years will = $100.00 and i = (0.08) Ptoday will be $96.43. 109) We can calculate the Ptoday by using equation 8 from the chapter: The equation,

where i is the discount rate, or in this case 0.06; g is the growth rate of the dividend, or in this case 0.04; and the Dtoday is the current dividend of $5.00. Inserting these values into the equation we solve for Ptoday and obtain $260.00

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110) First, we need to compute the growth rate of dividends, g. This is equal to 5% = ($21 - $20)/$20. Now, we can compute the price of the stock: P

today =

today(1 +

g)/( i - g)

today = $20(1 + 0.05)/(0.08 - 0.05)

today = $700

111) Bondholders are not owners of the company, meaning that they are not entitled to a share of the firm's profits, nor are they involved in the voting of the firm's managers. Stockholders are the company's owners, so they are entitled to these things. If a firm is bankrupt, then its creditors must be paid first. The stockholders are residual claimants. They collect any remaining assets once the bondholders (and other lenders) are paid. While the stockholders are owners of the firm, their liability is limited in that the bondholders cannot collect losses from the stockholders beyond the value of the company. 112) The payment to the equity holders and the expected return are as follows, (i) for 0% debt financing, the payment is $75 − $150, with an expected return of 11.25%; (ii) with 50% debt financing the payment to equity holders will be $35 − $110, with an expected return of 14.5%; and finally, (iii) with 80% debt financing, the payment to the equity holders will be $11 − $86, with an expected return of 24.25%. 113) We can employ the formula from the text: 100.

Using this formula, where d is the initial decline in the investment (60), the answer is 150%.

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114) We can employ the formula from the text: 100.

Using this formula, where d is the initial decline in the investment (50), the answer is 100%.

115) The required stock return is 10.5%. To find the price of the stock, we need to compute the growth rate of dividends: 6% = ($5.3-$5)/$5. Now, we can compute the current price of the stock: P

today =

today(1 +

g)/( rf + rp - g)

today = $5(1 + 0.06)/(0.105 - 0.06)

today = $117.78

116) The required stock return (i) = risk-free return (rf) + risk premium (rp). The risk-free return is the interest rate the investor could earn on a risk-free asset such as a U.S. Treasury bond. The risk premium is the compensation the investor requires due to the fact that the future selling price of the stock is uncertain. 117) where Dtoday is the current dividend; rf is the risk-free rate; rp is the risk premium; g is growth rate of the dividend; and, we are measuring the impact on Ptoday. From the formula we see that an increase in g will cause Ptoday to increase. In addition, a decrease in rf will also cause Ptoday to increase. An increase in rp on the other hand will reduce Ptoday as will a decrease in the annual dividend.

118) If people could accurately forecast price movements in stocks, they would immediately act on those forecasts, which would cause the price of the stocks to move today. When markets are efficient, the price at which a stock currently trades reflects all available information, so the future price movements are unpredictable.

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119) Hardly. The hypothesis does not claim that the market price is always right. On the contrary, it implies that the prices in the market are mostly wrong, but at any given moment it is not at all easy to say whether they are too high or too low. The fact that the best and brightest on Wall Street made so many mistakes shows how hard it is to beat the market. 120) As the chapter points out, there are four possibilities: (1) The managers have private or insider information, which is illegal; (2) They are lucky; (3) They are taking on more risk which will provide a higher return in some years but can also lead to lower than average returns for other years; and (4) Markets are not efficient. 121) A professional money manager who has an exceptional year will attract a lot of attention and money. The attention may be in the form of other professional managers who will copy the actions of the successful manager. The additional money will require the manager to put these funds to use which, due to the law of diminishing marginal returns, will also make it more difficult to duplicate the return. 122) Professor Jeremy Siegel's research points out that when held for the long run stocks are less risky than if held for a very short time. In fact, Professor Siegel's research points out that between the years 1871 and 1992 there was no 30-year period when bonds outperformed stocks. 123) (1) Affordability, (2) liquidity, (3) diversification, (4) management, and (5) costs are the five issues that need to be considered, and mutual funds address these in one way or another. Many mutual funds can be opened with relatively small amounts, and they usually allow for investors to sell their positions and withdraw their investment. Mutual funds are designed to provide more diversification than what most individual investors could hope to achieve on their own. Most are managed by professional managers and they provide different fees or costs for these management services. Version 1

124) If the prices of stocks reflect fundamental values, the resource allocation mechanism of the stock market works well. With accurate signals, investment resources flow to their most socially beneficial uses. 125) (1) Managed funds or mutual funds tended to perform worse than index funds. Also, (2) the fees for managed funds tend to run about 1.5% a year compared to 0.5% or less for index funds. The lower fees, even at the same return, would provide an investor with a much higher return over the long run. 126) Stock market bubbles can lead to the inefficient allocation of investment funds. Those companies that are positively affected by the bubble and see their stock prices increase will find it relatively less expensive to raise funds and consequently may over-invest. On the other hand, those firms who are not the object of stockholder euphoria will find it more expensive to attract funds and as a result may under-invest. For consumers, the bubbles can lead to increased wealth for some individuals who as a result may consume more, save less, buy expensive automobiles, homes, vacations etc. These individuals may even work less or retire early. When the bubble bursts these individuals are left trying to adjust, which can be not only inefficient but traumatic. Also, the companies that geared up to provide these luxury goods are left to adjust. So the result is the bubbles and their subsequent bursts result in real investment and spending that is inefficient.

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127) When a contagious virus such as COVID-19 spreads worldwide, consumers are advised to self-isolate to stop the spread of the disease. As economies slow abruptly, consumers stop spending, unemployment soars, and firms stop investing. Consumer and business confidence plummets, and stock indexes drop. Excessive pessimism causes a collapse in investment and economic growth. The stock market crash can destabilize the real economy and lead to the inefficient allocation of investment funds as investment dries up. Often, fiscal and/or monetary policy is needed to keep economies from grinding to a halt. 128) Not necessarily. Stockholders are usually interested in receiving the highest return possible and may even desire the firm to take additional risk if it means higher compensation. The managers and directors on the other hand may prefer job security and look at the increased risk as decreasing this job security if the results are poor, so they may move away from opportunities that stockholders would welcome. In fact, stockholders may not even be aware of the opportunities because managers and directors do not present them. Also, managers and directors may have their own interests in the sense that they prefer to manage a "larger" firm, feeling it increases their own individual influence and power. As a result they may propose mergers or acquisitions, or additional layers of management which may not be in the best interest of the stockholders. In economics, this is known as the principal-agent conflict and is the focus of significant research in economics and management.

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129) The common stockholders are residual claimants. This means that the most they can lose is their original investment, which pertains to the limited downside. The company could perform poorly, so poorly in fact that it could go bankrupt leaving many liabilities unpaid. For the common stockholders though, their losses are limited to their original investment. On the other hand, if the company is hugely successful, once the other liabilities are paid all, of the residuals belong to the common stockholders. This means that the dividends and or the future price of the stock will rise. There isn't a cap as to how large this potentially could be; it depends on the management and the success of the company. Stockholders do not face a ceiling on potential returns, which is the reason why the upside potential can be called "unlimited." 130) The common stockholders may have mixed feelings about this announcement. On one hand, they may applaud the proposal because the use of leverage by a firm can increase the expected return to equity, which are the stockholders. On the other hand, the stockholders are residual claimants, so the increased use of bonds means the company is required to honor its liabilities to the bondholders (interest payments) before any profits are distributed to the stockholders. If the expansion proves to be profitable it can certainly turn out to be a good decision for the stockholders who may see the higher return from leverage. On the other hand, if the company's estimate or forecast is wrong and the expansion does not prove profitable, the stockholders will see a lower return than they would have without the expansion. This reflects the trade-off presented by leverage discussed in the chapter. The expected return is increased but so is the standard deviation of that return (risk).

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131) If investors expect a recession, it is likely this will lead to an increase in the equity-risk premium. The potential losses associated with stocks are greater during economic downturns, so investors will have a higher required return on stock. All other things equal, this will lead to a decrease in stock prices. During an economic recession, U.S. Treasury securities are relatively more attractive than stocks, so we would expect that investors would purchase more of them relative to equity shares. Recall that stockholders are residual claimants. With bankruptcy more likely during a recession, the expected losses associated with being a residual claimant are higher. 132) The creation of two distinct markets will allow for a situation where the prices of the same stock may be different in the two markets. From an efficiency perspective, this is not a good thing. Ideally, those investors who value the stock most should have access to purchase the stock, regardless of which market they are located in. This separation of the two markets could lead to a misallocation of resources. One way to deal with this misallocation is to allow companies the option of issuing the number of shares that will allow them to equate the prices in both markets.

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133) The economy would probably be less efficient. If corporations needed to raise the same amount of capital but did so using fewer shares, the share prices would increase. The result would be fewer participants in the equity markets and less liquidity in the market which will decrease efficiency since stocks would be less attractive. Also, with low share prices many more people participate in the stock market which means a larger source of funds for companies seeking financing and basic principles of economics tells us that the greater the supply, everything else constant, the lower the price. And finally, with many more participants in the stock market we have a market that performs closer to the competitive market model where no one participant can exert considerable influence over the price. The increased competition leads to not only greater efficiency due to lower prices, but a better flow of information that allocates resources to their most efficient use.

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CHAPTER 9 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) A derivative is a financial instrument whose value is A) intrinsic to the instrument itself. B) determined by the value of its underlying asset. C) based on the outright purchase of a financial asset. D) based on the value of a positive-sum game between two parties.

Derivatives are financial instruments that A) present high levels of risk and should only be used by the wealthy. B) when used correctly can actually lower risk. C) should only be used by people seeking high returns from low risk. D) represent the outright purchase of a bond.

Why would a farmer routinely use derivatives? A) to transfer risk from the buyer of her crop to herself B) to pay for transaction costs of getting her crop to market C) to increase transparency about her financial transactions D) to insure herself against fluctuations in the market price of her crop

The value of a derivative is determined by A) the Federal Reserve. B) SEC regulation. C) the value of the underlying asset. D) the risk-free rate.

In a derivative transaction,

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A) the dollar amount of the transaction increases as the contract date approaches. B) the risk is less than if actually purchasing the underlying asset. C) what one person gains is what the other person loses. D) there is always a futures contract.

The purpose of derivatives is to A) increase the risk so the return is larger. B) eliminate risk for both parties in the transaction. C) postpone the risk for both parties in the transaction. D) transfer the risk from one person to another.

7) An investor has his own biases and emotions that influence decision making, particularly when there are market losses due to an event such as the 2020 COVID-19 global pandemic. Fraudsters can target investors who are trying to recoup losses, and derivative markets could be fertile ground in some respects because participants tend to be A) willing to accept risk. B) unconcerned with managing risk. C) straightforward in their market strategies. D) conservative in their investment strategies.

Forward contracts are A) an agreement between more than two parties. B) contracts usually involving the exchange of a commodity or financial instrument. C) always standardized. D) easily resold.

The short position in a futures contract is the party that will

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A) deliver a commodity or financial instrument to the buyer at a future date. B) suffer the loss. C) accept the risk. D) benefit from increases in price of the underlying asset.

10)

The long position in a futures contract is the party that will A) benefit from decreases in the price of the underlying asset. B) agree to make delivery of a commodity or financial instrument at a future date. C) benefit from increases in the price of the underlying asset. D) accept the greater share of the risk.

11)

With a futures contract, A) payment is made when the contract is created. B) no payment is made until the settlement date. C) the short position agrees to purchase the underlying asset. D) the risk is eliminated for both parties.

12)

The key difference between a forward and a futures contract is A) a forward contract is customized where a futures contract is not. B) a forward contract is bought and sold on organized exchanges. C) only the forward contracts have settlement dates. D) the amount of time involved.

13)

The clearing corporation's main role in the futures market is to

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A) set the market price of the contract. B) act as the counterparty to both sides of the transaction, thereby guaranteeing payment. C) provide the underlying assets so the contracts can be created. D) act as a mediator to settle differences between the seller and buyer.

14)

The process of marking to market A) is done by the clearing corporation to reduce risk in futures contracts. B) involves the margin accounts of only the buyers of future contracts. C) involves the margin accounts of only the sellers of future contracts. D) usually requires margin accounts to be adjusted weekly by the clearing corporation.

15)

Marking to market is a process that A) involves a transfer of risk. B) ensures that the buyers and sellers receive what the contract promises. C) always requires the sellers of contracts to transfer funds to the buyers of contracts. D) buyers and sellers can request for an additional fee when the contract is created.

16) There is a futures contract for the purchase of 100 bushels of wheat at $2.50 per bushel. At the end of the day when the market price of wheat increases to $3.00 per bushel, A) the buyer (long position) needs to transfer $50 to the seller (short position). B) the seller (short position) needs to transfer $50 to the buyer (long position). C) nothing happens since with a futures contract all payments are made at the settlement date. D) nothing happens since marked to market adjustments only take place when the market price falls below the contract price.

17) There is a futures contract for the purchase of 1,000 bushels of corn at $3.00 per bushel. At the end of the day when the market price of corn falls to $2.50,

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A) the buyer (long position) needs to transfer $500 to the seller (short position). B) the seller (long position) needs to transfer $500 to the buyer (short position). C) nothing happens since marked to market adjustments only occur if the market price rises above the contract price. D) nothing happened since no funds are transferred until the settlement date.

18) A U.S. Treasury bond dealer with a large portfolio who sells a futures contract for U.S. Treasury bonds is A) taking on additional risk in hopes of getting a larger return. B) ensuring the sales price of the bond through hedging. C) not likely to find a buyer for this transaction. D) should see the value of the futures contract increase as bond prices rise.

19)

A pension fund manager who plans on purchasing bonds in the future A) wants to insure against the price of bonds falling. B) can offset the risk of bond prices rising by selling a futures contract. C) will take the long position in a futures contract. D) will take the short position in a futures contract.

20) A baker of bread has a long-term fixed-price contract to supply bread. Which one of the following would not reduce her risk? A) taking the long position in a wheat futures contract B) hedging this risk in the wheat futures market C) forgoing the act of posting margin D) finding a wheat farmer who will take the long position in a wheat futures contract

21) A wheat farmer who must purchase his inputs now but will sell his wheat at a market price at a future date

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A) faces a market risk that cannot be offset. B) is a good example of a speculator. C) would hedge by taking the short position in a wheat futures contract. D) is unable to hedge risk by participating in a futures contract.

22)

Users of commodities are A) usually not participants in futures contracts. B) speculators preferring to get the large returns that result from large risk. C) likely to take the short position in a futures contract. D) buyers of futures.

23)

Speculators differ from hedgers in the sense that A) speculators do not like risk. B) hedgers seek to transfer risk. C) speculators seek to transfer risk. D) speculators have a profit motive.

24)

A possible explanation about why farmers in poor countries remain poor is that A) they know very little about farming techniques needed for the crop they are growing. B) they are poor assessors of the risks they face. C) risk taking is a deterrent to growth. D) poor farmers in many countries lack access to commodity futures markets.

25)

Futures markets and derivatives contribute to economic growth by A) decreasing speculation. B) increasing the risk-taking capacity of the economy. C) deterring the transfer of risk. D) forcing people to accept the risk their decisions create.

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26)

On the settlement date of a futures contract, the future’s price A) is always above the price of the underlying asset. B) is always below the price of the underlying asset. C) is equal to the price of the underlying asset. D) may be above or below the price of the underlying asset but not equal to it.

27)

As the time of settlement gets closer, the price of the A) futures contract will diverge from the price of the underlying asset. B) futures contract will always be above the price of the underlying asset. C) underlying asset and the future's price will show no correlation at all. D) futures contract will move in lockstep with the price of the underlying asset.

28) Tom buys a futures contract for U.S. Treasury bonds and, on the settlement date, the interest rate on U.S. Treasury bonds is lower than Tom expected. Tom will have A) lost money on his long position. B) gained money on his long position. C) lost money on his short position. D) gained money on his short position.

29) Sue sells a futures contract for U.S. Treasury bonds and, on the settlement date, the interest rate on U.S. Treasury bonds is lower than Sue expected. Sue will have A) lost money on her short position. B) gained money on her long position. C) gained money on her short position. D) lost money on her long position.

30) Tom buys a futures contract for U.S. Treasury bonds and, on the settlement date, the interest rate on U.S. Treasury bonds is higher than Tom expected. Tom will have

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A) gained money on his short position. B) lost money on his long position. C) gained money on his long position. D) lost money on his short position.

31) Sue buys a futures contract for U.S. Treasury bonds and, on the settlement date, the interest rate on U.S. Treasury bonds is higher than Sue expected. Sue will have A) gained money on her short position. B) gained money on her long position. C) lost money on her long position. D) lost money on her short position.

32)

If market participants believe next year’s corn crop is likely to be unusually large,

A) the current spot market price of corn is likely to be below the futures price of corn. B) the current spot market price of corn is likely to be above the futures price of corn. C) it would be impossible to find someone to take the short position in a futures contract. D) it will be impossible to find someone to take the long position in a futures contract.

33)

An arbitrageur is someone who

A) always takes the long position in a futures contract. B) always takes the short position in a futures contract. C) seeks the high returns that come from the high risk inherent in futures markets. D) simultaneously buys and sells financial instruments to benefit from temporary price differences.

34) If a futures contract for U.S. Treasury bonds increases by "12" in the financial page listings with a conversion factor of 1/32, the value of the contract increased by

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A) $120.00. B) $1,200.00. C) $375.00. D) $240.00.

35) If a futures contract for U.S. Treasury bonds decreases by "17" in the financial page listings with a conversion factor of 1/32, the price of the contract decreased by A) $531.25. B) $170.00. C) $340.00. D) $1700.00.

36)

A price of a futures contract for U.S. Treasury bonds listed as "111-15" is measured in A) 32nds. B) 12ths. C) 4ths. D) dollars; it stands for $111.15 but a dash is used instead of a period.

37) The user of a commodity who is trying to insure against the price of the commodity rising would A) take the short position in a futures contract. B) take the long position in a futures contract. C) be better off speculating on price movements and earning higher profits. D) want to hedge by selling a futures contract.

38) An individual who neither uses nor produces a commodity but sells a futures contract for the asset is

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A) speculating that the price of the commodity is going to fall. B) betting that the price is going to increase. C) hedging trying to transfer risk. D) using arbitrage to earn profits without taking a risk.

39) An individual who neither uses nor produces a commodity but buys a futures contract for the asset is A) betting that the price is going to fall. B) speculating that the price of the commodity is going to increase. C) is using arbitrage to earn profits without taking a risk. D) is hedging and transferring risk.

40)

The option holder is A) the seller of an option. B) another name for the clearinghouse used in futures contracts. C) the buyer of an option. D) always a speculator.

41)

The option writer is the A) seller of an option. B) buyer of an option. C) underlying asset of the option. D) individual who obtains the rights.

42) The right to buy a given quantity of an underlying asset at a predetermined price on or before a specific date is called a(n)

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A) put option. B) option writer. C) call option. D) arbitrage contract.

43)

A call option is an option

A) written more than sixty days into the future. B) giving the holder the right to buy a given quantity of an asset at a specific price on or before a specified date. C) giving the seller the right to sell a given quantity of an asset at a specific price on or before a specified date. D) where all rights are granted to the seller of the option.

44)

The strike price of an option is A) the market price at the time the option is written. B) the market price at the time the option is exercised. C) the price at which the option holder has the right to buy or sell. D) always above the market price.

45)

With a call option, the option holder A) has the right to sell the asset. B) has the right to buy the asset. C) can buy or sell, it is their option. D) can buy the asset but only after the date specified.

46)

With a put option, the option holder

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A) has the right to buy the asset. B) can buy or sell the asset, it is their option. C) has the right to sell the asset. D) can buy the asset but only on the date specified.

47) There's a call option written for 100 shares of GM stock for $85.00 a share, prior to the third Friday of October 2020. The option writer A) has the option but not the requirement of selling 100 shares of GM for $85.00. B) will sell 100 shares of GM for $85.00 on the third Friday of October 2020. C) has the option to back out of this contract prior to the third Friday of October 2020. D) is required to post margin.

48) There's a call option written for 100 shares of GM stock for $85.00 a share, prior to the third Friday of October 2020. The option writer: A) has the requirement to sell 100 shares of GM for $85 a share on or before the third Friday of October 2020 if the option holder wants to exercise the option. B) has the option to sell 100 shares of GM for $85 a share on or before the third Friday of October 2020. C) can cancel the option before the third Friday of October 2020. D) does not have to post margin while the option holder does.

49)

With a call option that is described as in the money, the market price of the stock A) is below the strike price. B) equals the strike price. C) is above the strike price. D) no higher than the strike price.

50)

A put option that is described as in the money would find that the

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A) market price of the stock is above the strike price. B) strike price is above the market price of the stock. C) market and strike prices are the same. D) option has been exercised.

51)

A call option described as at the money would find that the A) market price of the stock is above the strike price. B) market price of the stock is below the strike price. C) option has been exercised. D) market price of the stock equals the strike price.

52)

A put option described as out of the money would find that the A) strike price is below the market price of the stock. B) market price of the stock and the strike price are equal. C) market price of the stock is below the strike price. D) option has expired.

53)

A call option described as out of the money would find that the A) market price of the stock is above the strike price. B) option has been exercised. C) option has expired. D) strike price is above the market price of the stock.

54)

The main difference between European and American options is that A) holders of European options have more options than holders of American options. B) American option holders have more options than European option holders. C) European option holders can exercise the option prior to expiration. D) European options cannot be resold.

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55)

One key difference between options contracts and futures contracts is that A) in a futures contract, one part has more rights than the other. B) with an options contract, both parties have equal rights. C) in an options contract, the rights belong to one party. D) in a futures contract, all rights are held by just one party.

56)

Which one of the following can be sold prior to expiration? A) Call options can be sold prior to expiration but put options cannot. B) Put options can be sold prior to expiration but call options cannot. C) No option can be sold prior to expiration. D) Both American and European options can be sold prior to expiration.

57)

The seller of a put option A) is transferring the risk of a price decrease of the stock to the buyer of the option. B) is transferring the risk of a price increase of the stock to the buyer of the option. C) cannot transfer risk. D) is not transferring risk because only sellers of call options are transferring risk.

58)

Someone who purchases a call option is really buying insurance to protect against A) the stock not being available when they want to purchase it. B) the price of the stock falling. C) a seller not being able to deliver the stock. D) the price of the stock rising.

59)

Comparing an option to a futures contract, it would be correct to say that

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A) the risk involved in each is equal. B) a futures contract carries more risk than the option contract. C) an option contract carries more risk than the futures contract. D) neither involves risk since they are tools to eliminate risk.

60)

An investor who purchases a call option is A) highly leveraged for a gain but is limited in losses. B) limited in his or her gain but is highly leveraged in losses. C) highly leveraged for both gains and losses. D) limited in both gains and losses.

61)

Options are popular because of all of the following except that A) stock prices are volatile. B) they offer a tool to transfer risk. C) they present a tool to limit losses but also limit gains. D) they offer opportunities for high leverage.

62)

The two parts that make up an option's price are the A) extrinsic value and the time value of the option. B) commission and the time value of the option. C) intrinsic value and the time value of the option. D) price of the underlying asset and the time value of the option.

63)

The intrinsic value of an option A) is the amount the investor believes the option will be worth on the expiration date. B) is the amount the option is worth if it is exercised immediately. C) is equal to price of the underlying asset. D) cannot be determined without knowing the future price of the underlying asset.

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64)

As an option approaches its expiration date, the value of the option approaches A) the intrinsic value. B) the price of the underlying asset. C) zero. D) infinity.

65)

The time value of the option can best be defined as the A) commission earned by a broker. B) fee earned for the potential benefits from buying the option. C) service fee charged by the SEC for regulating the option market. D) fee paid for the potential benefits from buying an option (excluding its intrinsic

value).

66) Assume we have a stock currently worth $100. We also assume the interest rate is zero, and we can buy options for this stock with a strike price of $100. If the stock can rise or fall by $20 with equal probability over the option period, and the option cannot be exercised until the expiration date, what is the time value of the option? A) $20 B) $0 C) $10 D) $100

67) Assume we have a stock currently worth $100. We also assume the interest rate is zero, and we can buy options for this stock with a strike price of $100. If the stock can rise or fall by $5 with equal probability over the option period, and the option cannot be exercised until the expiration date, what is the time value of the option? A) $10.00 B) $5.00 C) $2.50 D) $0

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68) Assume we have a stock currently worth $50. We also assume the interest rate is zero, and we can buy options for this stock with a strike price of $50. If the stock can rise or fall by $10 with equal probability over the option period, and the option cannot be exercised until the expiration date, what is the time value of the option? A) $5 B) $10 C) $50 D) $40

69)

As the volatility of the stock price increases, the time value of the option A) decreases. B) is zero. C) increases. D) doesn't change.

70)

An option's value will never be less than zero because A) the intrinsic value is always less than zero. B) the option seller is required to make up any shortfall faced by the option buyer. C) an option holder will never make an additional payment to exercise the option. D) the time value of the option is always less than zero.

71)

The intrinsic value of a call option

A) is the difference between the option price and the interest rate. B) must be less than or equal to zero. C) is the greater of zero or the difference between the price of the underlying asset and the strike price. D) will be negative if the time value of the option is negative.

72)

At expiration, the value of an option is

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A) greater than the intrinsic value. B) less than the intrinsic value. C) equal to the time value of the option. D) equal to the intrinsic value.

73)

At expiration, the time value of an option is A) equal to the intrinsic value. B) greater than the intrinsic value. C) zero. D) less than the intrinsic value.

74)

The time value of the option should A) decrease the longer the time to expiration. B) increase the longer the time to expiration. C) not change with time to expiration. D) approach infinity at expiration.

75)

If the price of an underlying asset has a standard deviation of zero, then A) options for this asset would likely not exist. B) options for this asset would be highly valued. C) the intrinsic value of options for this asset would equal the asset's price. D) options for this asset would have a time value of the option equal to the price of the

asset.

76)

Considering a put option; if the price of the underlying asset increases, then the

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A) value of the put option also increases. B) intrinsic value of the option increases. C) value of the option decreases. D) time value of the option decreases.

77)

Considering a call option, if the price of the underlying asset decreases, then the A) intrinsic value of the option decreases if it is above zero. B) intrinsic value of the option increases if it is above zero. C) strike price decreases. D) value of the option increases.

78)

Options A) allow investors to get rid of the risks they do not want and keep the ones they do

want. B) can be used for hedging but not for speculation. C) obligate the holder to sell the underlying asset at a predetermined price on or before a fixed date. D) allow investors to bet that the price of an underlying asset will rise but not that it will fall.

79)

Considering a put option, an increase in the strike price A) causes the intrinsic value of the option to decrease if it is above zero. B) causes the intrinsic value of the option to increase if it is above zero. C) causes the value of the option to decrease. D) makes the option worthless.

80) If we have a stock selling for $95.00 and a call option for this stock has a strike price of $82.00 and an option price of $13.60, then the intrinsic value

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A) of the option is $0.60 and the time value of the option is $13.00. B) is $82.00 and the time value of the option is $13.60. C) of the option is $13.00 and the time value of the option is $0.60. D) is $0 since the option is out of the money.

81) We have a stock selling for $90.00. There is a put option for this stock with a strike price of $85 and an option price of $1.20. The intrinsic value of this option A) is $0.00 and the time value of the option is $1.20. B) is $90.00 and the time value of the option is $1.20. C) is –$5.00 and the time value of the option is $1.20. D) and the time value of the option cannot be determined since the strike price is less than the underlying asset price.

82)

For a given call option price, which one of the following statements is correct?

A) The closer the strike price is to the current price of the underlying asset, the smaller is the time value of the option. B) The closer the strike price is to the current price of the underlying asset, the larger is the time value of the option. C) As the strike price approaches the price of the underlying asset, the time value of the option approaches zero. D) As the strike price approaches the price of the underlying asset, the intrinsic value of the option increases and the time value of the option decreases.

83)

Ceteris paribus, speculators in options markets would prefer stocks with A) low volatility and options with near-term expiration dates. B) low volatility and options with long-term expiration dates. C) high volatility and options with near-term expiration dates. D) high volatility and options with long-term expiration dates.

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84) Which one of the following would tend to decrease the size of the time value of the option? A) The price volatility of the underlying asset is high. B) The time to expiration of the contract is far away. C) The underlying price of the asset approaches the strike price. D) The time to expiration of the options contract is near.

85)

Interestrate swaps are

A) exchanges of equity securities for debt securities. B) agreements between two parties to exchange periodic interestrate payments over some future period. C) agreements involving swapping of option contracts. D) agreements that allow both parties to convert floating interest rates to fixed interest rates.

86)

A key use of interestrate swaps is to A) eliminate risk for both parties involved in the transaction. B) earn the fees for constructing the swaps. C) provide a hedge against interestrate risk. D) manage government revenues.

87)

The principal in an interest rate swap is

A) always transferred from the originator to the counterparty of the swap. B) usually held by a clearinghouse to guarantee payment. C) usually borrowed from a third party. D) not borrowed, lent, or exchanged. It just serves as the basis for the calculation of cash flows.

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88) The figure illustrates a typical interest rate swap agreement. Which party is the bank and which is the dealer?

A) 1 is the bank, and 2 is the dealer. B) 1 is the dealer, and 2 is the banker. C) The bank is the party that agrees to pay the floating rate. D) The dealer is the party that pays a fixed rate in exchange for payments based on the floating rate.

89)

Considering interestrate swaps, the swap rate is A) the benchmark rate plus a premium. B) the rate being offered on U.S. Treasury securities of similar maturities. C) another name for the swap spread. D) a measure of overall risk in the economy.

90)

Considering interestrate swaps, the swap spread is A) another name for the swap rate. B) the difference between the benchmark rate and the swap rate. C) the benchmark rate plus the swap rate. D) a measure of the time value of the swap.

91)

One key difference between swaps and option contracts is that

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A) swaps are derivative agreements and options are not. B) swaps do not involve any risk and options do. C) options transfer risk, swaps create risk. D) options trade on organized exchanges and swaps do not.

92) The VIX, constructed from options on S&P 500 Index futures, is technically a measure of what? A) leverage B) market liquidity C) stock valuations D) implied volatility

93)

The primary risk in swaps is that A) interest rates will not change. B) one of the parties will default. C) they are highly liquid and the market price will change. D) high U.S. government deficits will limit the availability of swaps.

94)

Credit default swaps

A) are short-term agreements that do not require collateral. B) help reduce uncertainty about who bears the credit risk on a given loan. C) make it more difficult for sellers of insurance to assume and conceal risk. D) provide a division of labor where one party identifies loan opportunities and collects payments while someone else worries about default risk.

95)

Using a credit default swap,

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A) a lender can make a loan without facing the possibility of default. B) lenders cannot insure themselves against the risk that a borrower will default. C) financial institutions have more transparency about risk. D) the buyer pays a fee to the seller to accept the risk of default.

96)

Standardization of derivative contracts A) results in increased risk for the parties involved. B) makes them more difficult to understand and therefore leads to increased misuse. C) makes the premiums involved with these contracts increase. D) leads to greater liquidity and lower risk.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 97) As the chapter points out, there have been many cases where derivatives have led to a lot of abuse. If this is the case, why do derivatives exist?

98)

Explain how an interest rate futures contract differs from an outright purchase of a bond.

99)

What are the three main ways to categorize derivatives?

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100)

Explain why a forward contract may actually carry more risk than a futures contract.

101) Explain why the two parties in a futures contract technically do not make a bilateral agreement with each other.

102) Explain how the clearing corporation reduces the risk it faces in the futures market through the use of margin accounts and marking to market.

103) We have a futures contract for the purchase of 10,000 bushels of wheat at $3.00 per bushel. If the price of wheat were to increase to $3.50, explain what happens to the parties involved in the contract in terms of marking to market. Be sure to identify who is long and short and specifically how much is transferred.

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104) A lender obtains funds from depositors by offering short-term interest rates on savings accounts. The lender uses these funds to make longer-term installment loans. Explain how the lender might make use of the futures market to hedge the risk taken.

105) How is the lack of futures markets in poor countries linked to the fact that farmers in poor countries are likely to remain poor?

106) What is the process that makes sure the market price of an underlying asset equals the price of a futures contract at the settlement date? Provide an example.

107) Consider a call option. In terms of the option writer and option holder, who is the buyer? Who is the seller? Finally, who has the option? Explain.

108) With a put option, what specifically does the option holder receive for the price paid for the option?

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109) Suppose an investor is considering different options as described here. Answer the questions by filling in the table as directed. a. The investor could purchase a futures contract to buy a share of stock at some point in the future for $200. Fill in column A in the table to show the profit/loss at various prices on the settlement date. b. The investor could buy a call option at a strike price of $200, giving her the right to buy the stock for$200. She pays $1 for the right to make this purchase. Including this time value of the option, fill in column B in the table to show the profit from buying this call at the various prices in the table. c. The investor could sell a put option, which obligates her to buy the stock at a price of $200 if the buyer of the put exercises the option before the expiration date.Assume she receives $1 from the buyer of the put when she initially sells it.Including this put premium, fill in column C in the table to show the profit from selling this put at the various prices in the table. d. Compare your answers for profit from the futures contract with your answers for the profit from the options. What conclusion can you draw? What does this illustrate about derivatives? Price of Stock at Settlement or Price at Expiration

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Buy Futures Contract Profit (A)

Buy Call Option Profit (B)

Sell Put Option Profit (C)

110) Describe the condition that would have a call option in the money. Now describe the condition that has a put option out of the money.

111)

Explain the difference between American and European options.

112)

If the option holder is the individual with the options, why is anyone an option writer?

113) a. What are the four attributes on which the time value of any financial instrument depends? (Hint: The answer was first presented in Chapter 3.) b. Recalling that Option value = Intrinsic value + Time value, fill in the following table with “increase” or “decrease” to summarize how an increase in each factor affects the call (right to buy) and put (right to sell). Increase in One Factor, Holding All Others Fixed

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Call (the right to buy)

Put (the right to sell)

Increase in the strike price Increase in the market price of the underlying asset Increase in the time to expiration Increase in the volatility of the underlying asset price

114) Suppose you purchase a call option to purchase General Motors common stock at $80 per share in March. The current price of GM stock is $83 and the time value of the option is $5. What is the intrinsic value of the option? As the expiration date approaches, what will happen to the size of the time value of the option?

115) Suppose you purchase a put option to sell General Motors common stock at $80 per share in March. The current price of GM stock is $83 and the time value of the option is $1. What is the intrinsic value of the option?

116)

Why does the time value of the option tend to vary directly with the time to expiration?

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117) What would be the value of an option on a stock that sells at a fixed price with a standard deviation of zero? Explain.

118)

Identify four factors that will cause the value of call options to increase.

119)

Identify four factors that will cause the value of put options to decrease.

120) If the current closing price of the stock of XYZ, Inc. is $87.50 and the July expiration call options with a strike price of $80 are selling for $9.45, what is the intrinsic value of the option? What is the time value of the option?

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121) If the current closing price in the stock of XYZ, Inc. is $87.50 and the July expiration put options with a strike price of $80 are selling for $1.05, what is the intrinsic value of the option? What is the option premium?

122)

Why do government debt managers often use interestrate swaps?

123)

Explain the concept of notional principal used in swaps.

124)

How does trading in over-the-counter markets increase systemic risk?

125)

What is a credit default swap?

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126)

How did credit default swaps contribute to the financial crisis of 2007–2009?

127) Imagine a baker who has the opportunity to bid on a contract to supply a local military base with bread for an entire year. The problem is the baker must commit to a price today and hold to that price for the entire year. Identify the risk faced by the baker, and explain how the use of a futures contract could transfer the risk.

128)

A futures contract is a forward contract with some important differences. Explain these.

129) Explain the popularity of options in the context of the potential gains and losses they offer.

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130) Explain why, for speculation, the purchase of an option may be more attractive than a futures contract or the outright purchase of the underlying asset.

131) What questions should an employee ask before accepting options as a part of or instead of a salary?

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Answer Key Test name: Chap 09_6e 1) B 2) B 3) D 4) C 5) C 6) D 7) A 8) B 9) A 10) C 11) B 12) A 13) B 14) A 15) B 16) B 17) A 18) B 19) C 20) D 21) C 22) D 23) B 24) D 25) B 26) C Version 1

27) D 28) B 29) A 30) B 31) C 32) B 33) D 34) C 35) A 36) A 37) B 38) A 39) B 40) C 41) A 42) C 43) B 44) C 45) B 46) C 47) D 48) A 49) C 50) B 51) D 52) A 53) D 54) B 55) C 56) D Version 1

57) B 58) D 59) B 60) A 61) C 62) C 63) B 64) A 65) D 66) C 67) C 68) A 69) C 70) C 71) C 72) D 73) C 74) B 75) A 76) C 77) A 78) A 79) B 80) C 81) A 82) B 83) D 84) D 85) B 86) C Version 1

87) D 88) A 89) A 90) B 91) D 92) D 93) B 94) D 95) A 96) D 97) When used properly, derivatives are very helpful financial instruments. They allow people to transfer risk to those most willing to bear it and as a result they can undertake profitable but risky projects that they otherwise wouldn't. The economy, as a result, performs more efficiently. 98) An investor who purchases a bond does so with the thought that the price of a bond is going to rise. There really is no way to profit from a price decline when you actually purchase the bond. On the other hand, an investor can profit from price declines in bonds by using an interest rate futures contract. With such a contract, two individuals agree that they will make payments to the counterparty based on interest rate movements over some specified time period. Another key difference is that with the futures contract (derivative) one person's loss is the counterparty's gain. The amount on the table never changes, it just moves between the counterparties. Yet another difference is that a futures contract is equivalent to a low-cost, leveraged exposure to fluctuations in the bond price. 99) Derivatives can be categorized as forwards, futures, options, and swaps.

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100) A forward contract is a private agreement between two parties that is customized for the two parties. As a result, the high degree of customization makes them very difficult if not impossible to resell. Futures contracts on the other hand are highly standardized. The high level of standardization allows them to be bought and sold on organized exchanges, which increases their liquidity and reduces risk. In addition, forward contracts are private agreements and thus carry greater default risk. Futures contracts are usually settled through clearing corporations where procedures such as mark to market greatly reduce default risk. 101) With a futures contract, the high degree of standardization allows for the use of a clearing corporation. Of the many roles the clearing corporation performs, one is to be the actual counterparty. The two parties to a futures contract make an agreement with the clearing corporation which acts like an insurance company, guaranteeing that both parties will meet their obligations. This increases the efficiency and use of futures contracts. 102) The clearing corporation requires each party to a futures contract to place a deposit with the corporation. This practice is called posting margin in a margin account. The margin account serves as a guarantee that when the contract comes due the parties can meet their obligations. Minimum deposits must be maintained in these accounts or the contracts are sold. The daily process of marking to market has the corporation posting gains and losses to each party’s account. Again, this guarantees that obligations are met. If an individual's margin account falls below the minimum required the contract will be sold.

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103) The buyer of the contract, the long position, will pay $30,000 for 10,000 bushels of wheat. The seller of the contract, the short position, delivers 10,000 bushels of wheat and receives $30,000. If before expiration the market price of wheat increases to $3.50, the seller (short) will have to give the buyer (long) $5000, so that the buyer will still only have to pay $30,000 for the wheat. So the buyer's margin account will be marked to market (credited) with $5,000, which comes from the seller's margin account which is marked to market (debited) for the $5,000. 104) The lender faces the risk that short-term interest rates will increase. The lender can hedge this risk by selling futures contracts for U.S. Treasury bills that are also short term. If interest rates increase, the lender will profit from the futures contracts. 105) As discussed in the chapter, the access to and use of futures markets allows individuals to transfer risk to those most willing to bear it. For example, a wheat farmer in the U.S. does not need to worry about the price of wheat falling when the crop comes in because the farmer can sell a futures contract at a specified price. As a result of transferring this risk, the farmer will plant a larger crop and have a higher income. But as we also saw in the chapter, the use of futures requires the posting of margins. This is something that poor farmers would find very difficult to do. As a result, many poor farmers do not have access to the futures market, cannot transfer risk, and as a result, plant smaller crops and have lower incomes.

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106) The process that makes sure the price of the underlying asset and the price of the futures contract are the same at the settlement date is arbitrage. Arbitrage is the process where an individual earns a profit without incurring any risk. For example, let’s say one year before the settlement date the futures price for delivery of a 5 percent 10-year coupon bond is $1,100. Currently the spot market price of the bond is $1,000 and the investor can borrow at 5 percent. An investor could borrow $1,000, purchase the 10-year bond, and sell a bond future for $1,100 promising delivery of the bond in one year. The investor can use the interest payment on the bond to pay the interest on the loan and deliver the bond to the buyer of the futures contract on the delivery date. This transaction is riskless and nets the investor a profit of $100 without putting up any funds. 107) In the case of a call option, the option writer is the seller. Here the option writer is stating the underlying asset, strike price, and expiration or delivery date. The option holder is the buyer of the option. The option holder buys the right to have the option of actually purchasing the underlying asset on or before the expiration date for the strike price. The option holder has the option, because she could let the option expire and not "call away" the underlying asset, just foregoing the price paid for the option. 108) The option holder (buyer) receives the right, but not the obligation, to sell the underlying asset at a specific (strike) price on or before the expiration date of the option. If the strike price is above the spot or current market price, the option holder will profit from exercising the option. If the strike price is below the spot price of the underlying asset, the option holder will let the option simply expire. 109) Price of Stock at Settlement or Price at

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Buy Futures Contract Profit (A)

Buy Call Option Profit (B)

Sell Put Option Profit (C) 40

Expiration 190 195 200 205 210

−10 −5 0 5 10

−1 −1 −1 4 9

−9 −4 1 1 1

Note that the sum of the profit from the options (buying call and selling put) is equal to the profit from the future contract at each price. This illustrates the flexibility of derivatives. 110) A call option will be in the money when the strike price is below the spot or current market price. The option holder has the right to call the asset away from the option writer at a price below what the asset could be sold for on the spot market. A put option is out of the money when the strike price is below the spot or market price. Here the option holder has the right to put (sell) the asset to the option writer at a predetermined (strike) price. If the strike price is below the market price the option holder would be better off selling the asset on the spot market versus selling it to the option writer. 111) American options can be exercised on any date from the time they are written until the date they expire. As a result, the holder of an American option has three choices: (1) continue to hold the option, (2) sell the option to someone else, (3) exercise the option immediately. The holder of a European option has only two options on a date prior to expiration, hold or sell.

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112) Option writers really fall into two categories. One group is simply speculators. These individuals are willing to bet that the market price will not move against them and they will take this risk for the fee they obtain. The second category includes holders of the asset who can write a call option or dealers who are short of the underlying asset who can write a put option. When you own the underlying asset, writing a call option that obligates you to sell it at a fixed price does not carry as much risk. Similarly, when a dealer is short of the underlying asset, it is less risky to sell a put option. 113) a. As described in Chapter 3, the value of any financial instrument depends on the size of the promised payment, the timing of the payment, the likelihood that the payment will be made, and the circumstances under which the payment will be made. b. Increase in One Factor, Call (the right to buy) Put (the right to sell) Holding All Others Fixed Increase in the strike Decrease (intrinsic Increase (intrinsic price value falls) value rises) Increase in the market Increase (intrinsic Decrease (intrinsic price of the value rises) value falls) underlying asset Increase in the time Increase (time value Increase (time value to expiration rises) rises) Increase in the Increase (time value Increase (time value volatility of the rises) rises) underlying asset price

114) The intrinsic value of an option is equal to the difference between the current market price and the strike price, which in this case is $83− $80, or $3. The time value of the option at expiration is zero since the option value equals the intrinsic value.

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115) In this case the intrinsic value of the option is zero. The intrinsic value of a put option is the strike price less the price of the underlying asset, which in this case is a negative 3; however, an option will never have an intrinsic value less than zero since the option doesn't have to be exercised. 116) Prior to expiration there is always the chance that the market price of the underlying asset will move to make the option valuable. Since probability of this happening is greater with more time to expiration, the time value of the option moves directly with time to expiration since the time value of the option reflects this potential benefit. 117) Absent intrinsic value in the option, a stock that has no volatility in its price has an option that will never pay off, so no one would have any interest in owning it and the option would be worthless and so would not exist. In order for options to have value, the price of the underlying asset must have some volatility to it (meaning a standard deviation greater than zero). 118) Call options will increase in value if there is a decrease in the strike price; if there is an increase in the market price of the underlying asset, if there is an increase in the time to expiration, or if there is an increase in the volatility in the price of the underlying asset. 119) Put options will decrease in value if there is a decrease in the strike price, if there is an increase in the market price of the underlying asset, if there is a decrease in the time to maturity, or if there is a decrease in the volatility in the price of the underlying asset. 120) The intrinsic value of a call option is the market price less the strike price, or in this case $7.50. The time value of the option is the option price less the intrinsic value, which in this case is $9.45 less $7.50 or $1.95.

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121) The intrinsic value of a put option is the strike price less the market price, which in this case is a negative $7.50. An option cannot have an intrinsic value less than zero, however, since the option does not have to be exercised. So in this case the intrinsic value is zero. The option premium is the option price less the intrinsic value, so the option premium is $1.05. 122) Government debt managers find that oftentimes they can minimize borrowing costs by issuing longer term bonds. There is a strong market for these bonds. The problem, however, is that government revenues tend to rise during economic good times and fall during bad times. Short-term interest rates tend to follow the economy as well, rising during good times and falling during recessions. Government debt managers can often obtain both the benefits of offering long-term bonds and matching interest expenses with revenues by using interest rate swaps. 123) The idea of notional principal as used in swaps is a principal amount that serves as the basis for the calculations involved with swaps. The actual principal is never borrowed, lent, or exchanged. 124) By making markets less transparent. OTC transactions are bilateral and largely conducted out of the view of other market participants, reducing the transparency of such transactions. The lack of transparency means that traders cannot observe the risks taken by their counterparties and cannot charge an appropriate risk premium for a trader taking a large volume of concentrated risks. If such a large trader were to fail, its counterparties could be seriously impaired, posing a threat to the financial system. 125) A CDS is a credit derivative that allows lenders to insure themselves against the risk that a borrower will default. The buyer of a CDS makes payments to the seller, and the seller agrees to pay the buyer if an underlying loan or security defaults. Version 1

126) Credit default swaps contributed to the 2007–09 financial crisis in the following three important ways: (1) fostering uncertainty about who bears the credit risk on a given loan or security, (2) making the leading CDS sellers mutually vulnerable, and (3) making it easier for sellers of insurance to assume and conceal risk. 127) The baker faces the problem of not knowing what the future price of flour (wheat) will be. He may feel quite comfortable developing a price for the bread based on the current prices of wheat, but if the price of wheat should increase the bread-making profits will fall and may turn into significant losses. Without the ability to transfer this risk, the baker would probably have to pass on this opportunity. Fortunately, the baker could purchase a wheat futures contract that would expire in a year, giving him the right to purchase some quantity of wheat at a price reflecting today's market price. If the market price of wheat increases he will lose on the baking operation but the value of his futures contract will increase. If the price of wheat falls, his futures contract loses value but his baking profits will increase. 128) A futures contract is a forward contract that has been standardized and which is sold through an organized exchange. Forward contracts generally are private agreements between two parties and as a result are customized and therefore difficult to sell. The high level of standardization of futures increases their liquidity and reduces risk. In addition, since forward contracts are private agreements they carry greater default risk. Futures contracts are usually settled through clearing corporations that serve as the actual counterparty. The two parties to a futures contract make an agreement with the clearing corporation that acts like an insurance company, guaranteeing that both parties will meet their obligations. Moreover, procedures such as mark to market greatly reduce default risk. As a result of these differences, the efficiency and use of futures contracts are enhanced. Version 1

129) Option contracts are popular because for the option holder the upside of the option is very high. In the case of a call option, if the market price of the stock rises above the strike price the option gains significantly in value, and since (theoretically) market prices are not capped, the potential gains are very high. On the other hand, the option holder finds that the most he or she can lose is the fee paid for the option since the holder has the right to not exercise the option. From the option writer's perspective, many writers are speculating that the price of the asset will not move against them and for the option fee are willing to take that bet. It is hard to say that this is the group that makes the options popular. More likely it is the hedgers, the market makers in the underlying assets that transfer risk, that add to the popularity of options. 130) Let's say an investor believes that interest rates are going to fall over the next few months. There are three ways to bet on this possibility. One is to purchase a bond and if the investor guesses correctly, the bond price will rise as the interest rate falls. This is expensive since it requires the purchase of the bond. Another strategy is to purchase a futures contract, meaning take the long position. If the market price of the bond increases with falling interest rates, the investor will reap the profits. This approach requires a small investment, but this approach is also very risky since the investment is highly leveraged since the market price can move against the investor. A third strategy involves the use of an option. The investor could purchase a call option on a Treasury bond. If he or she is right and interest rates fall, the value of the call option will rise, which is the upside. On the other hand, if the investor bets wrong and interest rates rise, the option will expire worthless and the investor just loses the fee paid for the option. The bet is both highly leveraged and limited in its potential losses.

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131) Most of the time when employees receive the options (call options), the strike price is set at the current market price of the stock, and so the options are at the money. If the price of the company's stock increases, the value of the options will also rise and the rise can be dramatic. However, this is not unlike buying lottery tickets; there may be a high payoff but it may not come for years. And, if the company goes broke or you lose your job, the options may become worthless (some companies either do not permit employees to sell the options or may require that the employees stay with the firm in order to exercise them).

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CHAPTER 10 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) From October 1997 to January 1998, the economy of South Korea was in turmoil. One of the problems was A) the currency of South Korea appreciated considerably making it very difficult for Korean exporters to sell goods abroad. B) the value of the U.S. dollar compared to the Korean won fell by more than half. C) U.S. goods became very cheap to Koreans making it difficult for Korean manufacturers to compete with imports. D) the value of the won fell by more than half compared to the U.S. dollar, making U.S. goods very expensive to Koreans and Korean goods relatively inexpensive for U.S. residents.

An American traveling to Europe finds it easier to make purchases since 1999, because

A) most countries in Europe accept U.S. dollars. B) most of the countries of Europe have adopted the British pound as the standard currency. C) many of the countries in Europe now use the same currency, the euro. D) exchange rates in Europe do not change.

At its most basic level, the exchange rate is

A) the amount of goods in one country that could be obtained with a unit of currency from another country. B) always expressed as units of a foreign currency per U.S. dollar. C) the rate that one can exchange a good from one country into a domestic product. D) the tool used to measure the price of one currency in terms of another.

The nominal exchange rate is

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A) the amount of one country's goods that could be obtained with a basket of goods of another country. B) always expressed as units of a foreign currency per U.S. dollar. C) the rate that one can exchange the currency of one country for the currency of another country. D) a synonymous term for the swap rate.

5) If an American traveling abroad can obtain 115 euros for $100 U.S., the current euro per dollar exchange rate is A) 0.870 euros/$. B) 1.15 euros/$. C) 115 euros/$. D) 1 euro/$1.15.

6) If, in late 2020, 100 U.S. dollars exchanged for 118 euros and in mid-2021 100 U.S. dollars exchanged for 127 euros, then A) the euro appreciated relative to the dollar. B) the dollar appreciated relative to the euro. C) European goods became more expensive to Americans. D) American goods became more expensive to Americans.

If the Japanese yen appreciates against the U.S. dollar,

A) Americans should find Japanese goods are now less expensive. B) Japanese residents would find Japanese goods are relatively less expensive than American goods. C) U.S. goods should be less expensive relative to Japanese goods in both countries. D) Japanese goods should be less expensive relative to U.S. goods in both countries.

The nominal exchange rate is

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A) the price of a good in one country expressed in units of the same good in another country. B) fixed by the central banks of countries. C) the price of one country's currency stated in units of another country's currency. D) adjusted once a year and is the price at which goods are traded.

Which one of the following statements is most correct?

A) If the U.S. dollar depreciates relative to the yen, then it is likely also depreciating relative to the euro. B) If the U.S. dollar is appreciating relative to the euro, the euro is likely depreciating relative to the yen. C) If the U.S. dollar is depreciating relative to the euro it is likely depreciating relative to all currencies. D) If the U.S. dollar is appreciating relative to the yen, the yen is depreciating relative to the U.S. dollar.

10)

In quoting exchange rates,

A) one should always quote these as units of foreign currency over a unit of domestic currency. B) one should always quote the rate as the units of domestic currency over a unit of foreign currency. C) usually one should quote the rate in such a way that the value is greater than one. D) each country's central bank determines how the rate is to be quoted.

11)

The forward exchange rate is

A) the rate at which foreign exchange dealers are willing to commit today to buying or selling a currency in the future. B) a synonymous term for the nominal exchange rate. C) the same as the spot rate. D) always above the spot rate since it carries greater risk.

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12) Which piece of information is needed in order to determine whether a U.S. dollar will buy more in the U.S. or in a foreign country? A) nominal exchange rate B) real exchange rate C) Whether the nominal exchange rate is > or < than 1. D) Actual conversion of U.S. dollars to the foreign currency when you are physically in the foreign country.

13)

The real exchange rate is defined as the

A) nominal exchange rate plus the rate of inflation. B) spot exchange rate. C) cost of a basket of goods and services in one country compared to the cost of the same basket in another country. D) exchange rate that would exist if nominal rates were not fixed by governments.

14) If a Japanese Toyota sells for 2,500,000 yen and the nominal exchange rate is 110 yen per dollar, then the dollar price of the Japanese automobile is A) 22,727 yen. B) $20,000. C) $25,000. D) $22,727.

15) A bagel costs $1 in New York and 0.5 euros in Paris. If the real exchange rate is one-half of a New York bagel for a Parisian bagel, how many euros should you receive in exchange for $1? A) 0.1 B) 2 C) 0.25 D) 1.5

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16) A bottle of wine costs $50 in New York, and it takes 0.92 euros to buy 1 U.S. dollar. How much would the bottle of wine cost in Paris? A) $50.00 B) $46.00 C) 46 euros D) 50 euros

17)

Appreciation of the real exchange rate A) makes U.S. exports more expensive to foreigners. B) makes U.S. exports less expensive to foreigners. C) means a basket of U.S. goods would exchange for fewer foreign goods. D) benefits all U.S. producers.

18)

The real and nominal exchange rates differ in the sense that

A) the real exchange rate does not express differences in the purchasing power of a currency. B) the nominal exchange rate is adjusted for price differences between countries and the real is not. C) the nominal exchange rate does not reflect differences in purchasing power between currencies. D) nominal exchange rates are fixed but real rates are flexible.

19) If we let P = the domestic price of a basket of goods and Pf = the foreign price of the same basket of goods, and Ɛ = the nominal exchange rate of U.S. $/foreign currency, then the real exchange rate is best expressed as A) P/( Pf × Ɛ) B) P f / P C) P f /( P × Ɛ) D) (Ɛ × P)/ Pf

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20) If we let P = the domestic price of a basket of goods and Pf = the foreign price of the same basket of goods measured in domestic currency, then A) if P/ P f > 1 foreign products will seem inexpensive. B) if P/ P f >1 foreign products will seem expensive. C) if P/ P f = 1 the nominal exchange rate is also = 1. D) you cannot determine the relative prices of foreign goods from the equation P/ P f.

21)

Depreciation of the real exchange rate A) makes U.S. exports more expensive to foreigners. B) makes U.S. exports less expensive to foreigners. C) means a basket of U.S. goods would exchange for more foreign goods. D) means an appreciation of the nominal exchange rate.

22)

The annual volume of foreign exchange transactions is A) small relative to most financial markets. B) one-eighth the world GDP. C) three times the world trade volume. D) more than 18 times larger than world GDP.

23)

Considering foreign exchange transactions, A) the U.S. dollar is exchanged in roughly 50% of all currency transactions. B) all transactions involve the use of the U.S. dollar. C) most of these transactions are handled in New York. D) more transactions are handled in London than anywhere else.

24)

The law of one price

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A) is based on arbitrage. B) applies only to real goods and not financial assets. C) can explain short-run exchange rates but not long-run exchange rates. D) is a mathematical concept that is not useful in explaining exchange rates.

25) If the euro/U.S.$ exchange rate is 1.1€/U.S.$ in New York but 1.05€/U.S.$ in London, we should see A) people selling U.S. dollars and buying euros in New York and then selling those euros and buying dollars in London. B) people selling euros and buying dollars in New York and then buying euros by selling dollars in London. C) the price differential between the markets increase as people seek to take advantage of the situation. D) the dollar appreciate in New York relative to the euro.

26) If we ignore transportation costs and the price of a pair of Nike shoes in Detroit is 100 U.S. dollars, what should be the price of the Nike shoes in Windsor, Canada (in Canadian dollars) if the nominal exchange rate is 1.36 Canadian dollars/1 U.S. dollar? A) 74 B) 100 C) 136 D) 64

27) Considering the law of one price, evidence in the foreign exchange markets over brief intervals shows that A) the law works most of the time. B) this is the closest thing to a perfect law in economics. C) the law fails most of the time. D) the law only works in the very short run.

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28)

Which one of the following does not contribute to the failure of the law of one price? A) tariffs B) transportation costs C) technical specifications D) tastes are similar across countries

29)

The law of one price fails as a result of A) low tariffs. B) insignificant transportation costs. C) similar technical specifications. D) goods that cannot be traded.

30)

Concrete likely does not follow the law of one price due to A) technical differences. B) lack of information regarding prices. C) tariffs. D) high transportation costs.

31) With regard to exchange rate determination, the law of one price is a useful theory only when applied to A) long-run periods of time. B) forward exchange rates. C) very short-run periods of time. D) futures contracts.

32) The theory of purchasing power parity implies the real exchange rate between two countries is

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A) flexible. B) less than one. C) greater than one. D) equal to one.

33)

The theory of purchasing power parity says that

A) the real exchange rate is always greater than one. B) a dollar should buy the same goods no matter where in the world you go. C) the dollar price of a basket of goods in the United States should equal the yen price of a basket of goods in Japan. D) the real exchange rate is always less than one.

34)

The law of one price is not expected to hold for A) differentiated goods. B) financial assets. C) commodity goods. D) oil.

35)

A tariff disrupts the workings of the law of one price because tariffs A) are standardized by GATT. B) are taxes on imports and can vary across products and countries. C) apply only to goods countries export. D) are only applied to commodity products.

36) One reason the theory of purchasing power parity may not explain price differences between countries is that

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A) real exchange rates are almost impossible to calculate. B) inflation rates differ across countries. C) some products do not trade. D) nominal exchange rates are flexible.

37)

Purchasing power parity says that

A) differences in inflation rates between countries should have no impact on the exchange rate between those countries. B) differences in inflation rates between countries will create changes in exchange rates. C) the changes in exchange rates move independently from inflation. D) for inflation to change the exchange rate, the rate of inflation has to be the same between countries.

38)

The theory of purchasing power parity

A) contradicts the law of one price. B) explains exchange rate movements in the short run, while the law of one price explains exchange rate movements over the long run. C) assumes away inflation to have any validity. D) extends the law of one price to a basket of goods.

39) If Great Britain experiences higher rates of inflation than the United States over a long period of time, we should expect the British £ (pound) per U.S.$ (dollar) exchange rate to A) increase. B) hold constant because there isn't any link between inflation and exchange rates. C) decrease. D) fluctuate in a narrow range set by the Bank of England.

40) If inflation in the United States averages more than inflation in the euro area over a long period of time, we should expect

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A) the dollar to appreciate relative to the euro. B) the euro/U.S. dollar exchange rate to fluctuate in a narrow range set by the European Central Bank. C) the dollar to depreciate relative to the euro. D) no effect because there isn't a link between inflation and exchange rates over the long run.

41)

The theory of purchasing power parity assumes that the A) real exchange and nominal exchange rates are fixed. B) nominal exchange rate is fixed but the real exchange rate is flexible. C) real exchange rate is fixed but the nominal exchange rate is flexible. D) real exchange rate varies with the inflation differential.

42) Considering the theory of purchasing power parity, if inflation in Mexico is 5% while prices in the United States are stable, we should expect, over the period of a year, the A) dollar to appreciate 5% relative to the peso. B) peso to appreciate 5% relative to the dollar. C) nominal exchange rate to stay fixed. D) real exchange rate of U.S. goods / Mexican goods to appreciate 5%.

43) that

The empirical evidence on purchasing power parity over the long run seems to point out

A) the higher a country's inflation rate, the greater is the appreciation in the country's currency. B) the theory of purchasing power parity cannot explain long-run changes in exchange rates. C) the higher a country's inflation rate, the greater is the depreciation in the country's currency. D) there isn't any clear link between inflation rates and exchange rates.

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44)

The empirical evidence on purchasing power parity seems to point out that

A) it can explain long-run movements in exchange rates but does not hold up to scrutiny for short-run changes. B) it does a good job of explaining short-run movements in exchange rates, but does not hold up to scrutiny over the long run. C) it is a good theory for international trade, but it is of little use in explaining exchange rate movements. D) inflation and a country's rate of currency appreciation are positively correlated.

45)

Differences in inflation rates between two countries can explain

A) short-run changes in the exchange rate but not long-run changes. B) changes in the real exchange rate over the long run, but not changes in the nominal exchange rate. C) long-run changes in the exchange rate but not short-run changes. D) changes in the exchange rate in both the short run and the long run.

46)

When a currency is described as overvalued, this typically implies that

A) it is overvalued relative to the exchange rate set by the nation's central bank. B) it is selling at an exchange rate less than one. C) the exchange rate is higher than one year previous. D) its current market value is higher than the value that is thought to be consistent with purchasing power parity.

47)

When a currency is described as undervalued, this typically implies that A) it is undervalued relative to what the describer believes purchasing power parity to

be. B) it is undervalued relative to the exchange rate set by the nation's central bank. C) the exchange rate is greater than one. D) the exchange rate is lower than one year previous.

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48)

A country's current account represents the A) amount one country owes to another country. B) net flow of all transactions between one country and another country. C) amount a country imports from the rest of the world. D) net flow of goods and services between that country and the rest of the world.

49)

A country with a current account surplus A) has imported more than it has exported. B) has borrowed heavily from the rest of the world. C) has exported more than it has imported. D) also has a capital account surplus.

50)

A country that exports more than it imports will have a current account A) deficit and a capital account deficit. B) surplus and a capital account surplus. C) deficit and a capital account surplus. D) surplus and a capital account deficit.

51)

A country that exports less than it imports will have a current account A) deficit and a capital account deficit. B) surplus and a capital account deficit. C) surplus and a capital account surplus. D) deficit and a capital account surplus.

52)

A country's capital account

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A) is synonymous with the current account. B) will be in a deficit position when the current account is in a deficit. C) will be in a surplus position if the current account is in a deficit position. D) reflects the sum of exports minus imports.

53) When a country's current account balance is added to its capital account balance, the sum should be A) twice the current account. B) zero. C) positive. D) negative.

54) rate

A country running a current account deficit over a long time is likely to see its exchange

A) hold steady. B) appreciate. C) depreciate. D) rise, fall, or hold steady since the current account and the exchange rate are not linked.

55) rate

A country running a current account surplus over many years is likely to see its exchange

A) appreciate. B) depreciate. C) hold steady. D) rise, fall, or hold steady since the current account and the exchange rate are not linked.

56)

A country that has a capital account deficit

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A) is a net seller of assets. B) is importing more goods and services than it exports. C) also has a current account deficit. D) is a net buyer of assets.

57)

A country that has a capital account surplus A) is a net seller of assets. B) has a current account surplus. C) is a net buyer of assets. D) will see its currency remain steady.

58)

A country that has a capital account deficit A) is a net seller of assets. B) imports more goods and services than it exports. C) has a current account surplus. D) has a current account deficit.

59)

Short-run movements in nominal exchange rates are primarily due to A) changing prices of goods and services in the countries involved. B) changing expected rates of return on domestic and foreign assets. C) inflation differentials. D) changes in exports.

60)

A U.S. resident who wants to purchase an automobile that comes from Japan will A) be supplying yen on the foreign exchange market. B) make up part of the demand for dollars on the foreign exchange market. C) make up part of the supply of dollars on the foreign exchange market. D) not be a participant in the foreign exchange market.

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61) Which one of the following provides a strong incentive to supply dollars on the foreign exchange market? A) to purchase goods and services produced abroad B) to get a lower return paid on foreign currencies that is not subject to the risk associated with exchange-rate fluctuations C) to invest in U.S. assets D) to take advantage of higher inflation rates in other countries

62) Considering the euro/U.S. dollar exchange rate, as a U.S. dollar increases in value versus the euro (holding other factors constant), A) we would expect the supply curve of dollars to slope downward. B) foreign goods become relatively less expensive than American goods. C) foreign assets become relatively more expensive than American assets. D) American goods become relatively less expensive than foreign goods.

63) Considering the euro/U.S. dollar exchange rate, as a U.S. dollar decreases in value versus the euro (holding other factors constant), this would be represented by a(n) A) downward movement along the supply of dollars curve. B) upward sloping demand for dollars curve. C) leftward shift of the supply of dollars curve. D) upward movement along the demand for dollars curve.

64)

In the foreign exchange market, the demand for U.S. dollars is made up from A) foreigners desiring to purchase U.S. goods, services, and assets. B) Americans who want to hold more currency. C) Americans wishing to purchase foreign goods, services, and assets. D) Americans who want to invest in foreign assets.

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65) Considering the euro-U.S. dollar market, as a euro purchases a larger number of U.S. dollars, we should see A) the quantity of dollars demanded decrease. B) the quantity of dollars supplied increase. C) an increase in the purchase of U.S. assets by Europeans. D) a decrease in American exports to Europe.

66) If Americans develop a greater appreciation for Mexican-made goods, we should observe which one of the following change(s) in the U.S. dollar-peso market? A) The demand curve for dollars shifts right. B) The supply curve of dollars shifts left. C) The demand curve for pesos shifts right. D) There is a movement down the supply curve of dollars.

67) If Americans develop a greater appreciation for Mexican-made goods, we should observe which one of the following change in the dollar-peso market? A) The supply curve of dollars shifts right. B) The demand curve for pesos shifts left. C) The supply curve of dollars shifts left. D) The demand curve for dollars shifts right.

68) If Europeans increase their demand for American cars, everything else constant, we should observe which one of the following change in the U.S. dollar-euro market? A) The supply curve of dollars shifts left. B) The demand curve for dollars shifts left. C) The demand curve for dollars shifts right. D) The supply curve of dollars shifts right.

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69)

Select the change that could result in the shift illustrated in the following graph.

A) increase in riskiness of foreign investment (relative to U.S. investment) B) decrease in American wealth C) expected depreciation of the dollar D) decrease in real interest rate on foreign bonds (relative to U.S. bonds)

70) Select the change described below that could result in the shift illustrated in the following graph.

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A) increase in riskiness of U.S. investment (relative to foreign investment) B) decrease in foreign wealth C) expected depreciation of the dollar D) decrease in real interest rate on U.S. bonds (relative to foreign bonds)

71) An increase in wealth in the U.S. will lead to which one of the following in the foreign exchange market? A) a decrease in the demand for dollars B) a decrease in the supply of dollars C) an increase in the supply of dollars D) an increase in the demand for dollars

72) A decrease in Americans' preference for foreign goods will lead to which one of the following in the foreign exchange market? A) an increase in the demand for dollars B) a decrease in the supply of dollars C) a depreciation of the dollar relative to foreign currencies D) a movement down the demand curve for dollars

73) An increase in the real interest rate on U.S. bonds, everything else equal, will have which one of the following impacts on the foreign exchange market? A) The demand for dollars will decrease. B) The supply of dollars will increase. C) The dollar will depreciate relative to foreign currencies. D) The demand for dollars will increase.

74) An increase in the real interest rate on U.S. bonds, everything else equal, will have which one of the following impacts on the foreign exchange market?

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A) The demand for dollars will increase. B) The supply of dollars will increase. C) The dollar will depreciate relative to foreign currencies. D) There will be a movement up the existing demand for dollars curve.

75)

An increase in European wealth, all other factors held constant, should A) have no impact at all on the demand for dollars. B) cause the demand for dollars to decrease. C) cause the demand for dollars to increase. D) cause the supply of dollars to increase while the demand stays constant.

76)

An expected appreciation of the dollar, everything else held constant, should cause the A) supply of dollars to increase. B) demand for dollars to increase. C) demand for dollars to decrease. D) dollar to depreciate now relative to other currencies.

77) If a dollar currently purchases 120 Japanese yen, and it is expected that one year from now a dollar will purchase 130 yen, then the A) demand for dollars now will increase. B) demand for dollars now will decrease. C) dollar is expected to depreciate. D) yen is expected to appreciate.

78) If U.S. assets are seen as having greater risk relative to foreign assets in the market for foreign exchange, this should cause the

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A) demand for dollars to increase. B) supply of dollars to decrease. C) supply of dollars to increase. D) dollar to appreciate.

79) Between 1998 and the end of 2000, the United States ran a large trade deficit; this should have caused the dollar to depreciate against foreign currencies but instead the dollar appreciated. The main reason for this is that A) foreign exchange markets are slow to react. B) the supply of dollars actually fell. C) the dramatic increase in U.S. stock prices attracted a lot of foreign capital which increased the demand for dollars by more than the increase in the supply of dollars. D) the demand for dollars shifted left by more than the supply of dollars shifted right.

80) If government policymakers intervene in foreign exchange markets to cause the domestic currency to appreciate, this A) will benefit all residents of the country. B) will be beneficial to foreign consumers. C) would be harmful to exporters. D) would be harmful to importers.

81)

A foreign exchange intervention is

A) synonymous with a fixed exchange rate. B) the use of public statements by government officials to influence inflation expectations. C) only used in crisis situations. D) the buying/selling of currencies to affect supply or demand, which impacts the exchange rate.

82)

Large, advanced economies like the United States, Japan, and the euro area generally

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A) use fixed exchange rates to promote stability. B) allow their respective Treasuries to determine the exchange rates. C) allow supply and demand to determine exchange rates. D) give exclusive control of exchange rates to their respective central banks.

83) Over the past two decades, up to 2019, how often did U.S. policymakers intervene in the foreign exchange markets? A) almost constantly B) twice C) never D) about once a year

84) One lesson policymakers have learned, and which was evident from Japan's experience in 2002, is that A) an intervention in the foreign exchange market will not work unless accompanied by a change in the policy interest rate. B) an intervention in the foreign exchange market is almost always effective if done on a regular basis. C) in order for foreign exchange interventions to work, they must be frequent and expected. D) for an intervention in the foreign exchange market to work, the interest rate must be held constant by the central bank.

85)

The strong appreciation of the dollar for the last part of the 1990s

A) was a benefit to all U.S. residents but costly to most foreign producers. B) was a benefit to U.S. exporters, but put a severe strain on U.S. importers. C) was welcomed by all U.S. manufacturers. D) played a key role in keeping inflation in check even though the economy was growing rapidly.

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86) If the Federal Reserve in the United States begins to purchase foreign currency and pay for these purchases with dollars, this should cause A) the dollar to appreciate. B) the dollar to depreciate. C) import prices to decrease. D) exports to decrease.

87) Ignoring risk differences, if we observe American investors purchasing foreign bonds when the U.S. interest rate is above the foreign interest rate, we could assume that A) American investors lack good information. B) these investors expect the dollar to appreciate over the life of their investment. C) these investors expect the dollar to depreciate over the life of their investment. D) these investors expect that U.S. inflation will slow.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 88) Explain why an appreciating U.S. dollar does not benefit everyone in the U.S.

89) Assuming the law of one price, explain what the exchange rate between U.S. dollars and yen has to be if the price of steel in Japan is 15,000 yen per ton and the price in the U.S. is $125 per ton (assume no transaction costs).

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90) The following table lists various currencies and exchange rates. International man of mystery, Xuan, needs to find the Currency 1 price of Currency 2, but opportunities are limited. Currency 1 is provided in column 1, and the currency in which he wants to buy a good is in column 2. Assume that he cannot make the purchase directly. He has to exchange Currency 1 for another major currency and then exchange that currency for the currency listed in column 2. After that, he can find the Currency 1 price of a unit of Currency 2. Use the information provided in the table to find the Currency 1 price of Currency 2 for each exchange in the table. Currency 1

Bahrain Dinar Chinese Yuan Japanese Yen Swiss Franc Mexican Peso

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Currency 2

Exchange Rate of Exchange Rate of Currency 1 Currency 1 for indicated major price indicated major currency for of currency Currency 2 Currency 2 Brazilian $US 1 costs 1 real costs Real 0.38 dinar $US 0.19 Danish $US 1 costs $US 1 costs Krone 7.09 yuan 6.91 krone Mexican 0.0085 euro 1 euro costs Peso costs 1 yen 26.00 pesos Japanese 1 Swiss franc $US 1 costs Yen costs $US 1.02 108.43 yen Swiss Franc 1 pound 1.2 Swiss sterling costs francs costs 1 30.66 pesos pound sterling

91) Suppose more countries follow Britain’s lead and leave the European Union. Also, suppose this leads to the euro becoming less widely accepted—or, in other words, less liquid. Indicate how this will affect supply and demand for euros on the graph shown. Will the currency appreciate or depreciate? Explain.

92) How will an increase in the U.S. productivity of labor versus labor in the European Union impact the real exchange rate, all other factors held constant? Explain.

93) Please state whether you agree or disagree with the following statement, and why: "An increase in the price level of a country, relative to another country's price level, will cause its currency to appreciate."

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94) The price of a Big Mac in the U.S. is $5.58; the price in the euro area is 4.05 euros. The current exchange rate is 0.87€/$. What is the real exchange rate?

95) In looking at the foreign exchange rates in the Wall Street Journal, you notice the U.S. dollar–euro spot rate is 1.085€/U.S.$ and the six-month forward rate is 1.098€/$. What does this imply?

96) The same laptop computer cost $2,000 in the United States, 220,000 Japanese yen, £1,300 British pounds, and €1900 in Germany. If the law of one price holds, what are the yen/$; £/$ and €/$ exchange rates?

97)

Explain why the law of one price may best be applied to financial assets.

98)

In theory, the law of one price makes a lot of sense. So why do we see it fail so often?

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99) Explain why a real exchange rate that does not equal 1 implies purchasing power parity does not hold.

100) A basket of goods cost $100 in the U.S. and £65 in the United Kingdom. If purchasing power parity holds, what is the dollar–pound exchange rate?

101)

What is the link between purchasing power parity, inflation, and the exchange rate?

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102) The following figure presents data on 62 countries' inflation rates relative to the U.S. rate of inflation and the percent change in the exchange rate for the years 1980–2010. What was the relationship between these two variables?

103) Chapter 10 presents the Big Mac Index. While it is a clever illustration, the Big Mac Index is not really a good example to use to explain the theory of purchasing power parity. Why not?

104) If a country is running a current account deficit year after year, what should we expect to happen to the exchange rate for that country? Explain.

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105) For many years now the United States has been running large current account deficits. What do you know about the capital account for the United States and what you predict for the exchange rate in the future? Explain.

106) Considering the foreign exchange market, specifically the market for U.S. dollars and British pounds, who is supplying dollars in this market?

107) Using a model of supply and demand for the dollar–pound market where the horizontal axis is labeled quantity of British pounds, explain what happens when Americans have an increased demand for British automobiles.

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108) Consider the following graph, which illustrates supply and demand for the dollar–pound market, where the horizontal axis is labeled quantity of British pounds. Show on the graph and then explain what happens when there is an increase in Americans’ wealth. Does the British pound appreciate or depreciate? Explain.

109) Considering the market for U.S. dollars and Japanese yen, where the horizontal axis is the quantity of dollars, explain what is likely to happen to the demand and supply of dollars, as well as the exchange rate, if U.S. interest rates rise relative to Japanese rates.

110) Assume that currently one U.S. dollar will purchase £0.81. Investors believe that one year from now a U.S. dollar will purchase £0.86. If we consider the U.S. dollar–pound market, where the horizontal axis measures the quantity of pounds, explain what we are likely to see in terms of demand and supply and the exchange rate.

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111) Considering the foreign exchange market, identify four causes for an increase in the supply of dollars.

112) Considering the foreign exchange market, identify at least four causes for a decrease in the demand for dollars.

113) The government of a country that is experiencing strong currency appreciation might find itself under pressure from some of its own citizens. Who would be likely to bring pressure during this scenario and why?

114) Explain why the changes we observe in nominal exchange rates in the short run must be due primarily to changes in the real exchange rate in countries with low inflation.

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115) During the latter 1990s and into the early 2000s, the U.S. stock market boomed, reflecting rapid growth in the U.S. economy. In terms of demand for and supply of dollars, explain what possible impacts this rapid increase in stock market values could have on the exchange rate.

116) Briefly describe the size of the foreign exchange market. Where does most of the trading take place? Which currency makes up the largest percentage of trades?

117) Explain how a currency speculator could use something like the Big Mac Index to make a profit trading currencies.

118) Is it possible for a country to run a trade deficit and yet have the value of its currency not change? Use a supply and demand model of a foreign exchange market to explain how this could occur.

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119) In the spring of 2002, the Japanese Ministry of Finance intervened in the foreign exchange market by selling yen and purchasing dollars. Why? And why did the intervention fail?

120) Explain why many industrialized countries do not often intervene in the foreign exchange market.

121) U.S. President Donald Trump imposed tariffs on China soon after he was elected and began what became known as a trade war between the two countries. Ceteris paribus, what would happen in the foreign exchange market for dollars if China decided, as part of this “war,” to sell its stockpile of U.S. Treasury securities? Consider the model of supply and demand for dollars where the price is number of foreign currency per dollar to analyze the scenario. Would the dollar appreciate or depreciate as a result?

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Answer Key Test name: Chap 10_6e 1) D 2) C 3) D 4) C 5) B 6) B 7) C 8) C 9) D 10) C 11) A 12) B 13) C 14) D 15) C 16) C 17) A 18) C 19) A 20) A 21) B 22) D 23) D 24) A 25) A 26) C Version 1

27) C 28) D 29) D 30) D 31) A 32) D 33) B 34) A 35) B 36) C 37) B 38) D 39) A 40) C 41) C 42) A 43) C 44) A 45) C 46) D 47) A 48) D 49) C 50) D 51) D 52) C 53) B 54) C 55) A 56) D Version 1

57) A 58) C 59) B 60) C 61) A 62) B 63) A 64) A 65) C 66) C 67) A 68) C 69) C 70) A 71) C 72) B 73) D 74) A 75) C 76) B 77) A 78) C 79) C 80) C 81) D 82) C 83) B 84) A 85) D 86) B Version 1

87) C 88) An appreciating U.S. dollar will benefit importers and individuals who want to purchase foreign assets. On the other hand, it will make the price of foreign goods and services, as well as foreign assets, more expensive. 89) Given the price for steel in each country, the exchange rate has to be 120 yen per U.S. dollar. This makes the prices of steel equal in each country. If this weren't the exchange rate, steel buyers would have an incentive to buy in the country where steel was cheaper, and steel producers would have the incentive to sell in the country where the steel price was higher. The increased demand and decreased supply in the relatively cheaper country would increase the price there. The increased supply and decreased demand in the relatively higher priced country would decrease the price there. This process would continue until prices in both countries were the same. 90) Currency 1

Currency 2

Bahrain Dinar

Brazilian Real

Chinese Yuan

Danish Krone

Japanese Yen

Mexican Peso

Swiss Franc Japanese Yen

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Exchange Rate Exchange Rate Currency 1 price of Currency 1 of indicated of Currency 2 for major indicated currency for major currency Currency 2 $US 1 costs 1 real costs .38 dinar/$ × 0.38 dinar $US 0.19 $.19/real = 0.072 dinar/real $US 1 costs $US 1 costs 7.09 yuan/$ × 7.09 yuan 6.91 krone $1/6.91 krone = 1.02 yuan/krone 0.0085 euro 1 euro costs 1 yen/.0085 costs 1 yen 26.00 pesos euro × 1 euro/26 pesos = 4.52 yen/peso 1 Swiss franc $US 1 costs 1 franc/$1.02 × costs $US 108.43 yen $1/108.43 yen = 1.02 .009 franc/yen

Mexican Peso

Swiss Franc 1 pound sterling costs 30.66 pesos

1.2 Swiss francs costs 1 pound sterling

30.66 peso/1pound sterling × 1pound sterling/1.2 franc = 25.55 pesos/Swiss franc

91) The decrease in liquidity will decrease the demand for euros. Demand will shift to the left. It will now take fewer units of foreign currency to purchase a euro, so the euro is depreciating.

92) An increase in the productivity of American labor relative to European labor would cause prices in the U.S. to decrease relative to European prices. This would mean a basket of American goods would purchase more European goods, so American products will seem cheap relative to European goods. 93) Disagree. An increase in the price level of one country relative to another will cause that country's currency to depreciate. As the text points out, countries with relatively high rates of inflation experience relatively high rates of currency depreciation. 94) The real Big Mac exchange rate is the U.S. price of a Big Mac divided by the foreign price (converted into U.S. dollars at the nominal exchange rate) of a Big Mac. When the calculations are done we find the real Big Mac exchange rate is 1.20. This means that one U.S. Big Mac will purchase 1.20 French Big Macs. 95) This implies that people expect the dollar is going to appreciate relative to the euro over the next six months. The spot rate is the current exchange rate; the six-month forward rate is the price at which a foreign exchange dealer will agree to sell euros for six months from now. This implies that dealers expect the price of euros to be lower six months hence. 96) If the law of one price holds, the yen/$ exchange rate is 110 yen/$; the £/$ exchange rate is 0.65£/$; and the €/$ exchange rate is 0.95€/$. Version 1

97) Financial assets, for example shares of Microsoft stock, are ideal for explaining the law of one price. First of all, they are a homogeneous good; all shares of Microsoft stock are identical. Secondly, the transaction costs of shipping them can be extremely low, especially if they are sent electronically. Third, there are stock exchanges and dealers all over the world who are diligently watching for price differentials to profit from and so act on these differentials (arbitrage). 98) The law of one price fails often because in many cases countries will place tariffs on imports. Also, many products do not trade or ship easily, for example concrete. As a result, they can have significantly different prices across markets and countries. Also, there can be technical differences in products; many home appliances would have to be re-wired to be used in other countries. Finally, many services simply do not transport well, for example haircuts and restaurant meals. 99) Perhaps the best way to see this is with an equation. One equation for the real exchange rate is:

When this ratio equals 1, purchasing power parity exists. If the ratio is not 1, that reflects that you could not take the same number of dollars and purchase the same basket of goods in the foreign country. 100) We can answer this using the following equation:

Substituting the information in the question, we divide $100 by £65 and the answer is $1.538/£.

101) Purchasing power parity implies that when prices change in one country but not in another, the exchange rate should change as well. Specifically, if prices double in one country and not in another, the currency of the country experiencing the inflation will see its currency depreciate to the point where a unit of its currency will purchase half as many units of foreign currency as it did before.

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102) The data show that countries with high rates of inflation relative to the U.S. also experienced currency depreciation relative to the dollar. While the data do not line up perfectly to reflect purchasing power parity, it does show that purchasing power parity goes a long way in explaining the behavior of exchange rates over a long period of time.

103) The theory of purchasing power parity really looks at a basket of goods, not one single good, and would consider goods that are transportable since it is an extension of the law of one price. Big Macs are really not transportable. Finally, the price of the Big Mac is highly dependent on local costs such as wages, taxes, and rent. 104) A country running a current account deficit is exporting less than it is importing. This cannot go on forever; in fact, the exchange rate should adjust to move the current account toward a balance. A country with a current account deficit should see its exchange rate decrease (i.e., its currency depreciates). The depreciating currency will make imports less attractive and exports more attractive, eventually decreasing the current account deficit. 105) The current account deficits imply that the United States must be running capital account surpluses for many years. The capital account and the current account, when summed, equal zero. This indicates that the United States is a net seller of assets. The large current account deficits should result in a depreciation of the dollar. This is one of the adjusting mechanisms that tends to bring the current account eventually into balance. 106) The supply of U.S. dollars on the foreign exchange market in this case is primarily people in the United States who desire to buy British goods and services and/or British financial assets. In order to purchase these goods, the holders of dollars need to exchange their dollars for pounds.

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107) When the demand for British autos increases in America, the demand for British pounds will increase, meaning the demand curve will shift to the right. This will result in an appreciation of the pound relative to the dollar. 108) When Americans’ wealth increases, ceteris paribus, the demand for British pounds increases, meaning the demand curve will shift to the right. When this is added to the graph above, it is evident that it takes more dollars to buy a pound so that the pound has appreciated relative to the dollar.

109) If U.S. interest rates rise relative to Japanese rates, we should see the demand for dollars increase (shift to the right) as some investors in Japan will want to invest in U.S. assets to earn a higher return. This increase in demand will cause the dollar to appreciate relative to the yen. 110) In this case, investors expect a deterioration of the British pound. In the pound–dollar market, we should see British investors supplying a greater amount of pounds at the current exchange rate, thus in the graph, the supply of pounds shifts to the right. This will cause the pound to depreciate relative to the dollar. 111) The supply of dollars on the foreign exchange market will increase if there is an increased preference for foreign goods. The supply can also increase if the riskiness of foreign assets decreases compared to the U.S. assets, or an increase in wealth in the United States, or if there is an expected depreciation of the dollar. 112) The demand for dollars on the foreign exchange market will decrease if there is a decrease in the preference for American goods abroad; if there is a decrease in the real interest rate on U.S. bonds relative to foreign bonds; if there is a decrease in foreign wealth; if there is an increase in the riskiness of U.S. investment relative to foreign investment; or if there is an expected future dollar depreciation.

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113) A country experiencing strong currency appreciation will find that, as a result, imports are relatively cheaper—but, it may be more difficult to sell its products abroad. As a result, domestic manufacturers who sell abroad or who compete with imports will want the government to intervene in the foreign exchange market to slow the appreciation. 114) In the short run prices do not move that much, so changes we observe in the nominal exchange rate must be attributed to changes in the real exchange rate, since the real exchange rate adjusts for price differences. 115) The increase in U.S. stock values could have the following impacts: If U.S. stock prices were rising faster on a percentage basis than foreign assets, many foreign investors would be attracted to the U.S. assets and the demand for dollars would increase. At the same time, increases in the wealth of Americans would result in an increase in the supply of dollars on the foreign exchange market. This increase in supply would tend to cause the dollar to depreciate, while the increase in demand would tend to cause the dollar to appreciate. The net effect would be determined by which increase was larger. 116) The foreign exchange market is enormous in terms of volume of transactions. On an average day, more than $5.1 trillion in foreign currency might be traded in a market that operates 24 hours a day. Significant foreign exchange trading takes place in London, New York, Tokyo, Singapore, Frankfurt, and Zurich, with London having by far the greatest percentage of transactions. The United Kingdom is home to more than a third of foreign exchange trades. In terms of currency, though, the U.S. dollar is one side of more than 80 percent of currency transactions.

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117) The Big Mac Index is meant to be a simplified illustration of the theory of purchasing power parity (PPP). PPP really looks at a basket of goods, not one single good, and would consider goods that are transportable since it is an extension of the law of one price. Big Macs are really not transportable. Finally, the price of the Big Mac is highly dependent on local costs such as wages, taxes, and rent. That being said, a speculator would look at something like the Big Mac Index to determine which currencies are overvalued and which are undervalued. A speculator could profit by buying undervalued currencies (expecting their values to rise to where they "should be" in accordance with PPP) or by making forward transactions in overvalued currencies (selling them when they are high and expecting to buy them at a lower price over the course of the contract). A speculator would use a much more sophisticated tool than the Big Mac Index for such trading, but the index does give us a general idea of what is possible. 118) A trade deficit means that the country is importing more than it is exporting, which means a decreased demand for its currency and a depreciation of the currency such that the exchange rate falls. However, the country's assets may be attractive to foreign investors. This would increase the demand for the currency, and if this upward pressure is strong enough to balance the downward pressure, the exchange rate may not change. In fact, based on which effect is stronger, the exchange rate might decrease or even increase. 119) The attempt was to try to bring about a depreciation of the yen relative to the dollar to boost Japanese export industries and help to stimulate a stagnant Japanese economy. The intervention failed because as the Ministry of Finance was selling yen, the Bank of Japan (Japan's central bank) in conducting monetary policy was buying them.

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120) As Chapter 10 pointed out with the lesson of Japan in the spring of 2002, an intervention into the foreign exchange market by a government to appreciate/depreciate its currency can be reversed by monetary authorities who are pursuing their own interests. Because the targeting of an exchange rate can make monetary policy difficult to impossible to carry out, many industrialized countries do not intervene in the foreign exchange markets that often. Unless the central bank adjusts monetary policy (by raising or lowering its policy rate) accordingly, foreign exchange intervention alone is likely to fail. 121) If China sold a large amount of U.S. securities, this would increase supply in the loanable funds market which would decrease U.S. interest rates, ceteris paribus. This decrease in U.S. interest rates relative to foreign interest rates would decrease the demand for dollars, which would lead to a depreciation of the currency.

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CHAPTER 11 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) Financial intermediation is A) far less important than direct finance through stock and bond markets. B) only a little more important than direct finance in the United States. C) much more important than direct finance through stock and bond markets. D) the same thing as finance through stock and bond markets.

Financial intermediation exists, in part, because A) financial markets work so well. B) direct finance through stocks and bonds is the dominant form of financing. C) transaction costs of financial intermediation is always higher than direct finance. D) the transaction costs associated with direct finance can at times be prohibitive.

When the amount of direct and indirect financing are summed, the result is usually A) greater than 100% of GDP. B) equal to GDP. C) less than GDP. D) approximately 50% of GDP.

4) Emerging market economies, compared to industrialized economies, have financial markets that A) differ in composition and size. B) differ in composition but not in size. C) are the same in composition but differ in size. D) are similar in composition and size.

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5) All of the following except which one are reasons why financial intermediaries play such an important role in economies? A) information costs B) transaction costs C) complexity of financial transactions D) composition of GDP

6) Which one of the following is not a role of a financial institution acting as a financial intermediary? A) pooling the resources of small savers B) formulating oversight regulations C) providing ways to diversify risk D) supplying liquidity

7) Financial institutions, acting as financial intermediaries, perform all of the following, except which one? A) provide ways to diversify risk B) pool resources of small savers C) increase transactions costs D) provide safekeeping and accounting services

Financial intermediaries pool the resources of many small savers so that they can A) charge fees to these small savers and earn substantial income. B) obtain the funds necessary to make loans to borrowers seeking large amounts. C) lower their transaction costs of obtaining funds. D) avoid paying any interest to obtain funds to lend.

If financial intermediaries did not have the ability to pool the resources of small savers,

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A) borrowers needing large amounts of money would find it more costly to obtain the funds. B) the economy would grow faster. C) people would likely save more. D) the risk associated with lending would decrease.

10)

Financial intermediaries

A) increase the cost of financial transactions but offset these higher costs by providing safekeeping of customer funds. B) provide handling of payments but usually less efficiently than other firms. C) reduce the cost of financial transactions. D) provide safety of resources only for the large borrowing customers who can afford it.

11)

Financial intermediaries, through their ability to lower transaction costs, A) allow for people to be more self-sufficient. B) increase the amount of trading that occurs in an economy. C) take people away from their comparative advantage. D) reduce the number of financial transactions that occur.

12)

Financial intermediaries, through their ability to lower transaction costs, A) reduce the opportunity cost of specialization. B) decrease the efficiency of an economy. C) allow for people to be more self-sufficient. D) make collecting and processing information unprofitable.

13) The fact that a financial intermediary can hire a lawyer to write one contract that works for many customers is an example of

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A) economies of scale. B) the law of diminishing marginal returns. C) the law of increasing opportunity cost. D) the law of demand.

14) The fact that financial intermediaries employ experts to carry out particular activities and, therefore, reduce transactions costs is an example of which one of the following economic concepts? A) law of demand B) economies of scale C) comparative advantage D) information costs

15)

Economies of scale associated with financial intermediaries are realized when the

A) total cost of handling transactions falls as more transactions of different kinds are handled. B) cost per transaction falls as a larger volume of similar transactions are handled. C) cost per transaction increases as more transactions are handled. D) cost per transaction decreases regardless of the number of transactions.

16)

Examples of economies of scale include the

A) additional fees financial intermediaries charge on small accounts. B) decrease in overall transaction costs that occur as volume increases. C) reduction in the cost per transaction that occurs as the number of transactions increase. D) decrease in overall information costs that occurs as more transactions are handled.

17)

The reduction in transaction costs provided by financial intermediaries benefit

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A) small borrowers and small savers. B) large borrowers but not small savers. C) society in the net, but small savers bear much of the cost. D) small borrowers but not small savers.

18)

Automated teller machines provided by financial intermediaries are an example of

A) high transactions costs associated with financial intermediaries. B) diseconomies of scale. C) the ability of financial intermediaries to provide liquidity. D) the ability of financial intermediaries to earn profits by raising transaction costs above the norm.

19)

The function of providing liquidity by financial intermediaries A) includes depositors withdrawing funds but not borrowers. B) only considers people who borrow on a short-term basis, but not depositors. C) affects people who need to borrow and depositors who withdraw their funds. D) only affects customers with savings accounts.

20)

Since one function of financial intermediaries is to provide liquidity,

A) they must keep all of their funds in short-term securities. B) they keep almost all of their funds in cash. C) they must know approximately how much liquidity their customers will need each day and have these funds available. D) regulations require financial intermediaries to keep 50% of their assets in cash.

21) A bank can usually offer a saver a higher return for the same risk for all of the following reasons except

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A) the bank can usually purchase assets at a lower cost than any one saver. B) the bank can pool the resources of small savers and purchase higher valued assets. C) economies of scale can also be applied by the bank in its purchase of assets. D) savers do not have good enough information to know if the return is sufficient.

22)

Lines of credit provided by financial intermediaries

A) decrease liquidity for customers but increase income for the intermediary. B) are pre-approved loans that can increase liquidity and lower transaction costs. C) are costly for intermediaries to provide so are only available to large commercial customers. D) require deposits in the intermediary that equal or exceed the amount of the line of credit.

23) bank

When a bank takes savings from many small savers and lends it to many borrowers, the

A) decreases the risk to savers through diversification. B) increases the risk to borrowers through high transaction costs. C) decreases the risk to savers through economies of scale. D) decreases the return to savers and increases the cost to borrowers.

24) If a bank has 1,000 depositors, each of whom deposits $1,000 in the bank, and the bank makes loans of $10,000 each, then each depositor has contributed A) $100 to each loan. B) $1 to each loan. C) $10 to each loan. D) $1000 to each loan.

25)

Mutual funds offer investors

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A) a greater return for greater risk than what an investor can earn on his own. B) a lower return for more risk than what the investor could earn on his own. C) a lower return for less risk than what the investor could earn on his own. D) a way for individuals to eliminate the idiosyncratic risk associated with any single investment.

26)

Mutual funds are attractive because they

A) provide high returns from purchasing the financial securities of a few select companies. B) provide the investor with greater diversification at a lower cost than what most investors could obtain individually. C) have inside information that is not available to other investors. D) routinely obtain inside information because they run most of the companies they invest in.

27) A bank has 10,000 depositors, each of whom deposits $100 in the bank. If the bank makes 1000 loans for $1,000 each then each depositor has contributed A) $1 to each loan. B) $100 to each loan. C) $0.10 to each loan. D) $10 to each loan.

28) A lender usually knows less about the creditworthiness of a borrower than the borrower does. This is an example of A) opportunistic behavior. B) economies of scale. C) diminishing marginal returns. D) information asymmetry.

29)

Most individuals save at banks rather than lend directly because

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A) the bank creates information asymmetry. B) moral hazard exists only when individuals make loans directly to borrowers, it does not occur when banks issue loans. C) banks can reduce the cost of information asymmetry. D) information asymmetry is a problem for individuals but not for banks.

30) Financial intermediaries reduce the problems in lending associated with information asymmetries by all of the following except which one? A) collecting and processing standardized information B) screening applicants to be sure they are creditworthy C) monitoring loan recipients to be sure the funds are used properly D) charging interest rates high enough to discourage undesirable borrowers

31) Asymmetric information poses two important obstacles to the smooth flow of funds from savers to investors. They are A) adverse selection, which arises before the transaction occurs, and moral hazard, which occurs after the transaction. B) moral hazard, which arises before the transaction occurs, and adverse selection, which occurs after the transaction. C) adverse selection and moral hazard, both of which occur after the transaction. D) adverse selection and moral hazard, both of which occur before the transaction.

32)

Financial markets do not function as well as they could due to A) the fact that banking is highly monopolized. B) the cost of obtaining information, which can be high. C) regulation by governments. D) fluctuations in the inflation rate.

33)

The usual situation in banking regarding asymmetric information is that

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A) borrowers know more than lenders. B) lenders know more than borrowers. C) borrowers and lenders have the same information. D) lenders and borrowers have perfect information.

34) Guillaume moves from an hourly job where he is paid per unit of output produced to a salaried position where his income is not dependent on his output. He begins to take longer breaks and skip unpleasant tasks. This is an example of what type of information asymmetry? A) moral hazard B) adverse selection C) economies of scale D) increased diversification

35) Ping-Hsin is a 25-year-old woman who purchases health insurance after she begins to feel fatigued. It is soon discovered that she has an autoimmune disorder that will require expensive monitoring and medication for the rest of her life. If this information was not revealed prior to the purchase of the insurance, this is an example of what type of information asymmetry? A) moral hazard B) adverse selection C) economies of scale D) increased diversification

36) Mom's Pizzeria goes out of business due to a dramatic decrease in sales from a local newspaper article highlighting the fact that Mom's Pizzeria has been purchasing expired meat from a distributor at cut-rate prices for years. The decrease in business also results in Mom's defaulting on the loan they have with the bank. This is an example of A) symmetric information in the financial markets. B) perfect information in the financial markets. C) asymmetric information in the financial markets. D) perfect information in the pizza market.

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37) Mom's Bakery goes out of business due to decreasing sales resulting from the dramatic increase in people on low-carbohydrate diets. The decrease in business also results in Mom's defaulting on the loan they have with the bank. This is an example of A) lack of perfect information in financial markets. B) asymmetric information in financial markets. C) moral hazard in financial markets. D) symmetric information in financial markets.

38) We often see companies offering money-back guarantees to customers if they are not satisfied. These guarantees are a way to treat the problem of A) buyers having more information about the product than the seller. B) the seller having more information about the product than the buyer. C) symmetric information. D) adverse selection.

39)

Which one of the following is not true of adverse selection?

A) It exists because information is perfect. B) It describes the problem a lender faces in identifying loan applicants as good or bad risk borrowers. C) It arises because borrowers have more information than lenders regarding their creditworthiness. D) It arises if lenders try to charge an average price to all applicants.

40)

In a financial market where information is symmetric, A) there would be moral hazard. B) one party to a transaction knows information the other party does not. C) the ability to obtain information is available to only one party. D) there would be no adverse selection.

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41)

Two problems that arise from asymmetric information are A) adverse selection and diseconomies of scale. B) moral hazard and the free-rider problem. C) moral hazard and adverse selection. D) the free-rider problem and adverse selection.

42)

Which one of the following is a problem of adverse selection?

A) The lender has a problem of distinguishing good risk from bad risk borrowers. B) The lender has a problem determining that the proceeds from a loan are being used as the borrower stated. C) A person takes up the hobby of bungee jumping after purchasing health insurance. D) Individuals use more medical services as a result of their purchase of a health insurance plan.

43)

Which one of the following is a problem of moral hazard?

A) A lender cannot distinguish good risk from bad risk borrowers. B) An individual who purchases auto insurance begins to leave his or her keys in the car while running into a store. C) Life insurance companies offer an average premium to smokers and non-smokers so they do not have to have two different premiums. D) An auto insurance company charges higher premiums to younger drivers than what they charge to older drivers.

44)

One of the conclusions from Akerlof's paper titled "The Market for Lemons" was

A) high quality goods will drive low quality goods out of the market. B) lacking the ability to distinguish high from low quality, the market will end up offering only average quality. C) lacking the ability to distinguish high from low quality, low quality may drive high quality out of the market. D) high quality is always demanded by consumers over low quality.

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45) Mary Jones is the president of a local bank. She knows that half of the loan applicants in town she would classify as high risk and the other half as low risk. She observes that the other banks in town charge two different interest rates, a lower rate for low risk borrowers and the higher rate for high risk borrowers. She decides that to have an advantage over the other banks, she will offer an average rate to everyone. The likely result will be that Mary’s bank A) will be highly successful as this will provide the bank with a large competitive advantage. B) is likely to see a dramatic increase in both types of borrowers. C) will experience adverse selection and have a disproportionate number of low risk borrowers. D) will experience adverse selection and have a disproportionate number of high risk borrowers.

46)

One lesson that Akerlof's Lemons model provides is that

A) for high quality providers to survive, they must provide a way for customers to distinguish high quality from low quality. B) low quality will not survive in a market. C) people always prefer high quality to low quality goods. D) moral hazard is unavoidable.

47) A firm that has a well-earned reputation for providing high quality has found a way to address the A) free-rider problem. B) moral hazard problem. C) problem of adverse selection. D) problem of economies of scale.

48)

The interest rates charged on most credit cards are

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A) high due to the problem of adverse selection. B) high because Visa and MasterCard have a virtual monopoly on this business. C) high due to diseconomies of scale that exist in this market. D) lower than they should be given the problem of adverse selection.

49) Assume there are two companies that issue stock, but one is high quality and the other is low quality. If potential investors cannot distinguish the quality of the company, A) the shares of the low quality firm will disappear from the market. B) the shares of both companies will trade on the market. C) the shares of the high quality firm will disappear from the market. D) this is an example of moral hazard and the shares of both companies will cease to trade.

50)

The publication Consumer's Reports is one tool designed to address A) adverse selection. B) moral hazard. C) the free-rider problem. D) symmetric information.

51) In the bond market, the assigning of a risk premium is a tool designed to address the problem of A) adverse selection. B) information asymmetry. C) the free-rider. D) moral hazard.

52)

Used car dealers that provide warranties on the cars they sell are addressing the

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A) lemons problem. B) monopoly problem. C) problem of people preferring foreign cars. D) free rider problem of buyers preferring new versus used cars.

53)

Adverse selection A) increases the efficiency of most markets. B) usually causes prices to adjust faster than they otherwise would. C) makes it easier for all customers to find what they want. D) results in fewer market transactions.

54)

Which one of the following statements is true?

A) Adverse selection is a problem of monopoly and moral hazard is a problem of information asymmetry. B) Adverse selection and moral hazard are problems stemming from asymmetric information. C) Adverse selection is a problem that occurs after a transaction. D) Moral hazard is a problem that occurs before a transaction.

55)

Which one of the following statements is true? A) Adverse selection is a problem that occurs after a transaction. B) Moral hazard is a problem that occurs before a transaction. C) Adverse selection is a problem stemming from asymmetric information. D) Both adverse selection and moral hazard occur before a transaction.

56)

One reason lenders usually require a lot of information from loan applicants is to avoid

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A) the problem of moral hazard. B) the problem of adverse selection. C) being harmed by symmetric information. D) charges of discrimination in lending.

57) is to

One reason the government requires public corporations to disclose so much information

A) minimize the monopoly profits some corporations earn. B) give small corporations a better chance of competing against large corporations. C) address the potential harm from asymmetric information. D) discourage risk-taking by investors.

58)

A lender who wants to avoid the problem of adverse selection could

A) charge a very high interest rate and assume all loan applicants are high risk. B) charge the same average interest rate to all borrowers. C) charge a low interest rate and make the applicant prove they warrant the low rate by providing information. D) only lend by issuing credit cards.

59) The First Bank of Podunk has recently suffered some extraordinary losses on its loan portfolio due to the closing of the largest employer in town. As a result, the bank's management decides to raise the interest rate to new loan applicants. This move is likely to A) increase the profitability of the bank. B) cause even greater losses. C) significantly increase both loan applicants and profits. D) treat the problem of adverse selection that contributed to the losses the bank is experiencing.

60)

The problem of adverse selection created the opportunity for

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A) lenders to profit significantly at the expense of borrowers. B) significant deregulation of financial markets. C) a new market in the trading of information. D) stock prices for many years to be much lower than what they should have been.

61) Recent history has shown that the government regulations requiring the disclosure of information from public corporations have A) all but eliminated the problems of asymmetric information. B) reduced but not eliminated the problems of asymmetric information. C) just about eliminated the market for information services. D) resulted in symmetric information.

62)

The price for private information is likely higher than it should be due to the problem of A) adverse selection. B) free-riders. C) the government regulations regarding information. D) moral hazard.

63)

Moody's, Value Line, and Dun and Bradstreet are examples of companies that

A) provide information free to investors but charge the companies for the ratings provided on the company. B) provide information free to investors but recoup expenses through advertising done by the companies being rated. C) charge investors who subscribe to the services for the information. D) duplicate information that is available to investors at no cost.

64)

The scandals involving Enron, World Com, Global Crossing, and other large firms

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A) are examples of asymmetric information and led, at least temporarily, to a less wellfunctioning stock market. B) should have been expected on the part of investors since that is why there is a risk premium. C) have resulted in a cry for less government regulation of public corporations. D) demonstrate that the government should be responsible for collecting and distributing financial information on firms.

65)

Requiring that borrowers put up collateral to obtain a loan is a tool designed to treat the A) lemons problem. B) problem of adverse selection. C) problem of moral hazard. D) free-rider problem.

66) Which one of the following could the lemons problem, applied to financial markets, explain? A) lenders seeing a disproportionate share of high quality loan applicants B) an average interest rate that is too high for the actual risk obtained C) profits for many lenders increasing significantly D) high quality potential borrowers relying more on internally generated funds to finance investment

67)

An unsecured loan is A) a loan where the applicant does not have any net worth. B) a loan where the applicant does not post any collateral. C) another name for a mortgage loan. D) usually a low-risk loan.

68)

A home mortgage is a good example of

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A) an unsecured loan. B) a secured loan. C) a high risk loan. D) the problem of adverse selection.

69) Requiring a large net worth on the part of an applicant is one way lenders treat the problem of A) free-riders. B) adverse selection. C) moral hazard. D) the lemons market.

70) Requiring a home buyer to have a large down payment reduces risk to a mortgage lender because it means that A) if the price of the house falls, the owner suffers the loss. B) the buyer is less likely to sell the house. C) the buyer likely underpaid when she bought the house. D) there is more information available on the buyer.

71)

Which one of the following statements is false? A) Home mortgage loans are secured loans. B) Credit card loans are secured. C) Most automobile loans are secured loans. D) Secured loans usually carry less risk than unsecured loans.

72)

Unsecured loans

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A) generally involve very high interest rates as a result of the free-rider problem. B) generally involve very high interest rates as a result of adverse selection. C) are no longer made; all loans now must have some form of collateral. D) are only made to individuals with very high net worth because it is the only way to limit the risk.

73)

Deflation compounds information problems because it A) increases a company's net worth. B) tends to understate a company's assets and overstate their liabilities. C) reduces the dollar value of assets while the dollar value of liabilities stays constant. D) always harms lenders.

74) A borrower who obtains funds from a lender to purchase additional inventory but uses the funds to finance a trip to Las Vegas for a weekend of gambling at the opening of a new casino is an example of A) the problem of adverse selection. B) the free-rider. C) the moral hazard problem. D) lax government regulation.

75) Credit may dry up at the start of an economic downturn because of all of the following except which one? A) Lenders require information and accurate information is more difficult to obtain. B) It becomes more difficult for lenders to determine the creditworthiness of borrowers. C) Lenders see greater risk in making loans to borrowers. D) The free-rider problem worsens during a downturn.

76)

The principal-agent problem is

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A) a form of adverse selection. B) when stockholders are not acting in the best interest of managers. C) a form of moral hazard. D) due to managers not being able to monitor stockholder behavior.

77) that

The principal-agent problem is quite common in large public corporations due to that fact

A) large corporations generate large sales volumes. B) large companies employ many people. C) there is too little regulation by government. D) the people making the operational decisions are usually not the owners.

78) The fact that many companies employ supervisors to oversee the actions of workers is a way to treat A) moral hazard. B) adverse selection. C) the law of diminishing returns. D) the free-rider problem.

79) Tom borrows $100,000 from his local bank to purchase inventory for his store for the upcoming holiday season. Tom's neighbor tells him about a get-rich-quick scheme that can take this $100,000 and triple it in a month. Tom decides to buy into this scheme figuring he can repay the bank and still have plenty left for inventory. This is an example of A) adverse selection. B) sound risk analysis on Tom's part. C) diversification. D) moral hazard.

80) A bank usually treats the moral hazard problem by using all of the following, except which one? Version 1

A) not making loans B) requiring collateral C) requiring down payments D) restrictive covenants

81)

Moral hazard problems arise because A) lenders cannot distinguish good risks from bad risks. B) borrowers have incentives to act in ways that do not reflect the lender's interest. C) firms hire incompetent employees. D) lenders charge interest rates that are too low.

82)

One reason lenders may require a large net worth before making a loan is because A) then the borrower does not need the funds. B) it tells the lender the firm has good employees. C) it is one way to treat the problem of moral hazard. D) banking laws require that firms have significant net worth before a bank can make a

loan.

83)

Providing stock options to corporate managers was an idea designed to A) hide increases in pay of corporate executives from stockholders. B) align managers' interest with the stockholders' interest. C) treat adverse selection. D) treat the free-rider problem.

84)

The moral hazard that can result from debt financing is mainly due to the borrower

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A) not working as hard once he or she obtains the loan. B) wanting to refinance the loan. C) taking greater risk in hopes of obtaining a larger return. D) defaulting because the economy turned sour.

85) Each of the following is an example of a restrictive covenant on a mortgage loan, except which one? A) net worth requirements B) requiring that the borrower reside in a home for which he or she receives a mortgage C) insisting the borrower carry physical damage insurance on the property securing the loan D) requiring the borrower to obtain comprehensive health insurance

86)

One reason that financial intermediaries exist is that they A) are required by government regulation. B) have developed low-cost methods to obtain information. C) are the only way to obtain information. D) earn high returns from lending their own funds.

87)

The screening process a bank follows for a loan applicant

A) uses information that anyone can obtain, but the bank can usually obtain it cheaper. B) includes information that can be available to other firms, as well as proprietary information that only the bank would have. C) is based only on public information. D) uses only confidential information.

88) Large companies seeking to raise funds often will use a well-known investment bank because

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A) the investment bank's reputation identifies the company as being credit worthy. B) they are required to do so by government regulation. C) the investment bank is paying the company for the publicity and goodwill it will generate. D) this minimizes moral hazard.

89) Often a bank will require a loan officer to make personal visits on customers with loans outstanding. This is encouraged because A) the bank worries about another bank trying to steal their customers. B) the bank wants to make sure the business is busy. C) this is an effective monitoring technique and should reduce moral hazard. D) the bank has excess funds available and hopes to make another loan to the business.

90) If the threat of a takeover increases the likelihood that managers will act in the interests of stockholders or bondholders, what type of asymmetric information problem is eliminated? A) moral hazard B) adverse selection C) economies of scale D) increased diversification

91) Suppose that a study of compensation data for CEOs of large firms shows that, ceteris paribus, an increase in the annual probability of a takeover is accompanied by a decrease in the typical CEO’s annual total compensation. This suggests that tying these two variables together can help decrease what type of asymmetric information problem? A) moral hazard B) adverse selection C) economies of scale D) increased diversification

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92) Venture capital firms and private equity firms are types of financial intermediaries that can help reduce problems of A) moral hazard. B) adverse selection. C) a prisoners’ dilemma. D) limited liability.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 93) A friend of yours tells you she has an idea for a new product. She believes that once the prototype is built she can sell the rights to the product for $250,000. The problem is she needs $20,000 to build the prototype and she only has $5,000. She asks you to invest $15,000 in the idea and she will give you 75% of whatever amount she obtains when she sells the rights. You have the money available but should be reluctant to provide the money. Why?

94)

Explain how financial intermediaries contribute to increasing the output of an economy.

95) What is the difference between economies of scale and economies of scope? Provide an example of each that pertains to financial institutions.

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96) Read the scenarios in the following table and, for each one, determine whether it illustrates a problem of adverse selection or moral hazard. Write your answer in the last column. Scenario

Adverse Selection or Moral Hazard?

Carl buys a used car. The seller tells him the car is “like new” with a new transmission. A month after he buys the car, the transmission fails. The mechanic says it is old and needs to be replaced. Jackson plans an expensive dinner for his girlfriend and orders a bottle of gourmet wine. The restaurant charges him the gourmet price but substitutes a much cheaper bottle of wine without him knowing it. After June purchases homeowners insurance, she decides to get rid of the home security system that requires a monthly maintenance fee. Pat decides to purchase the additional coverage offered when he buys a new smartphone because he knows that he is not very careful and is likely to damage the device. Gopal is searching for a bond investment and cannot tell which borrowers are good or bad credit risks. He settles on requiring a risk premium equal to at least the average risk. He ends up with a high-risk borrower. ABC, Inc. is a large financial institution. Managers know that, if the institution fails, it will destroy the financial system. They take on more risk, as a result.

97) Is the conflict between a lender to a firm and the borrower/owner an example of adverse selection or moral hazard? Explain.

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98) If a lender faces a potential loan applicant pool made up of equal amounts of low risks and high risks, will charging an average interest rate provide the average (expected) return? Explain.

99) Explain how Federal Deposit Insurance (FDIC) could potentially create a moral hazard for the managers of deposit institutions.

100)

Why are financial intermediaries so important in most economies?

101)

What are the five functions performed by financial intermediaries?

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102) Provide an example of how a bank achieves lower costs in making a large loan to a company than could be achieved without the bank.

103) If diversification is such a good idea for a saver, why do so many people put a lot of their savings in the same bank?

104)

Explain how mutual funds offer small investors a low-cost way to achieve diversification.

105) Explain what will happen to the market for used cars if buyers cannot distinguish a good used car, worth $15,000, from a "lemon," worth $5,000.

106) A bank advertises a very competitive loan interest rate. Explain what measures the bank can take to address adverse selection.

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107) Discuss the role that companies like Standard & Poor's, Dun & Bradstreet, and Moody's play in solving the problem of adverse selection.

108) Respond to the following: "If it takes a significant period of time to uncover accounting manipulations by individuals in a major corporation, honesty may be the best policy but dishonesty can be a lot more profitable!"

109) Explain the difference between a secured loan and an unsecured loan, and the interest rate you would expect to see charged on each (all other factors equal).

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110) Explain what is likely to happen to the rate of mortgage loan default given the following: "For years home values across the country have increased, on average, 3 to 4% each year. Mortgage lenders have come to expect this to always be the case and so begin to offer mortgages with little to nothing down and no requirement for PMI insurance. Then an economic slowdown occurs, hitting a few areas of the country harder than others. Home values across the country begin to decrease with some areas seeing decreases of as much as 10%."

111)

Explain why deflation can be so troubling to borrowers and lenders.

112) Life insurance companies usually offer a lower premium to nonsmokers than the premium charged to smokers. Discuss first the potential for adverse selection and moral hazard and then ways the company can seek to reduce or eliminate these problems.

113) You have a friend that has run up a pretty large balance on his credit card. He mentions to you that he has missed a few payments but doesn't think it is that big of a deal since all it cost him is a little more interest on his balance. You tell him it may end up costing him a lot more than that. He presses you for an explanation. Explain to him how his handling of this debt can impact what he pays for future debt.

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114) It is not uncommon to read about highly successful mutual fund managers that spend considerable amounts of time visiting the companies with which they have placed their clients' funds. What might be the motive(s) behind these visits?

115) Explain how the threat of a leveraged buyout or a takeover can actually address the problem of moral hazard.

116) The United States, the United Kingdom, Germany, and Japan are all developed countries with highly developed and efficient financial markets. However, in all four countries the main source of business finance is internal funding. Why is this so?

117) Use examples to describe at least two possible solutions to the problem of adverse selection.

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118)

Use examples to describe at least two possible solutions to the problem of moral hazard.

119) Most credit cards charge a relatively high rate of interest, yet many people carry them, including people who would be considered low-risk borrowers. The concept of adverse selection suggests that low-risk borrowers would be less likely to use these. Why is that not the case?

120) A friend who is taking her first class in investments asks you why the regulatory bodies place so much emphasis on minimizing insider information if many of the potential problems associated with financial transactions stem from information asymmetry or a lack of information. How would you respond?

121) Explain how problems of adverse selection and moral hazard make securities finance expensive and difficult to get. Use examples to support your explanations.

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122) How did information asymmetries in the home mortgage market contribute to the financial crisis of 2007–2009?

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Answer Key Test name: Chap 11_6e 1) C 2) D 3) A 4) A 5) D 6) B 7) C 8) B 9) A 10) C 11) B 12) A 13) A 14) C 15) B 16) C 17) A 18) C 19) C 20) C 21) D 22) B 23) A 24) C 25) D 26) B Version 1

27) C 28) D 29) C 30) D 31) A 32) B 33) A 34) A 35) B 36) C 37) A 38) B 39) A 40) D 41) C 42) A 43) B 44) C 45) D 46) A 47) C 48) A 49) C 50) A 51) A 52) A 53) D 54) B 55) C 56) B Version 1

57) C 58) C 59) B 60) C 61) B 62) B 63) C 64) A 65) C 66) D 67) B 68) B 69) C 70) A 71) B 72) B 73) C 74) C 75) D 76) C 77) D 78) A 79) D 80) A 81) B 82) C 83) B 84) C 85) D 86) B Version 1

87) B 88) A 89) C 90) A 91) A 92) A 93) Your reluctance should come from the problem of moral hazard. It is true that if she sells the prototype for $250,000 you stand to gain $187,500, less your initial investment of $20,000 for a net gain of $167,500 and your friend gains $62,500, less her initial investment of $5,000 for a net gain of $57,500. On the other hand, if her idea isn't good, or she fails to build the prototype, and the project is worth $25,000 she stands to lose only $57,500. You stand to lose $167,500. This is a moral hazard problem since your friend will be the one controlling the success or failure of the project. 94) Financial intermediaries can lower the cost of obtaining information as well as the risk in lending. As a result, the lower cost (fewer resources used to obtain information) leaves more resources available to produce output. Also, the reduced risk encourages greater lending, which leads to more investment and increased future output.

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95) Economies of scale are the lowering of average cost as output increases. For example, a lender can spread the cost of developing a single loan application and single lending contract over many loans. Economies of scale are the lowering of average cost as output increases. For example, as a lender learns and develops special skills in obtaining information on loan applicants the cost of processing these applications will fall. Economies of scale result from exploiting gains from specialization. Economies of scope imply, for example, that one firm producing two different products can do so at a lower total cost than two firms producing one product each. For example, a bank may find that it can issue both credit cards and installment loans at a lower total cost than one bank issuing only credit cards and another making only installment loans. 96) Scenario

Adverse Selection or Moral Hazard? Carl buys a used car. The seller tells him the car AS is “like new” with a new transmission. A month after he buys the car, the transmission fails. The mechanic says it is old and needs to be replaced. Jackson plans an expensive dinner for his MH girlfriend and orders a bottle of gourmet wine. The restaurant charges him the gourmet price but substitutes a much cheaper bottle of wine without him knowing it. After June purchases homeowners insurance, she MH decides to get rid of the home security system that requires a monthly maintenance fee. Pat decides to purchase the additional coverage AS offered when he buys a new smartphone because he knows that he is not very careful and is likely to damage the device. Gopal is searching for a bond investment and AS cannot tell which borrowers are good or bad credit risks. He settles on requiring a risk premium equal to at least the average risk. He ends up with a high-risk borrower.

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ABC, Inc. is a large financial institution. Managers know that, if the institution fails, it will destroy the financial system. They take on more risk, as a result.

97) This is an example of moral hazard. The owner (borrower) is encouraged to take more risk since if the greater risk results in a higher return, the lender obtains just what the loan agreement specifies, usually a return of principal and interest. The owner (borrower) keeps anything above that, so the gains from taking the greater risk all belong to the borrower. 98) No, the lender will suffer adverse selection. The average interest rate is seen as a high rate by the good risks who will seek a more favorable rate elsewhere. The average rate will appear very attractive to the high-risk applicants who will seek this lender. As a result, the lender will not get the average mix but one skewed heavily toward high risks. 99) FDIC insurance pays off depositors (up to a limit) if a bank or other insured depository institution fails. As a result, the managers or owners of the bank have the incentive to attract funds (offer higher interest rates to savers), and then earn as high a return as possible (take greater risk). If the high returns appear, all they have to return to the depositors is the principal and interest; everything else is theirs. This is one reason why many financial intermediaries are highly regulated and restricted in their use of funds. 100) Financial intermediaries provide a variety of services that enhance growth. These include pooling savings, providing liquidity, diversifying risk and collecting and processing information. As a result, they help facilitate the low cost allocation of capital to its most productive uses, thereby enhancing growth.

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101) (1) Pooling the resources of small savers; (2) providing safekeeping and accounting services as well as access to the payments system; (3) supplying liquidity, converting savers' balances directly into a means of payment when needed; (4) providing ways to diversify risk; and (5) collecting and processing information in ways that reduce information costs. 102) If a company needed to borrow a large amount, without a financial intermediary (bank) they would conceivably have to approach many individuals, borrowing small amounts from each. This would be costly not only in time but also each individual would require a separate contract and perhaps negotiate different interest rates. The bank can have a lawyer, who specializes in contracts, draw up one contract that is fairly complete and can be used for most loans. Since there is only one transaction only one contract is needed (less time) and only one contract at one price. 103) The answer lies in the fact that the bank itself provides diversification. For example, if a saver has $10,000, and wants to earn a return, he or she could loan the entire amount to one borrower. This is not good diversification since the borrower may default. On the other hand, the saver could place the $10,000 in one bank that makes, say, 1,000 equal sized loans. Now the saver finds that he or she has $10 in each of these loans. This is good diversification and the saver obtains it at very low transactions cost.

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104) Mutual fund companies offer small investors a chance to purchase a diversified portfolio of stocks and eliminate the idiosyncratic risk association with any single investment. Many of the mutual funds based on the Standard & Poor's 500 Index require a minimum investment of as little as a few thousand dollars. Since the average price of each stock in the index is usually between $30 and $40, a small investor would need over $15,000 to buy even a single share of each of the 500 companies in the index (and would have to pay a broker to make the purchases). 105) If buyers cannot distinguish good-quality used cars from lemons, the average price being offered for used cars will have the owners of the high-quality cars keeping them off of the market and the lemons will dominate. This will exacerbate the problem. As more lemons appear, the "average" price will fall and eventually only lemons will remain. This is an example of the problem of adverse selection. 106) The advertisement will attract both high- and low-risk borrowers. The lender can collect information to distinguish the two, and offer a lower rate to the low-risk borrowers. Offering the same, average rate to the two types of borrowers would drive the low-risk borrowers to another lender. 107) Adverse selection is a problem that stems from information asymmetry, specifically the inability to distinguish good quality from lesser quality. The rating agencies provide information on firms and give potential lenders/investors the ability to distinguish quality and avoid the problem of adverse selection.

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108) As we saw in 2001 and 2002, as a result of accounting fraud at Enron and other firms, many corporate executives profited heavily from the manipulation of the financial statements. For example, managers who may have been given stock options, ironically to avoid the moral hazard problem, have the incentive to manipulate the statements, watch the stock price rise as a result of the incorrect figures, profit from their options and then correct the statements. 109) A secured loan is a loan that is backed by collateral. For example, with a mortgage, the property serves as the collateral or in the case of most auto loans, the automobile is the collateral that secures the loan. The lender has the right to seize the collateral in the event of default and the sale of the collateral will eliminate or minimize the losses from default. The collateral greatly reduces the risk from both adverse selection and moral hazard. Unsecured loans, like credit card debt, are not backed by collateral. Since unsecured loans present greater risk they usually carry higher interest rates. 110) It is likely that mortgage default rates will increase substantially. Not only are more people likely out of work with the slowdown, but many people will find that their mortgage will actually carry negative principal balances. If they started with little or no net worth in the home, their net worth will actually be negative. This will encourage many borrowers to simply "give" the house back to the lender.

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111) Deflation is troubling because it aggravates the problem of obtaining accurate information. During periods of deflation companies find that their liabilities are fixed in nominal dollars that are not declining, yet the value of their assets are going to decline and the revenue from the products they sell may also decline. This places greater burden on servicing debt, but perhaps more importantly from an information perspective, it makes the determination of actual net worth more difficult. If a lender cannot determine the actual net worth of a borrower the likelihood of the borrower obtaining a loan is decreased. 112) If the company cannot distinguish applicants by whether or not they smoke, it is likely that all applicants will claim to be nonsmokers. This then means that the company will take a greater risk than what the premium being charged warrants. Also, the potential for moral hazard is present because if the company cannot monitor the insured's behavior after the policy is issued, some nonsmokers at the time of policy issuance may become smokers without any subsequent increase in premium to reflect the now greater risk. The easier problem to solve may be the adverse selection problem; by requiring a simple blood test at the time of application the company is able to determine if the individual is a smoker. To solve the moral hazard problem the company may have to require periodic physicals or blood tests of policyholders to verify they are still nonsmokers. Both of these remedies are examples of transaction costs, or costs incurred to remedy information asymmetry. 113) Lenders often screen loan applicants. One tool that is used is the credit report or credit score that is compiled by a credit rating company. A poor payment history can impact your friend in the future since his poor record may result in a higher interest rate being charged or even a denial when he seeks a loan.

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114) One way to reduce moral hazard is through monitoring. These visits may accomplish a number of things but one is to let the managers of the corporations know that the manager of the mutual fund is paying attention to see that the firms are using the funds in the ways they stated. For example, the mutual fund manager may look to see if the president's office is overly ornate, or if excessive amounts are being spent on nonproductive assets. The mutual fund manager may also look to see if the company's facilities are operating at or close to capacity or if it appears that an excessive amount of inventory is on hand. 115) The potential for moral hazard exists in most corporations because the managers or officers of the corporation are often not the owners; this is called the principal-agent problem. The managers may not always act in the best interest of the owners. For example, the owners may prefer a higher return that calls for a greater risk to be taken. The managers (preferring to keep their jobs) may shun the additional risk, preferring the job security over a higher return for the owners. The threat that the company can be and likely may be purchased by others if it is under performing can actually motivate the managers to seek a higher return. 116) The only possible explanation for this fact is that information problems make external financing either from markets or from financial intermediaries prohibitively expensive and difficult to get. The fact that managers have superior information about the way in which their firms are and should be run makes internal finance the rational choice. (Remember, this financing is not "free." The firm is giving up a rate of return it could have earned investing its funds in something besides its own business. Therefore, one could argue that the firm has superior information about its own business and therefore chooses investing in it over investing in other possibilities.)

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117) In the case of buying a used car, a warranty could be included or the buyer could have the car examined by a mechanic prior to purchase. Past credit history and evidence of a reliable salary could help in the case of evaluating potential borrowers. Resumes and reference checks would be helpful in hiring decisions. 118) Building in incentives would be helpful in the case of moral hazard. For example, insurance companies could offer “no claims bonuses” or “safe driver discounts.” Bad behavior can be penalized such as increased premiums for claims based on poor decisions. Pay can be tied to performance to reduce on-the-job shirking. The knowledge that reviews will be published online can also reduce bad behavior at hotels and restaurants, or in exchanges on sites like eBay. 119) While it is true that credit cards usually carry a high rate of interest because they are basically unsecured lines of credit, they are not used by everyone in the same way. Individuals who may be considered low-risk borrowers may have cards with lower rates of interest, or may never actually carry over balances on the card, in effect never paying interest. For many of these individuals the card is not providing a loan but simply the convenience of not having to carry large amounts of cash to make purchases. Anyone who does carry over balances on a credit card is probably a greater risk and as a result should pay the higher interest rate reflecting the level of risk.

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120) While it is true that more information is almost always preferred to less, insider information is really a form of information asymmetry. In this case individuals privy to information not available to the public have a strong incentive to use that information and act opportunistically, in this case profiting from the information basically because others involved in the transaction do not share the same information. If this practice were not illegal and was seen as acceptable, in the long run trading in most financial assets (such as stocks and bonds) would probably cease. The majority of investors, being outsiders, would always feel that they were at a disadvantage to the insiders, and as a result of the increased risk would likely not invest in these assets. In order to assure the viability of the secondary financial markets insider information is prohibited, this reduces the likelihood of opportunistic behavior from information asymmetry. 121) Adverse selection and moral hazard are instances where there are information asymmetries. In the case of adverse selection, one party has more information and can choose to participate selectively in exchanges that benefit her or him. For example, there could be a problem distinguishing a good risk from a bad one before making a loan or providing insurance. In the case of moral hazard, one party has more information and may enter into an exchange and then behave in a way that is not in the interest of the other party. For example, someone might purchase an insurance policy and then behave more recklessly.

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122) Information asymmetries contributed to the financial crisis in several ways, including the following: 1. Mortgage lenders—the originators—eased standards and reduced screening to increase the volume of lending and the short-term profitability of their businesses. The result was many risky mortgages: When housing prices began to fall in 2006, defaults soared. 2. The firms that assembled these mortgages into securities for sale— the distributors—did little to forestall the decline of lending standards by originators. 3. Rating agencies might have halted the game early. Instead, they awarded their top ratings to a large share of mortgage-backed securities, severely underestimating the riskiness of the loans. In retrospect, we can now see that the agencies had little incentive to expend the resources necessary to adequately screen the underlying loans or the lenders. 4. Finally, many investors (and government officials responsible for overseeing intermediaries) assumed they could rely on other people— they were free riders. Rather than undertake their own costly screening efforts, they assumed the assessment of the rating agencies was accurate.

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CHAPTER 12 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) Depository institutions, nondepository institutions, and commercial banks A) are all financial intermediaries. B) offer the same kinds of financial services to the public. C) have the same types of liabilities and different types of assets. D) are different because only depository institutions are profit-driven.

Which one of the following correctly portrays a commercial bank's balance sheet? A) Total Bank Liabilities = Total Bank Capital + Total Bank Assets B) Total Bank Assets = Total Bank Capital − Total Bank Liabilities C) Total Bank Assets = Total Bank Liabilities − Total Bank Capital D) Total Bank Assets = Total Bank Liabilities + Total Bank Capital

3) Considering a commercial bank's balance sheet, which one of the following statements is true? A) Total Bank Assets = Total Bank Capital − Total Bank Liabilities B) Total Bank Assets = Total Bank Liabilities + Total Bank Capital C) Total Bank Assets + Total Bank Capital = Total Bank Liabilities D) Total Bank Assets + Total Bank Liabilities =Total Bank Capital

4) Considering a commercial bank's balance sheet, which one of the following statements is false? A) Total Bank Assets + Total Bank Liabilities = Total Bank Capital B) Total Bank Assets = Total Bank Liabilities + Total Bank Capital C) Total Bank Liabilities = Total Bank Assets − Total Bank Capital D) Total Bank Capital = Total Bank Assets − Total Bank Liabilities

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A bank's net worth is synonymous with its A) assets. B) assets + bank's liabilities. C) capital. D) required reserves.

6) Considering the balance sheet for all commercial banks in the United States, the largest category of assets is A) cash items. B) U.S. Government Securities. C) required reserves. D) loans.

7) Considering the balance sheet for all commercial banks in the United States, the largest category of liabilities is A) borrowing from other banks in the United States. B) checkable deposits and nontransaction deposits. C) checkable deposits. D) borrowings from nonbanks in the United States.

8) Considering the balance sheet for all commercial banks in the United States, the net worth of banks is about A) 5 times the total assets. B) 11% of total assets. C) the same as total assets. D) the same as total liabilities.

9) Considering the balance sheet for all commercial banks in the United States, the net worth of banks is about

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A) 11% of total liabilities. B) 5 times total assets. C) the same as total assets. D) 8 times total liabilities.

10)

The total assets of commercial banks in 2018 amounted to about A) three times nominal GDP in the United States. B) one-half of nominal GDP in the United States. C) four-fifths of nominal GDP in the United States. D) one-tenth of nominal GDP in the United States.

11)

A bank's reserves include A) U.S. Treasury bills. B) currency in the bank but not currency in the ATM machines. C) the bank's deposits at the Federal Reserve. D) U.S. Treasury bills and currency in the bank.

12)

A bank's reserves include A) vault cash. B) U.S. Treasury Securities. C) the bank's loan portfolio. D) U.S. Treasury bills and vault cash.

13) Which one of the following describes bank assets that are cash items in the process of collection?

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A) uncollected funds the bank is due to receive from the clearing of checks B) currency the bank is due from the Treasury C) late fees the bank is owed from loan payments that were not made on time D) payments from the FDIC insurance fund due the bank

14)

Banks do not hold a lot of their assets in the form of cash mainly because A) of regulation. B) of the fear of being robbed. C) of the opportunity cost of holding cash since cash does not earn interest. D) it can encourage employee theft.

15)

For U.S. commercial banks, marketable securities held as assets include A) stocks and bonds. B) only the stocks of U.S. corporations. C) only the bonds of the U.S. Treasury. D) only bonds.

16)

Secondary reserves for banks are A) the same as the bank's net worth. B) mainly the bank's liquid securities. C) vault cash. D) deposits the bank has at the Federal Reserve.

17)

Considering U.S. commercial banks, loans account for A) about one-third of total assets. B) more than one-half of total assets. C) two-thirds of liabilities. D) three-quarters of total assets.

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18)

One thing that is common for all bank loans is that they are A) securitized. B) liquid. C) part of the banks' assets. D) unsecured.

19)

Savings and loans primarily provide A) large commercial loans. B) unsecured credit card loans. C) student loans. D) home mortgages.

20)

Credit unions

A) focus on consumer loans while commercial banks primarily make loans to businesses. B) make loans and accept deposits while commercial banks just make loans. C) can make auto loans to individual and businesses while commercial banks can make auto loans only to businesses. D) do not have to hold reserves while commercial banks do.

21)

Commercial banks increased their involvement in mortgages over the years due to the

A) ability to securitize mortgages which made them more liquid. B) demands of regulators. C) increase in commercial loans demanded due to the development of the commercial paper market. D) reduced risk of borrowers defaulting on mortgage loans.

22)

Which one of the following statements is false?

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A) The largest source of funds for banks to lend comes from the owner's capital. B) Transaction deposits make up less than 15 percent of banks’ sources of funds. C) The largest source of funds for banks are nontransactions accounts. D) Borrowing is a larger source of funds for banks than transaction deposits.

23)

Checkable deposits have decreased since the 1970s mainly because

A) regulators allowed higher rates to be paid on these accounts and banks found them to be highly unprofitable. B) people prefer to use credit cards rather than write checks. C) these deposit accounts offer little or no interest so depositors find them to be expensive. D) as banks added fees to these accounts people increased their holdings of currency.

24) The primary difference between small CDs(certificates of deposit), which are those that are issued for $100,000 or less, and large CDs, which are those that exceed $100,000—other than the dollar amount—is that A) a bank does not have to include small CDs in its liabilities. B) large CDs are negotiable and therefore can be bought and sold. C) small CDs are issued for only six months or less. D) large CDs are issued for only six months or more.

25)

The federal funds market is the A) market where banks borrow from the Federal Reserve System. B) lending to banks by the U.S. Treasury when banks face liquidity emergencies. C) inter-bank market where excess reserves from one bank can be loaned to another

bank. D) market where American banks borrow from foreign lenders.

26)

Loans made in the federal funds market are

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A) highly collateralized. B) made by the Federal Reserve System to the bank within 24 hours. C) unsecured loans. D) insured by the FDIC.

27)

On a bank's balance sheet, A) liabilities show the uses of funds and assets show the sources of funds. B) assets show the sources of funds and the net worth shows the uses of funds. C) net worth shows the sources of funds and liabilities show the uses of funds. D) liabilities show the sources of funds and assets show the uses of funds.

28)

On a bank's balance sheet, A) assets show the sources of funds and the net worth shows the uses of funds. B) net worth shows the sources of funds and liabilities show the uses of funds. C) assets show the uses of funds and liabilities show the sources of funds. D) net worth represents both a source and a use of funds.

29)

Which one of the following is a commercial bank liability? A) mortgage loans B) demand deposits C) reserves D) U.S. Treasury securities

30)

Which one of the following is a commercial bank asset? A) demand deposits B) borrowings from other banks C) mortgage loans D) CDs

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31)

Which one of the following is not a commercial bank liability? A) reserves B) demand deposits C) non-transaction deposits D) federal fund borrowings

32)

Which one of the following is not a commercial bank asset? A) securities B) mortgage loans C) reserves D) nontransaction deposits

33)

Checkable deposits A) are a larger source of bank funds today than in 1970. B) are no longer a source of bank funds. C) are a less important source of bank funds today than in 1970. D) continue to be the largest source of bank funds.

34)

A non-transaction deposit would include each of the following, except A) a savings account. B) a checking account. C) a passbook savings account. D) a certificate of deposit.

35)

A repurchase agreement is

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A) an asset that represents the value of all collateral repossessed by the bank and held for sale. B) a long-term collateralized loan. C) an agreement where the parties agree to reverse the transaction on a specific day. D) only made between two or more banks.

36)

Repurchase agreements are usually used by banks that A) have a need for long-term financing. B) need cash for a very short period of time. C) have negative net worth. D) cannot obtain financing from any other source.

37)

Capital is the cushion banks have against A) sudden drops in the value of their assets. B) an unexpected decrease in liabilities. C) liquidity risk. D) moral hazard.

38)

How are money center banks different from community banks? Money center banks

A) are usually much larger. B) obtain their funds primarily through deposits and not through borrowing. C) are a much smaller percentage of the total number of banks. D) are not actively engaged in the money market.

39)

Savings and loan institutions

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A) are owned by the depositors. B) originally were formed primarily to make home mortgages. C) today offer a much smaller array of services than when originally formed. D) are owned by depositors who also have a common bond.

40) Of the roughly 5,400 commercial banks and savings institutions in the United States at the end of 2018, by far the greatest numbers of them were A) regional banks. B) money center banks. C) community banks. D) savings banks.

41) Suppose a particular bank is very large in terms of assets, and makes consumer and residential loans as well as commercial and industrial loans. The bank is probably a A) regional or super-regional bank. B) money center bank. C) community bank. D) savings bank.

42) Suppose a particular depository institution that specializes in residential mortgages is owned by its depositors. The institution is probably a A) regional or super-regional bank. B) money center bank. C) community bank. D) savings bank.

43) If a bank sells off all of its assets and pays all of its liabilities, the amount remaining would be its

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A) net profit. B) reserves. C) net worth. D) excess reserves.

44)

A bank's loan loss reserves are A) the amount of loans that have defaulted in the past twelve months. B) the same as equity capital. C) an amount the bank sets aside to cover potential losses from defaulted loans. D) a liability of the bank since it is a source of funds.

45)

The largest liability for commercial banks in the United States is A) demand deposits. B) non-transaction deposits. C) borrowing from other U.S. banks. D) borrowing from the Federal Reserve.

46) Suppose that a bank initially has a leverage ratio of 8 to 1. If this bank increases its capital by $1 million and its assets by $10 million, then the bank's A) risk increases and its leverage decreases. B) liabilities decrease and its leverage increases. C) leverage decreases and its liabilities increase. D) leverage and risk both increase.

47)

Which one of the following bank assets would be categorized as secondary reserves?

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A) U.S. Treasury bills B) cash C) mortgage loans D) deposits at the Federal Reserve

48) If a bank has $100 million in assets and a net worth of $10 million, its debt-to-equity ratio is A) 10 to 1. B) 5 to 1. C) 9 to 1. D) 0.1 to 1.

49) If a bank has $150 million in assets and a net worth of $20 million, its asset-to-equity ratio is A) 6.5 to 1. B) 7.5 to 1. C) 0.13 to 1. D) 0.15 to 1.

50) If bank with leverage of 8 to 1 increases its assets by adding $1 to capital for every $1 added to assets, then its leverage A) increases. B) decreases. C) stays constant. D) changes by an amount that cannot be determined from the information in the question.

51) If a bank with $100 million in assets and $10 million in equity increases its assets by adding $1 to capital for every $1 added to assets, then the debt-to-equity ratio will

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A) increase. B) remain constant. C) decrease. D) change in an indeterminate direction.

52)

A bank's return on assets (ROA) is calculated by dividing the bank’s A) assets by its net worth. B) net profits after taxes by its assets. C) net worth by its assets. D) assets less its net profit after taxes by its net worth.

53)

A bank's return on equity (ROE) is calculated by

A) dividing the bank's net profit after taxes by the bank's capital. B) dividing the banks liabilities by the bank's capital. C) adding together the bank's assets and the net profit after taxes and dividing this sum by the bank's capital. D) dividing the bank's net profit after taxes by the sum of the bank's assets and its liabilities.

54) Everything else equal, if the ratio of bank assets to bank capital increases, the bank's return on equity should A) remain constant. B) decrease. C) increase. D) change in a direction that cannot be determined from the information provided.

55) Everything else equal, if the ratio of bank assets to bank capital decreases, the bank's return on equity should

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A) decrease. B) remain constant. C) increase. D) change in a direction that cannot be determined from the information provided.

56) If a bank's return on equity remains constant, but the ratio of bank assets to bank capital increases, then the A) bank's return on assets must have increased. B) bank's return on assets must have decreased. C) bank's assets and capital must have increased by the same percentage. D) bank must be unprofitable.

57) If a bank's return on equity remains constant, but the ratio of bank assets to bank capital decreases, then the A) bank's return on assets must have increased. B) bank's return on assets must have decreased. C) bank's assets and capital must have increased by the same percent. D) bank must be unprofitable.

58) that

The tendency for large banks to have a higher return on equity than small banks suggests

A) small banks have better management than large banks. B) large banks can charge higher interest rates than small banks. C) there could be significant economies of scale in banking. D) larger banks are better able to escape the cost of regulation.

59)

Net interest income for a bank is the

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A) difference between gross income and net income after taxes. B) interest banks earn from uses of funds. C) difference between interest income and interest expense. D) difference between interest income and total expenses.

60)

A bank's net interest margin is calculated by taking net interest income and A) dividing it by the bank's capital. B) dividing it by the bank’s total assets. C) dividing it by the sum of the bank's assets and capital. D) subtracting taxes.

61) The weighted average difference between the interest received on assets and the interest rate paid for liabilities for a bank is the bank’s A) interest-rate spread. B) net interest margin. C) net interest income. D) return on equity.

62)

A bank's off-balance-sheet activities usually increase A) both its assets and liabilities while reducing net income. B) its net income but do not change its assets or liabilities. C) the bank's liabilities but not its assets. D) the bank's assets but not its liabilities.

63) A rumor starts that a bank has suffered significant losses and may not be able to honor its promises to depositors. This causes most of the depositors to line up in front of the bank the next morning wanting to withdraw their deposits. This is an example of

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A) liquidity risk. B) operational risk. C) interest-rate risk. D) credit risk.

64)

A bank that cannot meet its loan commitments is experiencing the results of A) interest-rate risk. B) credit risk. C) trading risk. D) liquidity risk.

65) Many people believed that when the calendar changed from December 31, 1999, to January 1, 2000, many bank records were going to be wiped out. If this had caused people to withdraw all of their funds, this would be an example of A) credit risk. B) operational risk. C) interest-rate risk. D) liquidity risk.

66)

The difference between a bank's reserves and its required reserves is A) profits. B) net interest income. C) excess reserves. D) vault cash.

67) If a bank has $200 million in deposits, the required reserve rate is 10% and the bank has $23 million in reserves, then the bank

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A) is short of required reserves. B) has excess reserves of $21 million. C) has excess reserves of $13 million. D) has excess reserves of $3 million.

68) If a bank has deposits of $250 million, reserves that total $30 million and has a required reserve rate of 10%, then the bank A) is short of required reserves. B) has excess reserves of $27.5 million. C) has excess reserves of $5 million. D) has excess reserves of $3 million.

69) If a bank has customer deposits of $150 million, $15 million in reserves, and the amount of excess reserves equals 0 (zero), then the A) required reserve rate is 15%. B) required reserve rate is 10%. C) required reserve rate is 1%. D) bank's net interest margin is zero (0).

70) Consider a bank with the following balance sheet. If the bank is holding no excess reserves, what is the required reserve rate? ASSETS Reserves Loans Securities

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LIABILITIES 50,000 500,000 500,000

Deposits Borrowing Bank Capital

1,000,000 0 50,000

A) 1%. B) 5%. C) 10%. D) 15%.

71) Consider a bank with the following balance sheet. If the bank is holding $10,000 in excess reserves, what is the required reserve rate? ASSETS Reserves Loans Securities

LIABILITIES 100,000 500,000 500,000

Deposits Borrowing Bank Capital

1,000,000 0 100,000

A) 5%. B) 9%. C) 10%. D) 11%.

72)

Regulators require a bank to hold some of its assets as reserves mainly to address A) liquidity risk. B) trading risk. C) credit risk. D) operational risk.

73) A bank that does not want to hold a lot of excess reserves but wants to manage liquidity risk is likely to A) hold a lot in highly liquid securities. B) make sure that most of its assets are in small business loans. C) have a high ratio of loans to securities. D) limit withdrawals by customers.

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74)

If Bank A sells some its loans to Bank B for cash, everything else equal, A) Bank A's assets decrease and Bank B's assets increase. B) Bank A becomes less liquid while Bank B becomes more liquid. C) Banks A's total assets do not change, but Bank A is more liquid. D) Bank A's liabilities decrease by the amount of the loans that are sold.

75)

A bank that meets deposit withdrawal by borrowing additional funds will alter the A) asset side of their balance sheet. B) liabilities side of the balance sheet. C) amount of bank capital. D) asset and liabilities side of the balance sheet.

76)

The credit risk a bank faces is the risk resulting specifically from A) the economy entering a recession. B) interest rates falling. C) some of the bank's loans not being repaid. D) the bank experiencing a decrease in deposits.

77)

A bank that specializes in granting loans to firms in a specific line of business may A) decrease both its operating cost and its credit risk. B) increase both its operating cost and its credit risk. C) increase its operating cost and decrease its credit risk. D) decrease its operating costs and increase its credit risk.

78)

One way for a bank to deal with credit risk is to

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A) charge all borrowers from the same industry an average rate for that industry. B) add a markup to the cost of funds for a specific borrower based on the borrower's credit history. C) avoid making loans to borrowers from a broad spectrum and specialize geographically and in specific industries. D) increase the number of loans made in any year.

79) The fact that a bank's assets tend to be long-term while its liabilities are short-term creates A) interest-rate risk. B) credit risk. C) decreased risk for the bank. D) trading risk.

80) A bank's assets tend to be long-term while its liabilities are short-term. Therefore, when interest rates rise, the value of the bank's assets A) increases by more than the value of its liabilities. B) decreases by more than the value of its liabilities. C) increases and the value of its liabilities decreases. D) decreases and the value of its liabilities increases.

81)

When interest rates fall, a bank's capital will usually A) not change. B) decrease. C) turn negative. D) increase.

82) If a bank has more interest-rate-sensitive liabilities than interest-rate-sensitive assets, an increase in the interest rate will cause profits to

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A) increase. B) decrease. C) remain constant. D) be negative.

83) For every $100 in assets, a bank has $30 in interest-rate sensitive assets, and the other $70 in non-interest-rate sensitive assets. The same bank has $60 for every $100 in liabilities in interest-rate sensitive liabilities while the other $40 are in liabilities that are not interest-rate sensitive. If the interest rate on assets decreases from 6 to 5%, and the interest rate on liabilities decreases from 4 to 3%, the impact on the bank's profits per $100 of assets will be A) a reduction of $0.30. B) an increase of $0.30. C) a reduction of $3.00. D) zero since the interest rates on assets and liabilities fell by the same amount.

84) For every $100 in assets, a bank has $40 in interest-rate sensitive assets, and the other $60 in non-interest-rate sensitive assets. The same bank has $50 for every $100 in liabilities in interest-rate sensitive liabilities while the other $50 are in liabilities that are not interest-rate sensitive. If the interest rate on assets increases from 5 to 6%, and the interest rate on liabilities increases from 3 to 4%, the impact on the bank's profits per $100 of assets will be A) an increase of $0.10. B) a decrease of $0.10. C) a reduction of $1.00. D) zero since the interest rates on assets and liabilities increased by the same amount.

85) The procedure that estimates the interest-rate sensitivity of a bank's assets and liabilities is called A) managing credit risk. B) estimating operating risk differential. C) trading risk minimization. D) gap analysis.

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86)

A bank that makes the most of its long-term loans at adjustable interest rates is

A) reducing both interest-rate and credit risk. B) increasing credit risk and reducing interest-rate risk. C) reducing credit risk and increasing interest-rate risk. D) increasing both interest-rate and credit risk.

87)

Trading risk faced by U.S. banks results from A) the free-rider problem. B) changes in regulations. C) adverse selection. D) moral hazard.

88)

A bank faces foreign exchange risk when A) it has assets denominated in one currency and liabilities in another. B) it lends to foreign borrowers because they are less likely to repay a U.S. bank. C) foreign governments restrict dollar-denominated payments. D) it has branches in other countries.

89) Ceteris paribus, when internal processes are inadequate or even fail, losses can occur that result from what type of risk? A) credit risk B) trading risk C) operational risk D) interest-rate risk

90)

Cyber risk describes losses that result from

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A) natural disasters. B) bank loans not being repaid. C) compromised information systems. D) fluctuating values in financial instruments.

91)

Cyber risk is reduced through A) the use of floating interest rates. B) diversifying the types of loans issued. C) cloud computing and other information redundancies. D) hiring traders to actively manage buying and selling of securities.

92)

Cyber risk is especially high in financial sectors because

A) cyberattacks are rarely concealed from the public. B) most governments place a high priority on protecting individual records. C) the network of users in the financial sector is generally small compared to the size of the economy. D) financial institutions and markets are heavily reliant on on-demand information.

93) Firms that pay for protecting electronic records and networks cannot reap the full benefit of their investments because there are A) natural monopolies in the financial sector. B) principal-agent problems with network protection. C) redistributive effects from investing in cybersecurity. D) positive externalities from putting protective measures in place.

94) Which type of government intervention would address market failures that exist in the area of cybersecurity by changing firms’ incentives to allocate resources to promoting cybersecurity? Government should

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A) use regulation to eliminate cyberattacks. B) provide cybersecurity within its borders. C) create a public agency to eliminate cyberattacks. D) strongly encourage disclosure and information sharing about breaches.

95) One of the lessons from the 2007–2009 financial crisis regarding the management of risk by financial institution is that A) many banks lacked real-time information that would allow them to assess their various risk exposures at the bank-wide level. B) some banks, especially large ones, overestimated the trading risk associated with mortgage backed securities. C) banks were holding too much capital as a protection against market risk. D) many of the usual mechanisms for managing liquidity risk actually worked pretty well.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 96) What is the equation that reflects a bank's balance sheet?

97) If a bank has a net worth that is negative, what do you know about the relationship between the amounts the bank has in assets and liabilities?

98) Identify the four broad categories that make up the asset side of the balance sheet for banks and identify which category is usually the largest.

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99) One of the cash items included on the asset side of banks' balance sheets is reserves. What makes up reserves and what is their purpose?

100) What are the securities that U.S. banks own and why are they often referred to as secondary reserves?

101) Explain why non-transactions accounts have become a more important source of funds for the bank than transaction accounts over the past thirty years.

102) Why would a bank usually want to minimize the amount of excess reserves it has on hand?

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103) A bank has a need for cash for a short period of time to meet its liquidity needs. The bank has significant holding of U.S. Treasury securities. The bank really does not want to sell the securities, realizing the liquidity need is a temporary problem. A pension fund has significant cash holdings and would like to earn some return on part of these holdings. The problem is the fund will need this cash in a few days to honor a purchase agreement it made for municipal bonds being issued. Is there any way these two organizations can work together to solve each other's problem?

104) Explain why a bank manager and a bank regulator would likely view the timing at which a loan should be charged to the loan loss reserve differently.

105) You are provided with the following information: a bank has a net income after taxes of $3.5 million; it has assets of $150 million; and bank capital of $12.5 million. What is the bank's return on assets; its return on equity, and its debt-to-equity ratio?

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106) Explain why a bank with a high debt-to-equity ratio may be more profitable than a bank with a lower ratio but would also have a higher level of risk.

107) Considering that, on average, the return on assets is the same for small and large banks, and the return on equity is higher for large banks than small banks, what can be one of the explanations for the trend toward bank mergers?

108) We saw in Chapter 12 that initially savings and loans were created to make home mortgages, and their main source of funds was deposits from savers. In the late 1970s and into the 1980s, the United States experienced rising interest rates that had depositors looking for higher returns. Congress quickly removed the interest-rate ceilings that savings and loans could offer. Explain the initial impact this had on the interest-rate spread and the net interest margin for the savings and loans.

109) As the end of the year 1999 approached, many people worried that banks and more specifically the banks' computers would not be able to read the year 2000 correctly. This was commonly known as the Y2K problem. Many people were concerned that their bank would lose the record of their deposits, etc., and made plans to take most of their funds out of the bank. Address the potential Y2K problem from the standpoint of bank risk. What two types of risk potentially could have been involved?

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110) If the Federal Reserve were to do away with the required reserve regulation, do you think banks would stop holding reserves? Explain.

111) A bank has the following assets: reserves of $15 million, loans of $150 million, and securities of $50 million. Their liabilities include deposits of $150 million, borrowed funds of $35 million, and bank capital of $30 million. If the required reserve rate is 10 percent, answer the following: What is the amount of excess reserves the bank is currently holding? What are the options available to the bank if customers decide to withdraw $10 million in deposits?

112) Information asymmetry that exists in lending creates what type of risk for banks? Discuss the ways for a bank to handle or minimize this risk.

113) If you focus on interest-rate risk, can you explain why banks offer higher interest rates on longer-term CDs than they do on short-term CDs?

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114) A bank has $100 million in assets and 50 percent of its assets are interest sensitive. The bank has $75 million in liabilities, 50 percent of which are interest sensitive. What is the bank's gap between interest-sensitive assets and liabilities?

115) A home buyer is presented with two options for financing the purchase of a home: a 20year fixed-rate mortgage or a 20-year adjustable-rate mortgage, where the rate adjusts once a year. Which mortgage would you expect to start at the lowest interest rate and why?

116) The trading losses that some banks incurred could be thought to be from trading risk, but in many cases the real cause of the losses could be attributed to moral hazard. Why was this the case?

117)

Why are U.S. banks prohibited from owning stocks?

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118) What should be the impact on a bank's return on assets and return on equity from increased use of off-balance-sheet activities?

119) A bank develops specialized skills in analyzing companies from one specific industry. This contributes significantly to the bank achieving economies of scale because a large portion of its total loan portfolio is made up of companies in this industry. What are the long-run profit prospects for this bank? Explain.

120) An argument that comes up from time to time is that credit unions have an advantage over other financial depository institutions in the sense that they are non-profit institutions and, therefore, are exempt from taxes on income that other private depository institutions pay. As a result, credit unions may be able to charge lower rates of interest to borrowers and pay a higher rate to depositors than these other institutions. What do you think of this argument?

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121) We have discussed the principal-agent problem as a form of moral hazard. Discuss the unique problems a bank manager faces in terms of trying to please the owners of the bank and at the same time trying to appease regulators.

122) ABC Co., Inc., has recently suffered a data breach and has been investigating how to prevent this from happening. They have researched the costs of developing a new data security system that could protect their entire industry, and possibly beyond, from cyberattacks. What type of market failure exists in this environment that might prevent ABC from investing in the new technology?

123) Why is it important for firms and regulators in the area of cybersecurity to focus on prospective risks?

124) Bank managers seem to have to walk a tightrope between managing risk and earning a profit. Explain.

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125) The primary difference among various kinds of depository institutions is in the composition of their loan portfolios. Do you agree or disagree? Explain.

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Answer Key Test name: Chap 12_6e 1) A 2) D 3) B 4) A 5) C 6) D 7) B 8) B 9) D 10) C 11) C 12) A 13) A 14) C 15) D 16) B 17) B 18) C 19) D 20) A 21) A 22) A 23) C 24) B 25) C 26) C Version 1

27) D 28) C 29) B 30) C 31) A 32) D 33) C 34) B 35) C 36) B 37) A 38) A 39) B 40) C 41) A 42) D 43) C 44) C 45) B 46) D 47) A 48) C 49) B 50) B 51) C 52) B 53) A 54) C 55) A 56) B Version 1

57) A 58) C 59) C 60) B 61) A 62) B 63) A 64) D 65) D 66) C 67) D 68) C 69) B 70) B 71) B 72) A 73) A 74) C 75) B 76) C 77) D 78) B 79) A 80) B 81) D 82) B 83) A 84) B 85) D 86) B Version 1

87) D 88) A 89) C 90) C 91) C 92) D 93) D 94) D 95) A 96) The equation reflecting a bank's balance sheet is: Total Bank Assets = Total Bank Liabilities + Bank Capital 97) If a bank has a negative net worth, it means the bank's capital is less than zero. This can only be the case if the bank's liabilities exceed its assets. 98) The four categories that make up the asset side of the balance sheet for banks include: cash items, securities, loans and all other assets. The largest category is usually loans. 99) Reserves are made up specifically of two items: one is cash in the bank, also referred to as vault cash. The other is deposits the bank has at the Federal Reserve. The main purpose of reserves is to make sure banks have enough liquidity to meet the demands of customers for withdrawal requests. 100) By regulation U.S. banks are not allowed to own stocks, so their securities are limited to bonds. And, for regulatory reasons, banks choose to hold U.S. government and agency bonds. Most of these bonds are highly liquid and in the case of need, can be sold quickly to back up the cash positions of the bank. As a result they are often referred to as secondary reserves.

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101) Non-transactions accounts include savings and time deposits, and certificates of deposit. Over the past quarter of a century financial innovation and technology have caused people to economize on their deposits in transaction accounts (checkable deposits) since most of these accounts paid little to no interest. The development of money market accounts and the technology that has allowed people to transfer funds out of savings accounts when their checking account balances run low has caused the balances in the savings accounts to increase significantly. 102) Reserves are assets held in the form of vault cash and deposits at the Federal Reserve in a non-interest bearing account. As a result, the opportunity cost of holding reserves is usually high. Regulations require banks to hold a certain amount of reserves, called required reserves, but any amounts held above this level are excess reserves and the bank is forgoing the return that could have been earned on these funds. 103) This is a situation that is ideal for a repurchase agreement. Here the bank would agree to sell the Treasury securities (or some portion of them) to the pension fund in return for cash, and at the same time the bank would agree to buy the securities back at a future date (usually a day or two later) at a price equal to what the bank sold them for plus an additional amount reflecting the interest payment on the loan. In this way, the bank gets the cash it needs and the securities back in a few days, and the pension fund earns income from the short-term loan and retains its cash position to make the securities purchase it planned.

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104) The loan loss reserve is part of a bank's capital. A loan is part of a bank's assets. To charge a loan against this reserve will reduce both the bank's assets and its capital. A manager will try to avoid this scenario. Regulators, on the other hand, are more concerned with the bank's ability to meet its obligations, including the liquidity needs of its depositors. Non-performing loans, while they may appear as an asset are really not. The regulators would rather charge these off to the loan loss reserve and obtain a clearer view of the bank's actual capital position and its ability to meet its obligations and also to withstand a shock. 105) The bank's return on assets is 2.33%; this is obtained by dividing the $3.5 million in net income after taxes by the asset amount of $150 million and multiplying by 100 to convert the decimal into a percentage. The return on equity is 28.0%. We divide the $3.5 million in this case by the equity of $12.5 million and multiply by 100 to obtain our answer. The debt-to-equity ratio requires we first obtain the amount in liabilities. This is done by realizing that bank capital (equity) and total liabilities must equal total assets. So taking the amount in assets, $150 million, and subtracting the amount in capital, $12.5 million, leaves us with liabilities of $137.5 million. Dividing the $137.5 million by $12.5 million produces a debt-to-equity of 11 to 1. 106) A bank with a high debt-to-equity ratio is financing the acquisition of assets with borrowed funds. The return (profit) earned on these assets belong to the owners (the providers of the bank's capital or equity). With a high debt-to-equity ratio, the owners of the bank stand to earn a higher return on equity than the owners of a bank with a lower debt-to-equity ratio, assuming the same return on assets. The problem or the risk comes from the fact that with the high leverage anything that reduces the value of assets can potentially wipe out the capital of the bank, leaving the bank insolvent since the capital cushion is inadequate to meet the drop in asset value. Version 1

107) The return on assets being the same suggests that large banks may not have any advantage in managing assets than small banks. The fact that large banks have a higher return on equity means that they must have higher leverage. This suggests that there are economies of scale in banking. 108) Before the dramatic increase in interest rates, savings and loans were paying a regulated rate on their liabilities (deposits) and earning a higher rate on their assets (mortgages). They had a positive interest-rate spread which also gave them a positive net interest margin. Since they were quite confident concerning the cost of funds, they could set mortgage rates that would ensure an adequate spread and margin. Once interest rates began to increase and the rate ceiling on deposits was removed, the interest rate offered to depositors (cost of funds) increased, but because most of the assets of savings and loans were in long-term mortgages, the interest earned on assets was fairly interest-rate insensitive. This quickly put many savings and loans into negative spread and margin positions and contributed to the crisis that was to hit this industry. 109) First, if the problem did arise and bank records would have been wiped out, this would have been an example of operational risk. A technological breakdown would have led to significant problems for many people and potentially a financial market panic. The risk would not have stopped there; as savers demanded their funds from banks, the banks would have faced liquidity risk. Most banks would not have been able to meet the demand for liquidity. This was a concern of the Federal Reserve, which had significant amounts of currency on hand in the event that people did start to withdraw their savings from banks.

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110) If the Federal Reserve did away with the required reserve regulation, the likely outcome is there wouldn't be much of a change in the reserve holdings of most depository institutions. The reason for this is that these institutions are very sensitive to managing liquidity risk and as a result would want to have liquid assets on hand to meet the liquidity needs of depositors. 111) The bank is not holding any excess reserves. With deposits of $150 million and a required reserve rate of 10%, the reserves of $15 million are what the bank needs. If customers decide to withdraw $10 million from the bank, the bank can meet this need either through asset adjustment or liability adjustment. First, from the asset side, the bank could sell securities for cash or decide not to renew some loans. Since the bank is interested in maintaining good customer relations, they would probably opt for the selling of securities. From the liability adjustment side, the bank could borrow the additional funds required or try to increase deposits, perhaps by offering an attractive interest rate on long-term CDs. 112) Information asymmetry leads to the problems of moral hazard and adverse selection. In banking this creates credit risk. The credit risk can be minimized by acquiring additional information. This additional information may be in the form of a loan application, a credit report, and credit scoring tools, charging different interest rates based on risk, and by monitoring the borrower after the loan is made. 113) In looking at bank balance sheets one important difference is that bank assets tend to be long term and its liabilities tend to be short term. This mismatch between maturities creates interest-rate risk. One way to reduce the risk for banks is to try to move more liabilities from short to long term. By offering higher rates on longer-term CDs banks may be able to lure savers from shorter-term to longer-term CDs thus increasing the average maturity of the banks' liabilities. Version 1

114) The amount of assets that are interest sensitive is 50 percent of $100 million, or $50 million. The amount of liabilities that are interest sensitive is 50 percent of $75 million, which is $37.5 million. Subtracting the interest-sensitive liabilities from the interest-sensitive assets leaves a gap of +$12.5 million. 115) The adjustable-rate mortgage should start at a lower interest rate. In the case of an adjustable-rate mortgage, the lender is able to transfer a significant amount of the interest-rate risk to the borrower. But as we saw in a previous chapter, most people are risk averse and in order to take on increased risk the individual requires compensation. Here the borrower is enticed to take on the interest-rate risk with the compensation in the form of a lower starting interest rate on the mortgage. 116) As the chapter points out, in the case of trading, often times the trader (the bank employee) is in a situation where, if the trades turn out profitable, the trader reaps a large portion of the gains; but if the trade generates losses, the bank loses. This is a classic moral hazard problem where the trader has a strong incentive to take significant amounts of risk. This was certainly the case with Nick Leeson and Barings Bank. 117) It probably has a lot to do with two main issues. One is the liquidity of these securities. The markets for these securities at times can be less liquid than say for U.S. Treasury securities, and that can have an adverse impact on a bank that needs to get liquidity. Another issue can stem from fluctuating market values for these securities. As their market values fluctuates so will the value of the banks' assets. Especially in those instances when market values may drop significantly (stock market crashes, etc.), banks may find that the value of their assets falls so much their net worth disappears and they may become insolvent. Compounding this will be the potential runs on banks if it is rumored that a particular bank owned a lot of stock of a company that is failing. Version 1

118) Since off-balance-sheet activities generate income but do not add to assets or liabilities, the impact should be to increase the return on assets. Since ROA is calculated by dividing net income after taxes by total assets, only the numerator is increasing, not the denominator, so ROA should increase. The same thing could be said about return on equity (ROE); the net return after taxes increases, but the bank's capital does not, so ROE increases. This is the main reason banks are increasing their use of off-balance-sheet activities. 119) The bank may have lowered its transaction costs due to its specialization of mainly lending to firms in one industry but it has considerably increased its idiosyncratic or credit risk. It would likely suit the bank better in the long run to diversify its portfolio so it is only exposed to systematic risk. Ideally if the bank could generate the loans and then securitize them and sell them off (like home mortgages), it may have the best possible outcome. 120) The argument may have some validity as stated; however, whether credit unions are able to charge a lower rate of interest to borrowers or offer a higher rate to depositors is questionable. Most credit unions are smaller than most banks, partially due to their employer ties and/or other restrictions on membership, and as a result are not as able to exploit economies of scale and scope as larger banks. Also, credit unions may have better information to assess members' creditworthiness; on the other hand, they may make more questionable loans, thinking that the borrower represents a better risk because of this membership. This is a form of adverse selection.

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121) The principal-agent problem arises from the fact that often the manager of a company is not acting in the best interest of the owners. In the case of a bank, the owners would certainly want a high profit with a reasonable amount of risk. On the other hand, the regulators of a bank prefer the bank minimize risk. For example, we saw that increasing the leverage (higher debt-to-equity ratio) can increase the return on equity, something the owners of the bank would prefer. The higher leverage on the other hand also increases the risk, something the regulators will frown upon. So the bank manager is in the unenviable position of having to balance the desires of the owners, the regulators, and to a large degree the depositors. This is not an easy task. 122) ABC will make their decision by weighing costs and benefits for their own business. They will consider only private benefits when there are additional benefits to the industry, and perhaps to society at large, if the technology could protect data in other areas as well. Since the firm does not reap the full benefits of the investment, the result will be a quantity of protection that is less than the socially desired level. There is no incentive to produce the socially desired level. Perhaps government intervention could help since there are spillover benefits. 123) There are rapid changes in technology and the financial system that bring new business opportunities but also bring the possibility for previously unimagined catastrophes. In fact, the odds of disaster rise with increased complexity and interconnectedness of finance. So, to stay competitive, firms and regulators need to anticipate risks and imagine the possible disasters that might occur. The “failure of imagination” is a source of vulnerability to attack. Therefore, resources need to be allocated to the study of prospective risks, or what might occur.

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124) If we consider the various forms of bank risk and the possible ways to manage it, we can see the challenges posed for a bank seeking to make the highest possible profit (to satisfy its owners). Managing liquidity risk means having to structure securities holdings so that sales can be carried out if needed. This means holding shorter-term securities such as Treasury securities, but they tend to pay less of a return. Managing credit risk means having to diversify, which may mean higher costs to the bank as it gives up a competitive advantage in a narrow line of business. Managing interest-rate risk means restructuring assets to better match liabilities and, as with liquidity risk management, this also reduces potential profitability. Add to this the limitations imposed by regulators (such as not being able to own stock and monitoring of bank leverage) and one might wonder how banks ever manage to earn a profit. 125) All depository institutions have deposits as their sources of funds and use those funds to make loans. There are three basic types of depository institutions: commercial banks, savings institutions, and credit unions. Commercial banks make loans primarily to businesses; saving and loans primarily provide mortgages to individuals; and credit unions specialize in consumer loans. However, the balance sheets of these depository institutions have changed over time and they now compete with each other to a greater degree than in the past. For example, on the deposits side, savings institutions offer types of checking accounts. In terms of the loan portfolios, commercial banks now serve individuals with consumer and residential loans, and savings and loan institutions today engage in a much broader range of financial activities than in the past. Therefore it is safe to say that while the depository institutions do differ from each other in terms of the loan portfolios, the differences will mostly be matters of the proportions of different types of loans each holds.

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CHAPTER 13 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) When compared to Canada or Japan, the United States is unusual in that it has A) far fewer banks than either of those countries. B) fewer banks than Japan but more than Canada. C) more banks than Japan but fewer than Canada. D) more banks than either Japan or Canada.

In recent years the U.S. banking structure has changed in such a way that there are now A) more banks. B) fewer branches. C) fewer banks but more branches. D) fewer banks and fewer banks with branches.

3) Why has the number of banks in the United States fallen steadily in the past three decades? A) Modern consumers prefer “brick and mortar” banks. B) Consumers do not use financial services as much as they used to. C) Firms obtain financing without the use of financial intermediation now. D) There has been a trend toward consolidation in the banking industry.

4) The financial crisis in the United States in 2007–2009 brought about all of the following changes except which one? A) a rise in the number of unit banks B) an increase in the deposit share of the top four U.S. commercial banks C) the placement of the two government-sponsored enterprises for housing finance into conservatorship D) a run on money-market mutual funds

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If someone wants to start a bank today they would have to A) obtain a charter from the federal government. B) simply have $5 million is startup capital, a charter is no longer needed. C) obtain a charter either from the federal or state government. D) obtain only a state charter since the federal government stopped issuing charters in

1970.

Unit banks are A) banks with no branches. B) more numerous in the United States than they were in previous decades. C) no longer permitted to exist in the United States. D) commercial banks that have combined into one unit with an investment bank.

A unit bank is a bank that

A) only makes one type of loan (e.g., home mortgages). B) only offers savings accounts. C) provides a myriad of financial services, so customers get all or most of their financial needs taken care of at the bank. D) has no branches.

The National Banking Act of 1863 initiated A) an abrupt shift in power toward the states. B) a gradual shift in power toward the states. C) an abrupt shift in power away from the states. D) a gradual shift in power away from the states.

9) Prior to the Civil War most state banks issued their own banknotes. Which one of the following is not true about these banknotes?

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A) Their values decreased as the holder moved farther from the bank. B) They were worthless if the bank failed. C) They were not efficient as a means of payment if the holder was far from the bank. D) They were usually redeemable in gold.

10)

The dual banking system in the United States today refers to A) a bank's ability to issue checking and saving accounts. B) a bank's ability to own another financial institution. C) the ability of banks to be either federally or state chartered. D) a deposit institution's decision to be either a bank or a savings and loan.

11)

In the United States today A) most banks are federally chartered. B) most banks are state chartered. C) there are approximately equal numbers of state and federally chartered banks. D) all new banks are federally chartered.

12)

Most banks in the United States today are A) state chartered so they can use state-issued banknotes. B) federally chartered because this is a more permissive environment. C) state chartered because this increases flexibility, and, thus, profitability. D) federally chartered because it locks the bank into a more secure environment.

13)

Banks exert some control over who will regulate them because banks A) spend a lot of money contributing to political campaigns. B) can switch their charter from state to federal and vice versa. C) have the right to choose which regulator will oversee their bank. D) pay the salary of the regulator.

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14)

In the early years of the Great Depression, 1929–1933, A) over one half of all U.S. banks failed. B) two-thirds of U.S. banks failed. C) more than a third of all U.S. banks failed. D) a little less than one-quarter of U.S. banks failed.

15)

The bank failures that occurred during the early years of the Great Depression A) hurt large depositors the most since it was the large money center banks that failed. B) hurt small depositors the most since it was mainly small banks that failed. C) hurt the taxpayers the most since the FDIC covered most of the losses of depositors. D) totaled about 30 percent of total bank customer deposits.

16)

The Federal Deposit Insurance Corporation (FDIC) was created A) in 1933 as a part of the Glass-Steagall Act. B) when the Federal Reserve was created in 1914. C) prior to the stock market crash of 1929. D) in 1927 as a part of the McFadden Act.

17)

The Glass-Steagall Act of 1933 A) required commercial banks to sell off their investment banking operations. B) eliminated the FDIC. C) required federally chartered banks to meet the branching restrictions of the states. D) required all state banks to get federal charters.

18)

The United States has many banks because

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A) small banks are more profitable than large banks. B) historically, many states outlawed bank branching. C) the Great Depression caused the failure of the large banks, leaving many small banks. D) the Glass-Steagall Act forced the splitting up of large banks.

19) Which one of the following statements most accurately describes the state of banking in the United States? A) a large number of large banks and a small number of small banks B) a large number of large and small banks C) a small number of large and small banks D) a large number of small banks and a small number of large banks

20)

As of 2019, the number of commercial banks in the United States is approximately A) 200. B) 4,700. C) 14,000. D) 80,000.

21)

Many states prohibited bank branching for all of the following reasons except

A) they feared the concentration and monopoly power of large banks. B) they generated significant revenue from issuing bank charters. C) they wanted to protect the profits of banks since they generated tax revenue from these profits. D) the McFadden Act of 1927.

22)

The actual results of the McFadden Act included

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A) increased efficiency of banking across the country. B) a tight network of interconnected banks across the country. C) the continued operation of small, inefficient banks. D) the elimination of banking monopolies.

23) The McFadden Act produced a fragmented banking system where competition was prohibited. The result, in economic terms, was A) less efficiency due to lack of pressure to innovate. B) spillover benefits to banks outside of the geographic region. C) modern banks with no restrictions on adopting new technologies. D) a decrease in wellbeing for everyone, including bank owners.

24)

One of the results of the limit on bank branching was A) increased diversification in the loan portfolio of small banks. B) curtailment of credit availability for borrowers in small towns. C) lower profits for banks. D) increased efficiency in the operations of banks.

25)

Bank holding companies developed A) to get around the limitations on bank branching. B) so foreign banks could open branches in the United States. C) to circumvent regulation by the Office of the Comptroller of the Currency. D) so that unit banks could combine into larger banks.

26)

Over the last four decades in the United States, the number of banks has

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A) been increasing slowly. B) stayed about the same. C) been decreasing. D) more than doubled.

27)

One way that a bank could offer nonbank services across more than one state was to A) file for a foreign bank charter. B) be a federally chartered bank rather than a state chartered bank. C) create a bank holding company. D) become a central bank.

28)

The Bank Holding Company Act of 1956 A) significantly broadened the scope of what bank holding companies could do. B) limited bank holding companies to operating only within their chartered state. C) limited the scope of bank holding companies in terms of services offered. D) repealed the McFadden Act of 1927.

29)

As a result of technology, many small businesses today A) are located geographically closer to their bank. B) are located geographically farther from their bank. C) have more face-to-face interactions with their banker. D) no longer need banks.

30) Technology has provided ways for customers to bank from a distance, which has lessened which type of market failure in the industry?

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A) free riding of customers B) monopoly power of local banks C) government regulation D) spillover costs from municipalities

31) One of the results of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 was A) a reversal of the branching restrictions of the McFadden Act. B) an increase in the number of banks in the United States. C) a decrease in the average size of banks. D) a decrease in commercial banks but an increase in the number of savings and loans and savings banks.

32) The sharp reduction in the number of banks that has occurred since the mid-1980s has been due primarily to A) bank failures from increased competition. B) bank mergers. C) the closing of banks by federal regulators. D) the revoking of state bank charters.

33) The Riegle-Neal Interstate Banking and Branching Efficiency Act permits banks to acquire an unlimited number of branches nationwide. This increased competition has led to A) less efficiency in the banking system. B) lower unemployment in local economies. C) higher fees to cover higher costs of management. D) higher profits for banks through lower operating costs and decreased loan losses.

34)

One result of the Riegle-Neal Interstate Banking and Branching Efficiency Act was that

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A) banking system efficiency decreased. B) banks became less geographically diversified. C) banking system efficiency increased. D) banks became less geographically diversified and banking system efficiency decreased.

35)

The Gramm-Leach-Bliley Act

A) repealed the Riegle-Neal Interstate Banking and Branching Efficiency Act. B) repealed the Glass-Steagall Act's prohibition of mergers between commercial banks and insurance or securities firms. C) repealed the McFadden Act's restriction on bank branching. D) reinforced the Glass-Steagall Act's limitation on commercial banks' availability to merge with insurance or securities firms by increasing the penalties for doing so.

36)

The Economic Growth, Regulatory Relief, and Consumer Protection Act

A) required increases in federal deposit insurance on deposits. B) increased penalties for banks who take on too much risk. C) increased regulation on banks by requiring more government oversight. D) relaxed regulatory requirements on small and medium-sized banks and even some larger banks.

37)

An Edge Act corporation is

A) a company created so a U.S. bank can operate in more than one state. B) a subsidiary of a bank created to provide insurance and securities services. C) a company created by a nonbank corporation used to purchase and operate banks. D) a subsidiary of a domestic bank that is established specifically to engage in international banking transactions.

38)

The growth of international banking has

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A) decreased the competition that domestic banks face. B) decreased the efficiency of most banks. C) enhanced economic growth in many countries. D) increased the monopoly power of most banks.

39)

Eurodollars are A) the currency of the European Economic Union. B) euro-denominated deposits in U.S. banks. C) dollar-denominated deposits in banks outside the United States. D) dollars that are specially printed for use abroad to minimize counterfeiting.

40) Eurodollar deposits often earn higher returns than U.S. bank deposits for all of the following reasons except A) Eurodollar deposits are not subject to U.S. reserve requirements. B) the bank does not have to pay deposit insurance premiums on these deposits. C) regulatory compliance may be more costly for a foreign bank than a U.S. bank. D) taxes on the profits on banks outside the United States may be lower on banks inside the United States.

41) As of 2019, but perhaps not beyond 2021, the world’s leading benchmark for short-term interest rates is the A) international federal funds rate. B) London Interbank Offered Rate. C) discount rate. D) International Prime Rate.

42)

Why is LIBOR “on life support” as a financial benchmark in 2019?

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A) It is immune to market transaction manipulations. B) It involves judgment and is not based on transactions. C) It is as close to default-risk-free as we are likely to get. D) It is based on a deep, liquid market making it easy to manipulate.

43)

The interest rate at which banks lend each other Eurodollars is known as the A) international federal funds rate. B) London Interbank Offered Rate. C) discount rate. D) International Prime Rate.

44) The gap between LIBOR and the expected Federal Reserve policy interest rate provides a key measure of the A) direction of movement of the Euro relative to the U.S. dollar on the foreign exchange market. B) persistence and intensity of the liquidity crisis. C) expected length of a coming global recession. D) movement of the U.S. stock market.

45)

Citigroup is an example of A) an Edge Act corporation. B) a foreign bank. C) a financial holding company. D) a unit bank.

46)

Universal banks are

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A) firms that engage in banking services across many countries. B) firms that engage a wide array of financial and nonfinancial activities. C) banks that make direct investment in nonfinancial firms. D) multinational corporations that own U.S. banks.

47)

Which one of the following is an accurate statement about universal banks?

A) In Germany universal banks do everything under one roof, including direct investment in the shares of nonfinancial firms. B) In Germany the provision of insurance, banking, and securities must be done by separate corporations. C) As in Germany, universal banks in the United States do everything under one roof, including direct investment in the shares of nonfinancial firms. D) Universal banks in the United States account for the largest share of financial intermediary assets.

48) Which one of the following is not a reason to create large financial holding companies? Financial holding companies A) offer a wide array of services under one brand name. B) need only one CEO, one Board of Directors, and one accounting system regardless of size. C) are well diversified so risk is reduced. D) are exempt from having to pay for FDIC insurance on deposits.

49) Which one of the following supports the economies of scale argument for increased profits for large financial holding companies? A) Financial holding companies offer a wide array of services under one name. B) Financial holding companies need only one CEO, one Board of Directors, and one accounting system regardless of size. C) Financial holding companies are well diversified so risk is reduced. D) The profitability of financial holding companies does not rely on one particular line of business.

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50) Which one of the following supports the economies of scope argument for increased profits for large financial holding companies? A) Financial holding companies offer a wide array of services under one name. B) Financial holding companies need only one CEO, one Board of Directors, and one accounting system regardless of size. C) Financial holding companies face declining average costs per dollar of deposits. D) The profitability of financial holding companies relies on one particular line of business.

51)

Which one of the following is not a nondepository institution? A) a savings and loan B) an insurance company C) a mutual fund company D) a pension fund

52) Over the past 50 years, the percentage(s) of assets for all financial intermediaries controlled by U.S. banks has A) increased while the percentage for mutual funds has decreased. B) decreased as has the percentage for mutual funds while insurance companies have increased their percentage. C) increased while the percentage controlled by insurance companies and mutual funds has decreased. D) decreased while the percentage for stock and bond funds has increased.

53) Over the past 50 years, the percentage(s) of assets for all financial intermediaries controlled by government-sponsored enterprises has

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A) decreased as has the percentage for mutual funds while insurance companies have increased their percentage. B) decreased and the percentage controlled by stock and bond funds has increased. C) increased while the percentage controlled by U.S. banks has decreased. D) increased as have those controlled by banks, insurance companies, mutual funds, and pensions.

54)

Modern forms of insurance can be traced back to around what year? A) 1400 B) 1700 C) 1800 D) 1900

55)

Lloyd's of London is famous for A) being the largest insurance company in the world. B) going out of business when it insured too many odd risks. C) offering insurance against unusual risks. D) being the oldest insurance company in the world.

56) Lloyd's of London is the best-known insurance company in the world today because they insure A) low-risk stable enterprises. B) unique and sometimes very odd situations. C) physical structures to minimize the risks to their underwriters. D) marine-related risks.

57) Insurance companies perform all of the following functions of financial intermediaries except

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A) transferring risk. B) pooling the resources of small savers. C) making large investments. D) supplying liquidity.

58)

Insurance companies offer which two basic types of insurance? A) life insurance and property and casualty insurance B) life insurance and mutual funds C) property and casualty companies D) whole life and term life insurance companies

59)

Whole life insurance

A) has a rising premium as the policyholder ages, but term life insurance has a fixed premium. B) is pure insurance while term life insurance has a savings component. C) is usually less expensive than term life insurance. D) is a combination of term life insurance and a savings account.

60)

Whole life insurance has decreased in popularity due to

A) many whole life insurance companies becoming bankrupt. B) cheaper savings alternatives that have developed, making whole life policies expensive savings vehicles. C) mergers with property and casualty companies, raising the cost of all insurance. D) lower interest rates on alternative savings vehicles.

61)

A typical automobile insurance policy is an example of

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A) liability insurance only. B) property and casualty insurance. C) property insurance only. D) casualty insurance only.

62) Property and casualty insurers will hold assets of shorter maturities than life insurance companies because A) shorter maturity assets usually have higher returns. B) life insurance companies may find they need to get liquid unexpectedly. C) property and casualty insurers can find themselves needing to get liquid unexpectedly. D) life insurance companies generally take on more risk than property and casualty companies.

63)

Insurance company assets will include A) stocks and bonds. B) only bonds. C) only stocks. D) only U.S. Treasury securities.

64) A young father needing to provide his family with financial security would be better off purchasing A) a whole life insurance policy. B) a term life insurance policy. C) as much life insurance as they can afford. D) no life insurance; instead he should focus on saving.

65)

Insurance companies can predict fairly accurately

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A) the percentage of policyholders who will have a claim and which policyholders will have a claim. B) which policyholders will suffer a loss but not the percentage of policyholders that will do so. C) the type of losses policyholders will incur but not the percentage of policyholders that will file claims. D) the percentage of policyholders that will file claims but not the policyholders that will file them.

66)

In order for insurance companies to generate predictable payouts, they need to A) spread the risk across many policies. B) accept policyholders from a very specific geographic area. C) focus on insuring only specific events, for example only fire. D) offer only life insurance.

67) Because most insurance companies insure many people, they do not have to worry about the problem of A) moral hazard. B) adverse selection. C) spreading of risk. D) information asymmetry.

68) A person who discovers that he has advanced stages of cancer and calls his life insurance agent to double his insurance policy is an example of A) a moral hazard risk. B) the risk of adverse selection. C) the problem of information symmetry. D) risk spreading.

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69) A homeowner discovers that a large tree in his yard is diseased and may fall in a bad windstorm which would likely destroy the garage. The cost to have the tree cut down is significant, but the homeowner has an insurance policy and the deductible is less than the cost to have the tree removed. He figures that if the tree falls and destroys the garage, the insurance company will pay. This is an example of A) information symmetry. B) adverse selection. C) moral hazard. D) screening.

70)

One way insurance companies deal with the problem of adverse selection is by A) charging the same price to everyone. B) screening applicants. C) monitoring policyholders after they have purchased insurance. D) spreading the risk in the same geographic area.

71) In many cases, life insurance companies will require applicants to complete a physical exam. This is done to avoid the problem of A) adverse selection. B) moral hazard. C) free riding. D) transaction costs.

72) Many health insurers require a deductible where the policyholder pays the first part of any loss. The use of a deductible most directly addresses the problem of A) free riding. B) adverse selection. C) people going uninsured. D) moral hazard.

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73) An insurance company provides liability insurance to a restaurant protecting the owner against claims from customers. One area of coverage is protection against food poisoning claims. The insurance company may periodically send an employee into the restaurant to observe food preparation and food storage processes. The insurance company is trying to avoid A) free riding. B) moral hazard. C) adverse selection. D) transaction costs.

74) The use of coinsurance clauses and deductibles is an attempt by insurance companies to deal with the problem of A) nonpayment of premiums. B) adverse selection. C) insufficient government regulation. D) moral hazard.

75)

Reinsurance is used by insurance companies faced with A) the prospects of a large but diversified risk. B) inadequate capital to handle a potential loss. C) insolvency. D) the problem of moral hazard.

76)

The reinsurance market is characterized as having A) a few buyers and many sellers. B) many buyers and sellers. C) few buyers and sellers. D) many buyers and a few sellers.

77)

Catastrophe bonds or "cat bonds" were developed

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A) by reinsurance companies to finance their growth. B) as an alternative to purchasing reinsurance. C) prior to the creation of reinsurance companies but are being phased out. D) by the U.S. government to provide insurance against national disasters.

78)

Pension funds resemble life insurance companies in the sense that

A) the payoff occurs only occurs when a person dies. B) they accept deposits. C) they offer the ability to make premium payments today in return for a promised payment under specified future circumstances. D) they both are better investments the longer you live.

79)

Pension funds resemble insurance companies by A) pooling the savings of only large investors. B) accepting deposits. C) spreading risk. D) becoming better investments the longer you live.

80) In most companies, an employee must work for a number of years before qualifying for pension benefits. This process is referred to as A) a defined-benefit period. B) vesting. C) regulated contribution period. D) mandatory benefit pending.

81)

Vesting can make job changes costly because

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A) you may not be able to take your entire pension benefit from your previous job with you. B) once you leave one job fully vested the only other pension you can be eligible for is Social Security. C) you can only become fully vested in one company's pension. D) vested employees earn higher returns on their funds.

82)

Defined-benefit plans

A) are more common than defined-contribution plans. B) pay a pension based on the amount contributed into the plan by the employee and employer. C) do not require any responsibility on the part of the employer for the employees' retirement income. D) usually require an employee to work a very long time for the same employer in order to reap a large benefit.

83)

In a defined-contribution plan,

A) only the employee makes contributions into the fund. B) the retirement benefits will vary with both the amount contributed and the performance of the fund. C) the benefits are determined mainly by years of service. D) no vesting is required; employees are eligible for benefits from the time they make their first contribution.

84)

Pension plans can be thought of as the opposite of life insurance because life insurance A) costs far more than pension plans. B) companies spread risk while pension plans spread risk only within the company. C) pays off when you die while the pension plan pays off if you do not die. D) pools the savings of many, and pension plans do not.

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85)

Which one of the following statements is false?

A) Pension plans and life insurance are often both offered by the same institution. B) Life insurance companies hold more in stocks than pension funds do. C) Life insurance pays off when you die while the pension plan pays off if you do not die. D) Pension plans and whole life insurance are both vehicles for saving.

86)

The Social Security System in the United States is best described as a A) defined benefits plan. B) defined contribution plan. C) employer funded plan. D) pay-as-you-go system.

87)

With the U.S. Social Security System, the burden of funding the system rests on the A) current workers. B) retirees. C) federal government. D) Social Security Administration.

88) The category of financial intermediaries called securities firms does not include which one of the following? A) mutual funds B) brokerages C) investment banks D) credit unions

89)

The practice of "placing the issue" is conducted by

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A) the underwriting services of investment banks. B) mutual fund companies. C) brokerage firms. D) commercial banks.

90)

The main risk that investment banks face from their underwriting services is that the

A) client may not pay for the service. B) company issuing the securities may go bankrupt. C) price investors pay for the security may be less than the guaranteed price to the issuing firm. D) price paid by investors may exceed the guaranteed price to the issuing firm.

91) Which one of the following is not true about the information and advice investment bankers provide to clients? The information and advice A) is public information that the bank compiles and makes available to anyone. B) is highly valued if the fees paid for it are any indication of its value. C) is often used to identify possible acquisition and merger candidates. D) helps improve the allocation of resources across the economy.

92)

Finance companies perform all of the following functions except A) issue commercial paper and securities. B) take deposits. C) make loans. D) lease equipment to firms.

93)

Accounts receivable loans provided by finance companies provide firms with

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A) start-up capital. B) the ability to turn a liability into an asset. C) the ability to turn a relatively illiquid asset into liquidity. D) inventory loans.

94) Most finance companies specialize in one of three loan types. Which one of the following is not one of those three types? A) consumer loans for purchases such as appliances B) margin loans for buying stock C) sales loans for purchases such as cars D) business loans for firms to use to buy new equipment

95)

A business needs a loan to help keep its shelves stocked. This is an example of A) an inventory loan. B) sales finance. C) equipment leasing. D) consumer finance.

96)

The main difference between sales finance and consumer finance is A) the type of borrower. B) the size of the purchase involved. C) the length of time until the loan has to be repaid. D) one deals with equipment leasing and the other does not.

97)

Congress chartered Sallie Mae to make loans to

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A) homeowners. B) customers of securities brokers. C) small business owners. D) students.

98)

Fannie Mae, Ginnie Mae, and Freddie Mac are examples of A) private regulatory bodies that supervise home mortgage lenders. B) government-sponsored enterprises chartered to encourage home lending. C) government-sponsored enterprises that were chartered to encourage small business

loans. D) government-sponsored enterprises that provide homeowners insurance to people that cannot obtain it from private insurers.

99) Government-sponsored enterprises like Fannie Mae and Freddie Mac usually borrow at interest rates that A) are below what private lenders pay. B) exceed what private lenders pay. C) are the same as private lenders since they are really a private lender. D) are slightly below the federal funds rate.

100) Fannie Mae, Freddie Mac, and similar government-sponsored enterprises obtain their funds from A) the U.S. Treasury. B) the Federal Reserve. C) issuing commercial paper and bonds. D) both the U.S. Treasury and the Federal Reserve.

101) In 2008, as a result of a run on government-sponsored enterprise debt, the U.S. Treasury placed Fannie Mae and Freddie Mac in

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A) conservatorship. B) receivership. C) bankruptcy. D) trusteeship.

102)

Hedge funds A) are strictly for millionaires. B) are heavily regulated. C) issue commercial paper and bonds. D) always employ diversification techniques called "hedging."

103)

Hedge funds can be described as A) low risk. B) moderate risk. C) very high risk. D) only as risky as the entire stock market as measured by an index such as the S&P

500.

104)

The Volcker rule in the Dodd-Frank Act does which one of the following? A) Creates a host of new agencies to streamline the regulatory process. B) Increases oversight of specific institutions regarded as a systemic risk. C) Introduces significant regulation of hedge funds. D) Forbids insured depositories from proprietary trading.

105)

The Dodd-Frank does all of the following except

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A) sets out new rules for financial institutions and markets. B) repeals the Glass-Steagall Act of 1933. C) requires closer government oversight over key establishments called systemically important financial institutions. D) sharply alters the authorities of the government agencies that govern the financial sector.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 106) Why does the United States have more banks than most other highly industrialized countries?

107)

Why did it take almost 100 years before the United States had its own national currency?

108)

What does it mean to say the United States has a dual banking system?

109) What is the source of regulatory competition in banking? Discuss how the focus of this competition has changed over time.

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110) It has been argued that the laws that prohibited branch banking were needed to protect consumers from large monopoly banks. Does that argument hold up to close scrutiny? Explain.

111) Explain why anti-branching laws often created credit crunches that slowed economic growth.

112) It has been argued that regulations can often be the source of innovation. Provide an example of this in the banking industry.

113) The number of banks in the United States has fallen almost by half in the past twenty years or so. Was this the result of bank failures or were some due to another cause? Explain.

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114) The Riegle-Neal Interstate Banking and Branching Efficiency Act has allowed banks to diversify themselves geographically. Has this geographical expansion resulted in the harm to consumers that early supporters of anti-branching laws feared? Explain.

115) Explain why a domestic bank in the United States might create a subsidiary bank in a foreign location like the Cayman Islands.

116)

Why is it important to have a financial benchmark for short-term interest rates?

117) Explain why authorities have committed to using the London Interbank Offered Rate (LIBOR) as a financial benchmark for short-term interest rates only through 2021.

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118) Owners and managers have cited three reasons for the creation of large financial firms or universal banks. What are these reasons?

119) The growth of internet banking seems to be on the rise. Discuss what the continued growth of internet banking should do to both the economies of scale and economies of scope of banking.

120) There are two current trends in the financial industry which run in opposite directions— generalists and specialists. Describe each of these. What might this mean for the future of the industry?

121)

What are the basic differences between term and whole life insurance?

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122) Which insurance companies, life or property and casualty, would you think would invest more in long-term assets? Explain.

123) Many insurance companies sell group policies that cover all of the employees at a particular firm, or all of the members of a particular organization. How could this policy help to overcome the problem of adverse selection?

124) Within the insurance industry a common saying is that insurance works because of the "law of large numbers." What do you think is meant by this?

125) A very controversial issue in many states currently is whether or not insurance companies should be allowed to use a person's credit history as a tool in determining the individual's automobile and homeowner insurance premiums. Without getting into the legal or ethical issues, what do you think the insurance companies' motives might be for wanting to use the credit report?

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126) Why do you think most health insurance policies require the first $100 or so of every claim and a percentage of the bill after that to be paid by the insured?

127)

Why do insurance companies often find it necessary to purchase reinsurance?

128) Explain why the decoding of the human genome has interesting implications for the life insurance industry.

129) Explain the difference between a pension fund that is a defined-contribution plan and one that is a defined-benefit plan.

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130)

In what way(s) can a pension plan be seen as the opposite of life insurance?

131) Why do you think Congress and the President are reluctant to fix the problems (identified in the text) with the Social Security System?

132) From a transaction cost perspective, discuss why a firm may contract with an investment bank to underwrite or place an issue.

133) Explain why a large equipment provider that sells to many of its commercial customers on account may use a finance company.

134)

Evaluate the pros and cons of the repeal of the Glass-Steagall Act of 1933.

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135) Considering the government-sponsored enterprises like Freddie Mac, Fannie Mae, and others, do you see any indication that the managers of these agencies are creating a moral hazard? Explain.

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Answer Key Test name: Chap 13_6e 1) D 2) C 3) D 4) A 5) C 6) A 7) D 8) D 9) D 10) C 11) B 12) C 13) B 14) C 15) B 16) A 17) A 18) B 19) D 20) B 21) D 22) C 23) A 24) B 25) A 26) C Version 1

27) C 28) A 29) B 30) B 31) A 32) B 33) D 34) C 35) B 36) D 37) D 38) C 39) C 40) C 41) B 42) B 43) B 44) B 45) C 46) B 47) A 48) D 49) B 50) A 51) A 52) D 53) C 54) A 55) C 56) B Version 1

57) D 58) A 59) D 60) B 61) B 62) C 63) A 64) B 65) D 66) A 67) C 68) B 69) C 70) B 71) A 72) D 73) B 74) D 75) B 76) D 77) B 78) C 79) C 80) B 81) A 82) D 83) B 84) C 85) B 86) D Version 1

87) A 88) D 89) A 90) C 91) A 92) B 93) C 94) B 95) A 96) B 97) D 98) B 99) A 100) C 101) A 102) A 103) C 104) D 105) B 106) The United States, for many years, had laws that prohibited banks from branching out either beyond one bank or their local city. As a result, as the country grew, so did the number of banks. 107) The writers of the U.S. Constitution feared a centralization of power so they made sure that the Constitution provided states with a lot of power. This explains why state-chartered banks issued currency and also why anti-branching bank laws existed for so long. It wasn't until many of the state banks that issued currency failed and trade and travel between states increased that the need for a national currency was realized and a currency was implemented.

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108) This means that banks can decide to be state chartered or federally chartered. There used to be very good reasons for selecting one over the other since choosing one over the other meant also deciding which regulators will oversee the bank. Although no longer the case, federally chartered banks were required to belong to the Federal Reserve and abide by reserve requirements and state banks were not. Now all domestically chartered banks must abide by the Federal Reserve's reserve requirements. 109) Regulatory competition in banking is the concept that the dual banking system in the United States has allowed banks to select whether to be state or nationally chartered. The selection of the charter also determined who or which agencies would regulate and/or oversee the institution. This competition between regulators, it can be argued, made regulations and regulators more efficient in that it hastened innovations within the banking industry. Lately the focus of this regulatory competition has shifted from between state and federal regulators to national government regulators as globalization of banking has grown. 110) Actually, the laws may have created more monopoly power. Often small banks were protected from competition in the form of more efficient large banks. The barriers to entry that the anti-branching laws created resulted in a system of small, geographically fragmented banks that faced virtually no competition. This promoted inefficiency which could also be detrimental to consumers.

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111) When a small community bank is protected from competition, almost all of its deposits and loans go to the community. For example, a small bank in a farming community would have a disproportionate number of depositors and borrowers that would be farmers. This is not sufficient diversification, which creates risk. The bank managers, aware of the risk of poor diversification may stop making loans to farmers, causing farmers to curtail operations. However, as incomes fall so will deposits and the problem can grow causing the local economy to contract. 112) A good example of regulations leading to innovation would be the creation of bank holding companies. These companies have been around since the early 1900s and were created to get around both the laws prohibiting bank branching and the laws preventing banks from offering nonbank financial services. 113) While some banks have certainly failed over the past 20 years, the major cause of the reduction in the number of banks has been bank mergers that have been fueled by the repeal of laws prohibiting branch banking and interstate branching. As a result, many banks wishing to do business in other states have been able to simply purchase banks in other states, reducing the number of banks. 114) As the text points out, the results have been dramatic. While it is true that bank profits have increased, it may be due mainly to the reduction in operating costs experienced by the banks as they have grown. Interest rates offered to depositors have increased and interest rates charges on loans have decreased, benefiting the customers of banks.

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115) A U.S. domestic bank may find it profitable to create a subsidiary bank in the Cayman Islands. The Cayman Island subsidiary may be regulated to a lesser degree allowing for more profitable (albeit higher risk) operations. In addition, the Cayman Island subsidiary may not have to meet the reserve requirements of the Federal Reserve nor purchase FDIC insurance. Both of these can increase the profits for the Cayman subsidiary as well as the parent bank. 116) The basic rationale for financial benchmarks is threefold. First, they lower transaction costs by providing an agreed basis for settling trades. Second, by focusing trades on a particular instrument, benchmarks foster competition and improve market depth. Third, benchmark-linked assets provide a mechanism for hedging common risks, increasing the overall risk-bearing capacity of the financial system. 117) Manipulation of the LIBOR began in the mid-2000s and led to a costly scandal. LIBOR is problematic because it is not based on transactions. Prior to 2014, the BBA calculated LIBOR from a survey of a panel of large London banks every business day to estimate their cost of uncollateralized borrowing in a specific currency at a specific maturity. Even after reforms have been implemented since the scandal, participating banks sometimes have to resort to expert judgment in making their daily submissions. This provides an opportunity for manipulation. 118) The first is diversification: their profits do not rely on one line of business. The second is economies of scale: one CEO, one Board of directors, one accounting system can work for the large firm. The third reason is economies of scope: one firm offering n number of goods and services may be able to do so at a lower total cost than n firms offering one product each.

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119) Internet banking allows a bank to avoid the traditional brick-andmortar costs that most people associate with banking. To add customers will not require the addition of another physical branch making the costs of expansion quite low. This implies that economies of scale could go on for quite some time as the marginal (additional) cost of adding a customer can be lower than the average cost over a large number of customers. Again, with the use of the internet a bank should find it cost efficient to offer their customers additional products/services. It is reasonable to assume that internet banking will lower costs and increase the economies of scale and scope for banks which should mean lower prices and other advantages for consumers. 120) The first is that large firms are working hard to provide one-stop shopping for financial services. The second is that the financial industry is splintering into a host of small firms, each of which serves a very specific purpose. It is impossible to determine what the future industry will look like; generalist, specialists, or both. 121) Term life insurance is just life insurance that pays off the face value of the amount of insurance purchased if the policyholder dies during the stated term. Whole life policies are a combination of a term life insurance policy and a savings account. The policyholder pays a fixed premium over his or her lifetime for a fixed benefit when the policyholder dies. The policyholder can discontinue the policy and have the cash value refunded. 122) Life insurance companies would have more of their assets invested in long-term vehicles such as commercial mortgages. The main reason for this is life insurance companies have more predictable payouts than property and casualty companies whose claims can be influenced by natural disasters and therefore they may need to get liquid unexpectedly. As a result, property and casualty companies are likely to hold more assets in short-term, highly liquid form. Version 1

123) By requiring all of the members of the firm or organization to purchase insurance then an average premium based on the group would work. If, on the other hand, the average premium is charged but purchasing is voluntary, only the people who are high risk or feel they really need the insurance will purchase it. 124) The law of large numbers means that insurance companies try to determine how many policyholders out of a pool of policyholders will have a loss over any specified time period. While insurance companies cannot accurately predict which specific policyholders will suffer losses, they can predict, on average, how many will. The key term is “on average.” This prediction works if the pool is large enough so that the laws of statistics hold and the firm is not suffering from adverse selection or insufficient diversification because of a limited selection. 125) This could be an information issue. It is very difficult and expensive for an insurance company to monitor a policyholder's behavior after the fact, so it may be that the insurance company is looking for a proxy (a stand in or signal) for moral hazard, and it may be that a person's credit history has been found to be an indicator as to whether or not the individual may become a moral hazard. 126) This is to treat the moral hazard problem. If policyholders didn't face any out of pocket cost to receive health care they may run to the doctor for problems that they might otherwise treat themselves or simply allow time to treat, such as a cold or the flu. By having coinsurance (copays), the insurance company can significantly reduce the total number of doctor visits by policyholders.

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127) Reinsurance is purchased when insurance companies find themselves in basically one of two possible positions. The first of these is inadequate diversification for the risk assumed. For example, a company offering homeowners insurance may find that it has too many homes insured in Florida relative to other parts of the country and one major hurricane may deplete their resources. The second reason is somewhat related to the first in that the insurance company may find its resources (capital) inadequate for the total risk that it has assumed and that the expected losses may deplete its capital or put it at risk. 128) The decoding of the human genome will make it relatively easy to predict if an individual is likely to experience a serious and perhaps terminal illness. This would make it easy for a life insurance company to predict not only how many individuals from a large pool may die at a certain age, but perhaps specifically which ones. This potentially could make some people uninsurable and raises the question as to whether insurance companies should have access to these tests or information. 129) A defined-benefit plan has the participant receiving a lifetime retirement income that is determined by her final salary and years of service. This makes it difficult for many people to earn a high retirement income if they have not worked for the firm or the same firm for a very long time. Under a defined-contribution plan, both the employer and employee make contributions into an account that belongs to the employee. The employer in a defined-contribution plan, unlike in a defined-benefit plan, takes no responsibility for the size of the employee's retirement income.

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130) A pension plan pays off if you live while life insurance pays off if you don't. Both vehicles have some similarities, though. With a pension plan, a saver makes regular payments (which may or may not be specified, depending on the type of pension plan) which are invested by the institution that oversees the plan. Upon retirement (or other specified circumstances) the person can draw funds out of the plan. With an insurance policy, the insured makes regular payments of premiums (the amount of which are set by analysis of risk factors) and the policy would pay off only in the case of the insured's death. Indeed, with term insurance, the insured pays the premium and if he lives there is no payoff at all. That's why term insurance is usually cheaper than whole life insurance, particularly for younger people. 131) As the text points out, the system cannot go on in its current state indefinitely. The issues are complex and politicians may be reluctant to deal with these issues for two main reasons. One, Social Security is something that impacts just about everyone. The current recipients (retirees and disabled) are dependent on the income and will not look favorably on any politician that will talk about reducing benefits. Also, those who are still working but approaching retirement age will not look favorably on any politician who talks about extending the time before a worker can begin drawing benefits. On the other hand, those currently working will not look favorably on any politician that discusses raising the Social Security tax, since those currently working are paying for those currently receiving. What we see is a form of moral hazard on the part of politicians. It may be easy to run for office and say you will address the problems, but once elected there is a strong incentive to pass the problem on those to follow.

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132) Investment banks generate their fees from the services they offer, which are generally based on their specialties and the information they possess. The investment bank is able to exploit its specialized knowledge of evaluating the worth of firms and, as a result, can tell the issuing firm what the securities are worth. It may offer the firm somewhat less than this amount but the firm gets all of the funds immediately and avoids the high cost of waiting and other transaction costs. The investment bank can use its knowledge of what the firm and/or securities are worth and its extensive client base to sell the issue, again exploiting specialized skills and information. 133) A large equipment provider may use a finance company to obtain loans against its accounts receivables. The equipment provider can turn a relatively illiquid asset into a liquid asset by using the accounts as collateral against the loan.

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134) The Glass-Steagall Act was enacted by Congress in 1933 in response to the numerous bank failures that occurred in the early years of the Great Depression. As noted in the text, from 1929 to 1933 more than a third of all U.S. banks failed, costing depositors (mostly small depositors) about $1.5 billion, or about one and a half weeks' pay (on average).The Glass-Steagall Act created the FDIC and curtailed the activities of commercial banks. In particular, banks were forbidden from dealing in securities, providing insurance, or engaging in any of the other activities undertaken by nondepository institutions. But by separating commercial banks from investment banks, the law limited the ability of financial institutions to take advantage of economies of scale and scope that might exist. The Glass-Steagall Act was repealed in 1999 with the passage of the Gramm-Leach-Bliley Financial Services Modernization Act, but with the repeal of Glass-Steagall came concerns about potential mismanagement of large financial holding companies (a limited form of universal banks). The poor performance and outright failure of some of the largest U.S. intermediaries during the financial crisis of 2007–2009 have intensified these management concerns. 135) These agencies can borrow at interest rates less than what private lenders must pay because they are viewed as being "backed" by the U.S. government. Because of the lower rate that they can then offer or the guarantees they can provide on private mortgages, their services are in high demand. If the managers really believe that they will ultimately be backed by the U.S. government in the event of not being able to meet their obligations, they (as well as the stockholders) have a strong incentive to take on a lot more risk than if the implied guarantee from the U.S. government did not exist. Also, due to the sheer volume of business done by these firms they may be in the "too big to fail category" which also compounds the moral hazard issue. Version 1

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CHAPTER 14 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) Empirical evidence points to the fact that financial crises A) are newsworthy but have no impact on economic growth. B) in more advanced economies lead to less public debt as a percent of GDP. C) have a negative impact on economic growth for years. D) can have a positive impact on economic growth as weak borrowers are weeded out.

Rumors of a bank failing, even if not true, can become a self-fulfilling prophecy because

A) customers will not want to obtain loans from this bank. B) equity investors will not be able to sell the bank’s stock. C) regulators will scrutinize the bank heavily looking for something wrong. D) depositors will rush to the bank to withdraw their deposits and the bank under normal conditions would not have sufficient liquid assets on hand.

Banks serve essential functions in an economy, but their fragility arises from the fact that A) the government controls banks. B) banks provide liquidity to depositors. C) banks must screen and monitor borrowers. D) only healthy banks are immune to depositors’ loss of confidence.

4) In principle, banks are like any other business such that new ones could open up and others close every year. It is problematic, however, if banks fail at the same rate as, say, restaurants because banks A) are too big to fail. B) provide access to the payments system. C) generate much of the tax revenue in the community. D) are typically run by prominent community members.

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5) Ceteris paribus, which one of the following business practices increases the possibility of a bank run? Banks A) must maintain a positive net worth. B) pay interest on accounts that meet certain requirements. C) promise to satisfy withdrawal requests on a first-come, first-served basis. D) keep cash at the ready in a vault in order to meet depositors’ withdrawal requests.

What matters most during a bank run is the A) number of loans outstanding. B) solvency of the bank. C) liquidity of the bank. D) size of the bank's assets.

Contagion is the A) failure of one bank spreading to other banks through depositors withdrawing of

funds. B) phenomenon that if one bank loan defaults it will cause other bank loans to default. C) rapid contraction of investment spending that occurs when interest rates are increased by the Federal Reserve. D) rapid inflation that results from the printing of money.

What is the difference between solvency and liquidity for a bank?

A) Nothing. These are different words for the same concept. B) Solvency is enough to stop a bank run, but liquidity is not. C) A solvent bank has a positive net worth while a bank with liquidity means that the bank has sufficient reserves and immediately marketable assets to meet withdrawal demands. D) Solvency means that the bank has enough cash on hand to meet withdrawal requests while liquidity means that the bank has access to enough cash to meet withdrawal requests within a specified time period.

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A bank run involves A) illegal activities on the part of the bank's officers. B) a bank being forced into bankruptcy. C) a large number of depositors withdrawing their funds during a short time span. D) a bank's return on assets being below the acceptable level.

10) The federal government is concerned about the health of the banking system for many reasons, the most important of which may be that A) banks are where government bonds are traded. B) a significant number of people are employed in the banking industry. C) many people earn the majority of their income from interest on bank deposits. D) banks are of great importance in enabling the economy to operate efficiently.

11) are

When healthy banks fail due to widespread bank panics, those who are likely to be hurt

A) government regulators. B) households and small businesses. C) the FDIC. D) the Federal Reserve.

12)

It is difficult for depositors to know the true health of banks because

A) regulations prohibit banks making their financial statements publicly available. B) the financial statements of banks are too difficult for most people to understand. C) most of the information on bank loans is private and based on sophisticated models. D) banking is competitive and financial records of banks are not divulged to prevent competitor banks from having an advantage.

13) The reason that a run on a single bank can turn into a bank panic that threatens the entire financial system is Version 1

A) information asymmetries. B) moral hazard. C) the lack of regulation. D) the increased reliance on web-based funds transfers.

14)

Bank failures tend to occur most often during periods of

A) stock market run ups when, like many companies, banks tend to be overvalued. B) high inflation when the fixed rate loans of many banks cause their real returns to decrease. C) recessions when many borrowers have a difficult time repaying loans and lending activity slows. D) wars and other civil unrest.

15)

Deflation causes financial disruption when

A) bank balance sheets swell as more borrowing occurs. B) problems of asymmetric information decrease as borrowers’ net worth rises. C) borrowers are attracted to new financing with better terms for business and residential loans. D) borrowers have invested in real assets whose value declines while loan payments stay the same.

16)

Which of the following does NOT tend to precede a financial crisis?

A) an abrupt downturn in the business cycle B) decreases in liquidity C) a reduction in systemic risk D) too much easy credit

17) The Financial Crisis of 2007–08 occurred in three distinct phases which, in the order of occurrence, are Version 1

A) a solvency crisis, a liquidity crisis, and government intervention. B) a liquidity crisis, a solvency crisis, and a recapitalization of the system. C) government intervention, a liquidity crisis, and a recapitalization of the system. D) a recapitalization of the system, a solvency crisis, and government intervention.

18)

The first phase of the Financial Crisis of 2007–08 began when

A) the Fed provided support to a solvent, but illiquid, nonbank. B) Bear Stearns collapsed due to toxic assets held in hedge funds. C) the French bank BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime mortgage debt. D) Lehman Brothers failed after holding on to large positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages.

19) Policy responses were critical in arresting the Financial Crisis of 2007–08 and promoting recovery. The responses used include all of the following except which one? A) macro-prudential stress tests B) elimination of interest rate floors C) use of taxpayer funds to recapitalize the financial system D) introduction of unconventional tools such as quantitative easing

20) The reasons for the government to get involved in the financial system include each of the following, except which one? A) preserve a bank's monopoly position B) protect investors C) ensure stability of the financial system D) protect bank customers from monopolistic exploitation

21)

An economic rationale for government protection of small investors, in particular, is that

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A) large investors can better afford losses. B) often small investors cannot adequately judge the soundness of their bank. C) there is inadequate competition to ensure a bank is operating efficiently. D) banks are often run by unethical managers who might exploit small investors.

22) The government regulates bank mergers, sometimes denying the proposed merger. Often the reason given for the denial is to protect small investors. What are small investors being protected from? A) Larger banks are more likely to take greater risk and may fail. B) In order to pay for the merger, the bank may seek higher returns and put depositors' funds at greater risk. C) Mergers can increase the monopoly power of banks, and the bank may seek to exploit this power by raising prices and earning unwarranted profits. D) Bank runs hurt larger banks more than smaller banks.

23) that

The financial system is inherently more unstable than most other industries due to the fact

A) in banking, customers disappear at a slower rate than in other industries so the damage is done before the real problem is identified. B) banks deal in paper profits, not in real profits. C) a single firm failing in banking can bring down the entire system unlike in most other industries. D) there is less competition in banking than in many other industries.

24)

The government is “lender of last resort” to which one of the following groups? A) large manufacturing firms that employ thousands of people B) depositors—by insuring depositors' balances in banks that fail C) developing countries that are trying to build their financial systems D) banks that experience sudden deposit outflows

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25)

The government provides deposit insurance which protects A) large corporate deposit accounts in excess of the $250,000 deductible. B) depositors for up to $250,000 should a bank fail. C) the deposits of banks in their Federal Reserve accounts. D) the deposits that people have at federally chartered banks.

26) The government's providing of deposit insurance and functioning as the lender of last resort has significantly A) decreased the incentive for bank managers to take on risk. B) increased the amount of regulation of banks required, but has had no effect on bank's incentive to take on risk. C) increased the incentive for banks to take on risk, but has had no effect on the amount of regulation of banks required. D) increased the amount of regulation of banks required and increased the incentive for banks to take on risk.

27)

One of the unique problems that banks face is that A) they hold liquid assets to meet illiquid liabilities. B) they hold illiquid assets to meet liquid liabilities. C) they hold liquid assets to meet liquid liabilities. D) both their assets and their liabilities are illiquid.

28) As of January, 2019, the interbank loans that appear on banks' balance sheets represent about what proportion of bank capital? A) 33 percent B) 10 percent C) 3 percent D) less than 1 percent

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29) The best way for a government to stop the failure of one bank from turning into a bank panic is to A) make sure solvent institutions can meet the withdrawal demands of depositors. B) declare a bank holiday until solvent banks can acquire adequate liquidity. C) limit the withdrawals of depositors. D) provide zero-interest rate loans to all banks regardless of net worth.

30)

The need for a lender of last resort was identified as far back as A) the start of the Great Depression in 1929. B) 1913, when the Federal Reserve was created. C) 1873, by British economist Walter Bagehot. D) 1776, by the first U.S. Secretary of the Treasury, Alexander Hamilton.

31)

The creation of the Federal Reserve in 1913

A) provided the opportunity for lender of last resort but not the guarantee that it would be used. B) guaranteed the Federal Reserve would always act as lender of last resort. C) eliminated bank panics in the United States. D) was in response to the Great Depression in the United States.

32) If the lender of last resort function of the government is to be effective in working to minimize a crisis, it must be A) reserved only for those banks that are most deserving. B) used on a limited basis. C) credible, with banks knowing they can get loans quickly. D) only available during economic downturns.

33)

The first test of the Federal Reserve as lender of last resort occurred with the

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A) attack on Pearl Harbor by the Japanese. B) widespread failures of Savings and Loans in the 1980s. C) introduction of flexible exchange rates in the United States in 1971. D) stock market crash in 1929.

34)

One lesson learned from the bank panics of the early 1930s is that A) the lender of last resort function almost guarantees that bank panics are a thing of the

past. B) the mere existence of a lender of last resort will not keep the financial system from collapsing. C) only the U.S. Treasury can be a true lender of last resort. D) the financial system will collapse without a lender of last resort.

35)

During a bank crisis, A) officials at the Federal Reserve find it easy to sort out solvent from insolvent banks. B) it is important for regulators to be able to distinguish insolvent from illiquid banks. C) it is easy to determine the market prices of bank's assets. D) a bank will go to the central bank for a loan before going to other banks.

36)

A moral hazard situation arises in the lender of last resort function because a central bank A) finds it difficult to distinguish illiquid from insolvent banks. B) usually will only make a loan to a bank after it becomes insolvent. C) usually undervalues the assets of a bank in a crisis. D) is the first place a bank facing a crisis will turn.

37)

If your stockbroker gives you bad advice and you lose your investment,

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A) the government will reimburse you just as it would reimburse depositors if a bank fails. B) the government will not reimburse you for the loss because you are not protected from bad advice by your stockbroker. C) you can recoup your losses through FDIC insurance since these losses would be covered. D) your investment would only be covered by FDIC insurance if the stockbroker was employed by a bank.

38)

The existence of a lender of last resort creates moral hazard for bank managers because A) they have an incentive to take too much risk in their operations. B) officials are likely to undervalue the bank's portfolio of assets. C) they are less likely to apply for a direct loan from the central bank. D) banks seek loans from the central bank only after exploring other options.

39) During the financial crisis of 2007-2009 in the United States it was revealed that the function of a lender of last resort had not kept pace with the evolving financial system because A) financial intermediaries had grown sufficiently large so as not to need a lender of last resort. B) shadow banks lacked access to the financial resources available through the lender of last resort. C) banks were sufficiently linked to one another that the need for a lender of last resort had diminished. D) banks had become sufficiently diversified so as to be able to provide for their own liquidity.

40) When the Federal Reserve was unable to stem the bank panics of the 1930s, Congress responded by

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A) taking over the lender of last resort function and assigning this function to the U.S. Treasury. B) ordering the printing of tens of billions of dollars of additional currency. C) creating the FDIC and offering deposit insurance. D) declaring a bank holiday and closing banks for 30 days.

41)

One reason customers do not care about the quality of their bank's assets is that A) most people cannot distinguish an asset from a liability. B) the quality of a bank's assets changes almost daily. C) they assume the bank only has high quality assets. D) there is deposit insurance which protects deposits even if the bank fails.

42) On November 20, 1985, the Bank of New York needed to use the lender of last resort function due to A) a run on the bank started by a rumor that the president of the bank embezzled tens of millions of dollars from the bank. B) a computer error caused the bank's records to wipe out the balances of all of its customers. C) a rumor that the bank was about to be taken over by FDIC due to insolvency. D) a computer error that made it impossible for the bank to keep track of its Treasury bond trades.

43) Which one of the following best describes the payoff method used by the FDIC to address the insolvency of a bank? The FDIC A) pays the owners of the bank for the losses they would otherwise face. B) pays off all depositors the balances in their accounts so no depositor suffers a loss, though the owners of the bank may suffer losses. C) pays off the depositors up to the current $250,000 limit, so it is possible that some depositors will suffer losses. D) takes all of the assets of the bank, sells them, pays off the liabilities of the bank in full, and then replenishes their fund with any remaining balance.

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44)

Under the purchase-and-assumption method of dealing with a failed bank, the FDIC A) finds another bank to take over the insolvent bank. B) takes over the day to day management of the bank. C) sells the failed bank to the Federal Reserve. D) sells off the profitable loans of the failed bank in an open auction.

45) Do depositors of a failed bank generally prefer that the FDIC use the “payoff method” or the “purchase-and-assumption method” for dealing with the failed bank? Depositors would:

A) be indifferent between the two since the impacts on depositors are the same in both methods. B) prefer the purchase and assumption method since deposits over $250,000 will also be protected. C) prefer the payoff method since they will have access to their funds earlier. D) prefer the payoff method since it is typically seamless for the depositor.

46)

Under the purchase-and-assumption method, the FDIC usually finds it

A) can sell the failed bank for more than the bank is actually worth. B) can sell the bank at a price equaling the value of the failed banks assets. C) has to sell the bank at a negative price since the bank is insolvent. D) cannot sell the bank and almost always has to revert to the payoff method for dealing with a failed bank.

47)

Which one of the following incentives promotes more risk of moral hazard? A) eliminating protection of financial institutions that are “too-big-to-fail” B) raising the deposit insurance limit C) allowing smaller financial institutions to fail D) increasing restrictions on lender-of-last-resort loans.

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48) Since the 1920s, the ratio of assets to capital has more than doubled for commercial banks. Many economists believe this is the direct result of A) lower quality management in banks. B) the increase in branch banking. C) allowing banks to offer nonbank services. D) government-provided deposit insurance.

49) As a result of government-provided deposit insurance, the ratio of assets to capital for commercial banks since the 1920s has A) just about doubled. B) almost tripled. C) not changed. D) decreased.

50)

The moral hazard problem caused by government safety nets A) is greater for larger banks. B) is greater for smaller banks. C) is pretty constant across banks of all sizes. D) only exists for banks with high leverage ratios.

51)

The government's too-big-to-fail policy applies to

A) certain highly populated states where a bank run impacts a large percent of the total population. B) large banks whose failure would start a widespread panic in the financial system. C) large corporate payroll accounts held by some banks where many people would lose their income. D) banks that have branches in more than two states.

52)

Implicit government support for "too-big-to-fail" banks

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A) increases the scrutiny of the bank's risk by large corporate depositors. B) increases the risk that depositors will flee at the first sign of uncertainty. C) reduces the risk faced by depositors with accounts exceeding $250,000. D) reduces the moral hazard problem of insuring large banks.

53)

If the government did not offer the too-big-to-fail safety net, then

A) large banks would be more disciplined by the potential loss of large corporate accounts. B) the moral hazard problem of insuring large banks would increase. C) the moral hazard problem of insuring large banks would not be affected. D) the FDIC deposit insurance limits would have to be raised.

54) Governments employ three strategies to contain the risks created by government safety nets. These include each of the following, except which one? A) government taxation B) government regulation C) government supervision D) formal bank examination

55) The purpose of the government's safety net for banks is to do each of the following, except which one? A) protect the integrity of the financial system B) eliminate all risk that investors face C) stop bank panics D) improve the efficiency of the economy

56)

Governments supervise banks mainly to do each of the following, except which one?

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A) reduce the potential cost to taxpayers of bank failures B) ensure that banks are following the regulations set out by banking laws C) reduce the moral hazard risk D) eliminate all risk faced by depositors and investors.

57) Which one of the following is not involved in regulating savings banks and savings and loans? A) the Federal Reserve System B) the Comptroller of the Currency C) the Federal Deposit Insurance Corporation D) state authorities

58) Savings banks and savings and loans are regulated by a combination of agencies, which includes the A) Federal Reserve System. B) Office of the Comptroller of the Currency. C) Securities and Exchange Commission. D) Internal Revenue Service.

59) Which one of the following regulates commercial banks as well as savings banks and savings and loans? A) the Federal Reserve System B) the Securities and Exchange Commission C) the Office of the Comptroller of the Currency D) the Internal Revenue Service

60)

Credit unions are regulated by a combination of agencies, which includes

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A) state authorities. B) the Federal Reserve. C) the Federal Deposit Insurance Corporation. D) the Office of the Comptroller of the Currency.

61)

Banks can effectively choose their regulators by deciding whether to A) be a private or public corporation. B) align with the U.S. Office of Thrift Supervision. C) purchase FDIC insurance or to forgo the coverage. D) be chartered at the national or state level.

62)

The fact that banks can be either nationally or state chartered creates A) opportunities to avoid regulation altogether. B) a cooperative regulatory framework. C) regulatory competition. D) redundant regulation by more than one agency.

63)

One negative consequence of regulatory competition is that A) it is expensive. B) financial institutions are over-regulated at a cost to customers. C) financial institutions often seek out the most lenient regulator. D) it minimizes competition.

64) You hold an FDIC-insured savings account at your neighborhood bank. Your current balance is $275,000. If the bank fails you will receive

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A) $275,000. B) $250,000. C) $100,000. D) $125,000.

65) You have two savings accounts at an FDIC-insured bank. You have $225,000 in one account and $40,000 in the other. If the bank fails, you will receive A) $225,000. B) $40,000. C) $115,000. D) $250,000.

66) You have savings accounts at two separately FDIC-insured banks. At one of the banks your account has a balance of $200,000. At the other bank the account balance is $60,000. If both banks fail, you will receive A) $250,000. B) $60,000. C) $260,000. D) $200,000.

67) You have savings accounts at two separately FDIC-insured banks. At one of the banks your account has a balance of $200,000. At the other bank the account balance is $60,000. You find out the banks are going to merge. If this happens and the merged bank fails, you would receive A) $250,000. B) $60,000. C) $260,000. D) $200,000.

68)

A long-standing goal of financial regulators has been to

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A) prevent banks from growing too big and powerful. B) minimize the competition that banks face. C) encourage banks to grow as large as possible. D) discourage small rural banks.

69) As of 2018, the four largest commercial banks held what share of total deposits at U.S. commercial banks? A) 73 percent. B) 50 percent. C) 36 percent. D) 25 percent.

70) Bank mergers require government approval because banking officials want to make sure that the A) merger will create a larger bank. B) merged bank will be a monopoly. C) merged bank will be more profitable. D) merger will not result in regulatory competition.

71)

Financial regulators A) do everything possible to encourage competition in banking. B) work to prevent monopolies but also work to prevent strong competition in banking. C) discourage competition in banking. D) prefer banks to have monopoly power in their geographic markets.

72)

Banking regulations prevent banks from

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A) holding more than 10 percent of their assets in common stock of companies. B) owning corporate jets. C) owning common stocks of corporations. D) building big office buildings.

73)

One reason that financial regulations restrict the assets that banks can own is to A) combat the moral hazard that government safety nets provide. B) limit the growth rate of banks. C) prevent banks from being too profitable. D) keep banks from spending lavishly on perks for executives.

74) Financial regulators set capital requirements for banks. One characteristic about these requirements is that A) every bank will have to hold the same level of capital. B) the riskier the asset holdings of a bank, the more capital it will be required to have. C) the more branches a bank has, the more capital it must have. D) the amount of capital required is inversely related to the amount of assets the bank owns.

75)

The original Basel Accord was

A) the basic set of guidelines the Federal Reserve applies in regulating domestic banks. B) a set of guidelines for basic capital requirements for internationally active banks. C) an agreement between state and federal regulators to try to have one standard set of guidelines for all banks. D) a set of guidelines applied only to international banks operating with U.S. boundaries.

76)

Which one of the following is not a positive effect of the Basel Accord?

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A) It forced regulators to change the way they thought about bank capital. B) It promoted a more uniform international system. C) It provided a framework that less developed countries could use to improve the regulation of their banks. D) It provided a system to differentiate between bonds based on their systemic risk.

77)

Which one of the following is not a pillar of the latest Basel Accord?

A) a revised set of minimum capital requirements B) it includes liquidity requirements in addition to capital requirements C) it supplements capital requirements based on risk-weighted assets with restrictions on leverage D) uniform international laws for bank regulation

78) Banks are required to disclose certain information for all of the following reasons except which one? A) to enable regulators to more easily assess the financial condition of banks B) to allow financial market participants to penalize banks that carry additional risk C) to allow customers to more easily compare prices for services offered by banks D) to create uniform prices for standard bank services

79)

The supervision of banks includes A) requiring bank officers to attend classes on an annual basis. B) on-site examinations of the bank. C) extensive background checks of all bank officers. D) requiring banks to file monthly reports on their revenues, expenses, and profits.

80) Prior to the financial crisis of 2007–2009 banks did all of the following except which one to bulk up their profit?

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A) bought or sponsored hedge funds B) traded securities for customers C) purchased equities for their own account D) colluded to fix benchmark interest rates

81)

One reason a bank's officer may be reluctant to write off a past-due loan is that it will A) increase the bank's liabilities. B) decrease the bank's assets and capital. C) increase the bank's liabilities and assets, requiring more capital to be held. D) make the bank’s accounts less transparent.

82) The acronym CAMELS, which is the criteria used by supervisors to evaluate the health of banks, includes all of the following except which one? A) asset quality B) losses C) management D) earnings

83)

The CAMELS ratings are

A) made public monthly to the financial markets so people can judge the relative quality of banks. B) published once a quarter in banking journals issued by the Federal Reserve. C) included in the annual report of publicly owned banks. D) not made public.

84) A bank supervisor examines the bank's portfolio of loans to see if the loans are being repaid in a timely manner. In terms of the CAMELS criteria, this would be part of rating the bank's

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A) asset quality. B) losses. C) management. D) earnings.

85) one?

Regulators and supervisors of banks are challenged by all of the following except which

A) globalization of financial services B) the use of new financial instruments that shift risk without shifting ownership C) technological innovation D) reinforcement by Congress of functional and geographic barriers in banking

86)

In today's world, the goal of financial stability means A) no institution should fail. B) competition should be eliminated. C) preventing large-scale financial catastrophes. D) creating one mega regulatory agency.

87) The financial crisis of 2007–2009 has made which one of the following regulatory goals a top priority for government? A) disclosure of accounting information B) enforcement of minimum capital requirements C) avoidance of systemic risk D) promotion of competition

88) Which one of the following is not an important addition made to the Basel Accords by Basel III in 2010?

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A) It supplements capital requirements based on risk-weighted assets with restrictions on leverage. B) It introduces three buffers over and above capital requirements itself. C) It adds a liquidity requirement that compels banks to hold a quantity of high-quality liquid assets. D) It ends the too-big-to-fail problem.

89)

Which one of the following was not a goal of the Dodd-Frank Act of 2010? A) to anticipate and prevent financial crises by limiting systemic risk B) to end "too big to fail" C) to promote competition D) to reduce moral hazard

90)

How was the Dodd-Frank Act of 2010 relatively inefficient?

A) It promoted competition among financial institutions that were too big to fail. B) It failed to adopt least-cost mechanisms to make the financial system more resilient. C) It aimed to reduce systemic risk instead of addressing risk in particular areas of the financial system. D) It imposed increased capital requirements to reduce distortions arising from the government safety net and “too-big-to-fail.”

91)

The 2016 elections in the United States

A) brought increased political support for Dodd-Frank. B) led to resistance to Dodd-Frank becoming enshrined in law and regulatory changes. C) ushered in practitioners that supported the additional regulations accompanying Dodd-Frank. D) led to more nonbanks being designated as systemically important financial institutions (SIFIs).

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ESSAY. Write your answer in the space provided or on a separate sheet of paper. 92) The text points out that there is an inverse relationship between the fiscal cost of a bank crisis and real GDP growth. What are some of the reasons that can explain this inverse relationship?

93)

Why might there be a trade-off between a bank's profitability and its safety?

94) Why do bank runs usually have people rushing to their bank instead of waiting for the lines to taper off so they do not have to wait so long?

95)

What is the difference between a bank that is insolvent and one that is illiquid?

96) Why is it that a run on a single bank can turn into a widespread financial panic, or what the text identified as contagion?

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97) How do banks potentially make economic downturns more severe and how do economic downturns contribute to the increased failure of banks?

98)

Why is the financial industry inherently more unstable than most other industries?

99) Briefly describe the combination of strategies used by government officials to protect investors and ensure the stability of the financial system.

100) Explain why depository institutions receive a disproportionate amount of attention from government regulators (compared to most other industries).

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101) In 1873, British economist Walter Bagehot proposed that the central bank function as the lender of last resort. Specifically, he suggested the central bank lend freely to banks which have good collateral at high rates of interest. Why are the requirements of good collateral and a high rate of interest important?

102)

Does the lender of last resort function guarantee an end to bank runs? Explain.

103)

How does the lender of last resort potentially create a moral hazard problem?

104) You have a retirement account in a bank that has failed. The balance in your account is $330,000. Does it make a difference to you if FDIC uses the payoff method or the purchase-andassumption method for resolving this insolvency? Explain.

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105) Imagine a situation where the deposits at state-chartered banks would be insured by a state insurance fund and deposits at nationally chartered banks would be insured by the FDIC. How would you expect both depositors and banks would react?

106) Explain why the ratio of assets to capital increased dramatically for commercial banks from the 1920s to the present.

107) You are the head of finance for a very large corporation located in a relatively small town. At a local chamber of commerce meeting, the president of the local bank asks you why you keep the corporation's bank accounts in a very large mid-western bank and not in his local bank. From a risk reduction perspective, how could you answer his question?

108) What is the link between the safety net provided by the government to the financial industry and the relatively heavy regulation of the same industry by the government?

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109) What three strategies are employed by government officials to ensure that the risks created by the government safety net are contained?

110)

What potential problems are created by regulatory competition?

111) Besides regulating banks, the government also regulates nondepository financial institutions, such as insurance companies. Consider a property casualty insurance company. Why would the government need to regulate them?

112) Explain how bank regulators face a bit of a paradox regarding preventing monopoly power by banks and spurring competition.

113) Why are banks restricted in the assets that they can own? For example, why do you think banks are prohibited from owning common stock?

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114) If we lived in an economy where interest rates were highly volatile, would you expect the maximum asset to capital ratio that a regulator would allow to increase or decrease? Why?

115)

What was the primary motivation behind the creation of the 1988 Basel Accord?

116)

What were the positive effects of the 1988 Basel Accord? What were its shortcomings?

117) Identify at least two problems a borrower would face if banks were not required to disclose the information that they are currently required to make available.

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118) List the components of the CAMELS criteria and explain how a CAMELS rating is calculated.

119) Make a case for releasing CAMELS criteria and ratings about the health of banks to the public and a case for keeping this information private.

120) What is meant by the problem of time consistency in the conduct of financial system policy?

121) Suppose the FDIC reduced deposit insurance limits to $25,000. What ramifications might result from this change?

122) How can regulations such as deposit insurance and the Basel Accord (of 1988) create moral hazard?

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123) The FDIC used to charge all banks the same rate for insurance on deposits. From what you have learned, what problems did this create for not only the FDIC but for well-run banks?

124) Make the case for a "super-regulator" in the context of what you have learned about "regulatory competition."

125) Describe the three phases of the Financial Crisis (FC) of 2007–09 and the critical policy responses that likely kept the U.S. from suffering another Great Depression.

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Answer Key Test name: Chap 14_6e 1) C 2) D 3) B 4) B 5) C 6) C 7) A 8) C 9) C 10) D 11) B 12) C 13) A 14) C 15) D 16) C 17) B 18) C 19) B 20) A 21) B 22) C 23) C 24) D 25) B 26) D Version 1

27) B 28) D 29) A 30) C 31) A 32) C 33) D 34) B 35) B 36) A 37) B 38) A 39) B 40) C 41) D 42) D 43) C 44) A 45) B 46) C 47) B 48) D 49) A 50) A 51) B 52) C 53) A 54) A 55) B 56) D Version 1

57) A 58) B 59) C 60) A 61) D 62) C 63) C 64) B 65) D 66) C 67) A 68) A 69) C 70) C 71) B 72) C 73) A 74) B 75) B 76) D 77) D 78) D 79) B 80) D 81) B 82) B 83) D 84) A 85) D 86) C Version 1

87) C 88) D 89) C 90) B 91) B 92) One obvious cost is that funds that have to be used to "clean-up" the crisis must be diverted from some other use, so there is the opportunity cost that is faced. Another reason is that the process of channeling funds from savers to borrowers is disrupted or inefficient. If savers become leery of banks, they may not save or they may not channel these funds through banks so the economy is not as efficient as it could be. Also, investment projects that should be funded will not be, and those that shouldn't be may receive funding since financial intermediation is not working as it should. Another, and perhaps the largest cost, is that if investment is curtailed the ability to produce output in the future will be harmed leading to a lower standard of living not just for the current year but for many years. 93) The assets that tend to bring the bank the highest return tend to be the least liquid. Highly liquid assets have relatively low returns. So if a bank seeks high profits it is likely to invest in relatively illiquid assets. On the other hand, a bank needs to be liquid, especially in situations where customers may desire to withdraw their deposits. If a bank does not have liquid funds or if it cannot convert illiquid assets to a liquid form without taking significant losses, it may fail. 94) Banks promise to satisfy depositors' withdrawal requests on a firstcome, first-served basis. As a result, people thinking the bank has limited cash (which is usually true) want to get theirs before the bank runs out and so rush to the bank to be first in line.

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95) A bank that is insolvent is in a position where the bank's assets are less than its liabilities, so it has negative bank capital. A bank that is illiquid may be solvent, meaning it has assets that exceed its liabilities, but it may not have sufficient reserves, marketable assets, and capital to meet all of the depositors' demand for withdrawals. 96) The reason for the spread of panic or contagion is information asymmetries. It is due to the fact that most depositors cannot tell a healthy from an unhealthy bank. As a result, the safest thing for individuals to assume is their bank is unhealthy and to withdraw their funds. 97) When an economy begins to slow some people lose their jobs and/or their incomes are reduced. As a result, these individuals may default on their loans, reducing the value of a bank's assets and also reducing the bank's capital, especially if the loans are in default. As bank capital is reduced, lending will also be reduced which will further slow the economy as consumer durable good spending will fall, and so will investment spending. But the slowing of the economy will also continue to push more loans into default and further reduce bank capital leading to even more bank failures. 98) In most other industries the failure of one participant does not put the other participants and the industry at risk. The same cannot be said of the financial industry. The failure of one bank or financial institution, through contagion, can put the entire system at risk. This is due to information asymmetries that can have depositors assuming their bank is going to also fail and seeking to withdraw their funds. This then leads to liquidity risk, because most banks would lack the liquidity to withstand the run.

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99) Government officials employ a combination of strategies to protect investors and ensure the stability of the financial system. First, they provide the safety net to insure banks that face sudden deposit outflows. This consists of operating as the lender of last resort and the provider of deposit insurance. However, this safety net can result in moral hazard (bank managers have an incentive to take on too much risk), therefore the government must also engage in regulation and supervision. 100) Depository institutions receive this attention because of their central role in the economy and their unique problems. We all rely heavily on banks for access to the payments system and this makes them unique among financial institutions. Furthermore, banks are prone to runs because they hold illiquid assets to back up liquid liabilities. This again makes banks unique compared to other financial institutions. Finally, banks are linked to each other both on their balance sheets and in their customers' minds. Bank failures can be contagious. 101) The requirement of good collateral is to ensure the loans are going to solvent banks. The high interest rates will penalize a bank for not holding adequate reserves to meet its liquidity needs. If the interest rate charged is low, the bank will have a strong incentive to seek higher returns through illiquid assets knowing it can count on the central bank in times of liquidity need. 102) The Great Depression is evidence to the fact that just because a central bank has the function of lender of last resort, there is no guarantee that banks will use it or the central bank will lend freely. The experience in the early years of the Great Depression showed that banks did not take advantage of borrowing from the Fed.

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103) The lender of last resort function provided by a central bank will have a bank turning to the central bank for a loan after all other options are exhausted. The bank manager knows that the central bank will want to avoid a widespread bank panic and will be generous in evaluating the value of the bank's assets and to grant a loan even if it suspects the bank may be insolvent. Knowing this, bank managers will tend to take too many risks. 104) It does make a difference. Under the payoff method, the FDIC simply pays off the depositors the balance in their account up to the legal limit, which is currently $250,000. You would potentially lose $80,000. Under the purchase-and-assumption method, the FDIC will find a firm to take over the failed bank and your account will stay intact. 105) Depositors would quickly learn that no state insurance fund can withstand a run on all banks in its state. As a result, they would seek to withdraw their funds and place them in a nationally chartered institution. The owners of the state-chartered banks would then seek to change their charters to national charters and pick up FDIC insurance. The reason people do not fear the FDIC running out of funds is that it is backed by the U.S. Treasury and as a result can withstand a deep crisis. 106) The answer to this question is simply deposit insurance. Without deposit insurance a bank would have to make sure its assets were highly liquid and that it maintained adequate capital to withstand either the shock of assets losing value or a run on the bank. With deposit insurance, the bank manager knows that the insurance fund will protect most depositors and so feels comfortable assuming more risk. While the additional return from the greater risk will belong to the bank's owners, the potential loss from the greater risk will be borne primarily by the insurance fund. This is a classic moral hazard problem.

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107) You might employ the concept of too-big-to-fail. As the text points out, the likelihood of bank regulators allowing a large bank to actually fail is very remote. A small bank failure, while certainly disruptive to the bank's depositors and owners, is not likely to cause wide-scale panic. If you had your company's funds in this bank and it failed, your company may only recover up to the legal limit. On the other hand, the failure of a large bank might cause wide-scale panic, so realizing this, you decide to place your company's funds into a bank that you believe is in the too-big-to-fail category thus protecting your company's deposits. 108) The link is that the safety net provided, which includes FDIC insurance, too-big-to-fail provisions, and lender of last resort availability, while very valuable, also creates strong moral hazard and adverse selection problems. To minimize these problems, governments have developed different strategies to manage the risks created by the safety net. 109) Governments have developed three strategies to manage the risks created by the safety net. First, government regulation establishes a set of specific rules for bank managers to follow. Second, government supervision provides general oversight of financial institutions. And third, formal examination of banks' books by specialists provides detailed information on the firm's operation. 110) Regulatory competition often allows a financial institution to select who will regulate it by selecting who charters it. One problem is that this will encourage the institution to select the regulator(s) that they believe will be the most lenient.

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111) The insurance company takes premiums from people and makes the promise to pay claims should certain events occur. In the case of property insurance, often times these events could be widespread and quite severe, like a hurricane or an earthquake. When a loss like this occurs, it is similar to a liquidity crisis for banks; the insurance company faces a run in the sense that it will need to be liquid and quickly. Regulators then want to ensure at least three things, one is that the insurance company is solvent, meaning its assets exceed its liabilities. They also want to make sure that the assets are liquid and that the value stated reflects market value, and third, that the company has adequate capital to withstand fluctuations in asset value should it have to get liquid at a time when asset prices may be depressed. 112) One of the goals of banking regulators is to prevent any bank from growing so large that it effectively becomes a monopoly in its geographic market. Monopolies are inefficient and are seldom of benefit to consumers. On the other hand, while we usually think of competition as being beneficial to consumers because it results in low prices and new products, within the financial industry, competition can cause banks to seek other ways to earn profits, which may expose the bank to greater risk and threaten the integrity of not just one institution but the entire system. 113) One reason for this is that many of these assets are relatively illiquid and can cause wide swings in the value of assets. If the value of these assets were to decrease significantly, the institutions' capital would be negatively impacted putting the institution and the system at risk. Another reason is the problem of moral hazard. The government is providing a safety net, which by itself would cause a bank to want to seek a higher return by taking on more risk. To combat this problem, regulators restrict the institution in the types of assets it can hold.

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114) An environment where interest rates are highly volatile means that the value of a firm's assets would also be volatile. For example, if interest rates significantly rise unexpectedly, the value of a bank's assets would fall unexpectedly. This would put a strain on the capital of the bank, especially in the sense that the bank's capital is the cushion that it would fall back on should it face a liquidity crisis. The bank could find itself insolvent if interest rates rise a lot and its capital was inadequate. As a result, we would expect regulators to insist on a lower asset-tocapital ratio. 115) The primary motivation was globalization, in the sense that foreign banks could enter a market and compete with domestic banks. The problem was that oftentimes the foreign banks would be operating under different regulatory restrictions that would provide them with a competitive advantage. The Basel Accord is an attempt to place minimum capital requirements on financial institutions that are internationally active. 116) The Basel Accord of 1988 was an attempt to place minimum capital requirements on financial institutions that are internationally active. One of the positive effects is that, by linking minimum capital requirements to the risk a bank takes on, it forced regulators to change the way they thought about bank capital. Also, it promoted a more uniform international system. Finally, the Accord provided a framework that less developed countries could use to improve the regulation of their banks. However, the Accord did have the major shortcoming that in adjusting for asset risk, there was no differentiation among bonds with different default risks (for example, the Treasury bonds of the United States versus the government bonds of an emerging-market country). This encouraged banks to shift their holdings toward riskier assets in ways that did not increase their required bank capital.

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117) One problem would be that a bank could charge hidden fees for a checking account or a loan application. In addition, the customer would face very high search costs in the sense that she would have to ask a lot of questions of each institution to uncover these hidden costs. Another problem is determining the way that interest is calculated for savings accounts and loans. For example, is the interest being paid on a savings account based on the average balance or is it based on the balance that exists at the beginning or end of the month? Also, how are the interest rate charges on the loan calculated—is this expressed as an annual rate or is this calculated using some other formula? The disclosure laws that banks face are designed to reduce these costs to customers and make the comparing of prices across banks easier. 118) The CAMELS criteria are as follows: Capital adequacy; Asset quality; Management; Earnings; Liquidity; and Sensitivity to risk. Examiners give the bank a rating from one to five in each of these categories (one being the best rating) and combine the scores to determine the overall rating. 119) The case for making it public would be to encourage the managers of banks to do whatever is necessary to earn a high rating to keep depositors and to attract investment capital. This information would go a long way toward treating the moral hazard problem. The case for keeping it private is to avoid a run on the bank. If a bank is having difficulty, regulators may have the opportunity to work with the management to solve the problem and avoid a bank run which is likely to push the institution into insolvency and end up costing some depositors and taxpayers more than it would have if they worked the problems out without public scrutiny.

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120) In good times, governments and central banks typically promise not to bail out financial behemoths and other intermediaries, hoping to limit their risk-taking and thus prevent a crisis. But these intermediaries know that, in bad times, policymakers will have an overwhelming incentive to bail them out to limit a crisis. If these policymakers also have the tools to implement a bailout, their good-times promises will lack credibility. When it is not feasible to make a credible commitment, policy cannot be time consistent.

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121) If deposit insurance limits were reduced to $25,000 a few things would happen. First, many people would have more at risk by saving at their banks (their balances above $25,000 would no longer be insured). The result may be for people to either keep less on deposit at the bank; this will reduce the funds available to banks or will require the banks to offer higher interest rates to depositors to attract funds since the depositors will now face greater risk, increasing the cost of acquiring funds. Another likely outcome is that banks may actually put out more information to the public advertising how safe and well run a particular bank is; this would be done to again attract depositors who now are seeking a relatively safe place to put their funds. There may be less of a moral hazard incentive on the part of bank managers. Any decrease in bank returns or any increase in risk has the manager facing the widespread withdrawal of funds by depositors who face a higher cost of bank failure. There could also be more innovation. For example, savers could still get the U.S. government to guarantee their principal by purchasing U.S. Treasury securities. We would likely see greater use of saving vehicles where all funds are placed in Treasury securities and savers have convenient ways to access these funds (much like many current money market accounts.) Banks seeking to attract deposits would have to offer products and/or higher returns to compete with the Treasury securities. It also will increase the incentive of depositors to monitor their banks’ health.

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122) Deposit insurance creates moral hazard for bank managers. Knowing that any gains from risky assets will go to owners but any losses will be covered by the insurance fund, managers have an incentive to take on added risk. Similarly, with the 1988 (first) Basel Accord, the system that was developed failed to distinguish among assets with different default risks (such as the Treasury bonds of the United States and bonds of emerging-market countries like Turkey). This gave banks an incentive to shift their holdings toward riskier assets in ways that did not increase their required bank capital. 123) For FDIC the immediate problem is adverse selection. The average rate would have attracted more low-quality, or in this case highrisk, banks. Now the FDIC could get around the adverse selection problem by simply asking for a regulation requiring all banks to purchase insurance through them. This is similar to an insurance provider providing group insurance to an employer but insisting the employer get most if not all of the employees to purchase coverage and it not be voluntary. The FDIC cannot escape the problem of moral hazard, however; here the presence of insurance will have some banks wanting to take on more risk. In fact, the well-managed (low-risk) banks will be at a disadvantage, actually subsidizing the high-risk banks. The only way to address the problem of cross-subsidization is through a premium that is risk based so that the lower-risk company will pay a lower premium, which would in theory allow it to offer lower rates on loans and or higher rates to depositors.

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124) Regulatory competition describes the current situation in which banks can effectively choose their regulators by choosing whether to be a state or national bank and whether or not to belong to the Federal Reserve System. If one regulator allows an activity that another prohibits, a bank's managers can threaten to switch, or argue that a competitor who answers to a more permissive regulator has an unfair advantage. This has two consequences: first, regulators force each other to innovate, improving the quality of the regulations they write. This is a positive outcome because it ensures that regulators and banks follow current best practice. But there is also a less desirable outcome in that bank managers can "shop" for the most lenient regulator. This was compounded in the 1990s when Congress removed the functional (and geographic) barriers that once separated commercial banking from other forms of financial intermediation (and which had outlawed interstate branching). It is likely that in the future regulators and supervisors will have no choice but to combine forces, either cooperating or merging, and the creation of a "super-regulator" would have the advantage of making the process more uniform and coherent.

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125) The first phase of the FC began in 2007 when BNP Paribus suspended redemptions from three mutual funds invested in U.S. subprime mortgage debt. Market and funding liquidity dried up, and the aggregate supply of credit to financial firms shriveled precisely when their need for funds surged. In 2008, Bear Stearns collapsed and kicked off the second phase of the crisis. This led to the first time since the Great Depression that the Fed provided support to a supposedly solvent, but illiquid, nonbank. The failure of Lehman Brothers later in 2008 ushered in the most intense period of the deepest financial crisis in the U.S. and Europe since the Great Depression. Measures of financial stress spiked far above levels seen before or since. The spillover to the real economy was rapid and dramatic. The three interrelated policy responses that were critical in arresting the crisis and promoting recovery were aggressive monetary stimulus by the Fed including the introduction of unconventional policy tools, the use of taxpayer funds to recapitalize the U.S. financial system, and the first round of macro-prudential stress tests introduced by the Fed in early 2009 to combat adverse selection.

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CHAPTER 15 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) The central bank in the United States is the A) Bank of America. B) Federal Reserve. C) U.S. Treasury. D) Bank of the United States.

Central banks around the world

A) saw the Financial Crisis of 2007–2009 coming and tried to prevent it. B) saw the Financial Crisis of 2007–2009 coming but could not prevent it. C) did not see the Financial Crisis of 2007–2009 coming and were not able to prevent it. D) did not see the Financial Crisis of 2007–2009 coming but had processes in place to prevent it.

The actions of central banks around the world A) are most extreme in developing economies. B) are politically controversial during financial crises. C) are vital to the day-to-day operation of any modern economy. D) affect citizens of modern economies only during times of financial crisis.

The number of central banks that exist in the world today is A) less than 10. B) about 250. C) about 180. D) over 50 but less than 100.

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One monopoly that modern central banks have is in

A) regulating commercial banks. B) making loans to banks. C) issuing U.S. Treasury securities. D) issuing currency.

In the U.S., the authority to issue currency is held by the A) Federal Reserve. B) U.S. Treasury. C) Office of the Comptroller of the Currency. D) U.S. Mint.

Monetary policy in the United States is under the control of the A) U. S. Treasury. B) President. C) Federal Reserve. D) U.S. Senate.

The ability to create money means the central bank can control A) the availability of money and credit in a country's economy. B) tax revenue. C) the unemployment rate. D) government expenditures.

Which one of the following statements is true?

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A) Printing currency can be a profitable venture for a government. B) Printing currency, while necessary, is a losing venture for a government. C) Printing too much money usually leads to lower prices. D) In the modern economy the amount of money created has no effect on prices.

10)

Many governments give their central bank control over issuing currency because

A) printing currency can be profitable for a government, providing a strong incentive to print too much. B) having large amounts of currency can lead to lower rates of inflation. C) central banks use the profits from issuing currency to finance their operations. D) the only way to distribute currency to banks is through the central bank.

11)

Operation Bernhard was a German operation to attack the United Kingdom by using A) German Panzers. B) counterfeit British pounds. C) tariffs and other trade barriers to limit British exports to Germany. D) sophisticated economic policy to discredit the British Parliament.

12) In its role as the bankers' bank, a central bank performs each of the following except which one?

A) providing loans during times of financial distress B) providing deposit insurance C) overseeing commercial banks and the financial system D) managing the payments system

13)

The central bank has the ability to create money, which means that it

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A) can control the availability of money but not the availability of credit in the economy. B) can make loans only when other institutions can. C) can impact the rate of inflation. D) has an objective to maximize its profit.

14)

The stability of the financial system is enhanced by the ability of central banks to A) be a lender of last resort. B) provide loans to insolvent banks. C) provide deposit insurance. D) convert poorly run banks into branches of the central bank.

15)

In 2018, the average daily volume on the Federal Reserve's Fedwire system was A) $28 billion. B) $280 billion. C) $2.8 trillion. D) $280 million.

16)

The Federal Reserve's Fedwire system is used mainly to provide

A) a means for foreign banks to transfer funds to U.S. banks. B) an inexpensive and reliable way for financial institutions to transfer funds to one another. C) an inexpensive way for individuals to pay their bills online. D) a means for the Treasury to collect tax payments.

17)

One function of modern central banks is to

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A) control securities markets. B) control the government's budget. C) control the availability of money and credit. D) manage fiscal policy.

18)

The rationale for the existence of central banks is mainly that A) financial markets lack transparency. B) they are needed for the supervision of banks. C) financial intermediation cannot occur without a central bank. D) financial systems are prone to periods of extreme volatility.

19)

The specific goals of central banks include all of the following except which one? A) high stock prices B) low and stable inflation C) high and stable real growth D) a stable exchange rate

20)

The specific goals of central banks include each of the following except which one? A) high and stable real growth B) low and stable inflation C) high levels of exports D) low and stable unemployment

21)

A primary goal of central banks is to A) reduce the idiosyncratic risk that impacts specific investments. B) reduce systematic risk. C) keep stock and bond prices high. D) keep inflation rates high.

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22)

Central banks often find that A) they can efficiently pursue all of their goals simultaneously. B) there are tradeoffs that make pursuing all of their goals simultaneously impossible. C) the goal(s) they pursue will be determined by their profitability. D) they must keep their goals secret or else they cannot be attained.

23)

The primary objective of most central banks in industrialized economies is A) high securities prices. B) low unemployment. C) price stability. D) a strong domestic currency.

24)

If prices are not stable, A) money becomes less useful as a store of value. B) money performs better as a unit of account. C) it may be an inconvenience, but resources are still allocated efficiently. D) prices become highly useful for conveying information.

25)

Which one of the following is the best analogy? Inflation is like a A) pound having more ounces. B) day having more hours. C) minute having fewer seconds. D) mile having more feet.

26)

The efficient allocation of resources requires

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A) that prices reflect the relative value of goods and services. B) that inflation not exceed three percent a year. C) deflation. D) prices to remain constant.

27)

As the inflation rate A) increases, inflation becomes less stable. B) decreases, inflation becomes less stable. C) decreases, inflation becomes more volatile. D) increases, inflation becomes more stable.

28)

Stable inflation implies that A) the rate of inflation averaged over many years is zero. B) inflation is predictable. C) the rate of inflation conceals relative price changes. D) there are low rates of unemployment.

29)

The correlation between high rates of inflation and economic growth is A) direct; one brings about the other. B) inverse; high inflation usually means low economic growth. C) nonexistent; there is no correlation between these measures. D) direct at low rates of economic growth and inverse at high rates.

30)

Most economists agree that the target rate of inflation for central banks should be A) between 7 and 9 percent. B) less than zero. C) above zero for fears of deflation. D) something over 3 but less than 6 percent.

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31)

The problem for a central bank setting a zero-inflation policy would be that A) there is risk of high employment. B) it is impossible to have zero inflation. C) firms would have to cut the nominal wage to reduce the real wage. D) economic growth would also have to be zero.

32)

Higher than expected inflation will increase the A) real interest rate borrowers pay on fixed rate mortgages. B) nominal amounts people need to save for retirement. C) real interest rate savers earn on fixed rate CDs. D) real interest rates both paid on mortgages and earned on CDs.

33)

The main problem from inflation as seen by most economists is that A) inflation raises prices more than wages. B) inflation harms lenders more than it benefits borrowers. C) during periods of inflation some prices fall. D) inflation creates risk.

34)

In terms of economic growth, the central bank would like to A) have the maximum growth rate possible. B) keep the growth rate averaging zero. C) keep the economy close to its potential or sustainable rate of growth. D) balance every recession with a boom.

35)

Potential output depends on all of the following except which one?

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A) technology B) the number of firms in the economy C) the size of the capital stock D) the number of people who can work

36)

Over very long periods, U.S. real economic growth has averaged around A) 3 percent per year. B) 1 percent per year. C) 5 percent per year. D) 7 percent per year.

37) Everything else equal, if the growth rate of a country exceeds its sustainable rate, the central bank A) will keep interest rates low to keep the momentum. B) will now identify this new rate as the sustainable rate and try to maintain it. C) is likely to raise interest rates to slow the rate of growth. D) is likely to lower the interest rate thinking a slowdown is coming to offset this boom.

38)

Which one of the following statements is not true?

A) Periods of growth above the potential level are periods of high employment. B) Periods of growth below the potential level are periods of low unemployment. C) Periods of growth above the potential level are periods of low unemployment. D) Periods of growth below the potential level are periods of high unemployment.

39) All of the following are consequences of an economy operating above its potential level except which one?

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A) high rates of inflation B) high interest rates C) low unemployment D) stable prices

40) The relationship between stability and economic growth is best summarized by which one of the following statements? A) Stability results in higher output growth rates. B) Inflation volatility results in higher output growth rates. C) There is no correlation between the volatility in growth rates and annual output growth. D) The more volatile the growth rate, the higher is the annual output growth.

41)

At a growth rate of 6 percent an economy will double in size in A) 7 years. B) 14 years. C) 12 years. D) 6 years.

42)

Since the Federal Reserve was created, it has A) averted all financial panics that could have plagued the U.S. economy. B) averted a few financial panics but not most. C) improved its skill at securing financial stability. D) proved to be much better at preventing international panics than domestic ones.

43)

Keeping interest rates stable is

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A) the most important goal for a central bank. B) a key goal, because stable interest rates will result in all other goals being achieved. C) a secondary goal for central banks. D) not a goal of the central bank.

44)

Interest rate volatility is a problem because it

A) adds to uncertainty, thereby diminishing an investment. B) decreases risk. C) can impact productivity in a positive way. D) can make financial decisions less difficult.

45)

Central banks are in a position to control risk in the economy because they control A) the unemployment rate. B) the economy's real growth rate. C) short-term interest rates. D) tax rates.

46)

Exchange rate stability is likely to be a more important goal for the central banks of A) emerging market economies than the central bank of the United States. B) the United States and Japan than most small developing countries. C) countries where exports and imports make up a small total of all economic activity. D) large, closed economies.

47) Which one of the following would give the most importance to the goal of exchange rate stability?

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A) large, closed economies B) the United States and Japan and other developed countries C) emerging market countries where exports and imports are central to the structure of the economy D) Europe

48) The 1990s saw inflation fall and real growth increase in the United States and in many other countries. This is partially attributed to all of the following except which one? A) technological innovation B) redesign of many central banks C) central banks becoming better at their jobs D) central banks focusing more on exchange rates in a global environment

49)

A time-consistent policy is one where A) actions are taken each month on the same day. B) a future policymaker lacks the opportunity or incentive to renege. C) there is means and motivation to break the commitment in the future. D) policymakers operate with complete discretion now and in the future.

50)

Time consistency is critical for economic policy to be credible because

A) people make decisions today with no regard for the future. B) the ability to update decisions over time is necessary for policy to be effective. C) it is not possible to improve outcomes by limiting discretion in future time periods. D) an effective policy is a strategy for the future, so it must be costly for policymakers to renege.

51)

Successful monetary policy relies most on

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A) luck. B) the institutional environment. C) having an ample supply of highly qualified people. D) knowledgeable citizens who know how to react to the policy.

52)

Most economists agree that a well-designed central bank would A) be independent of political pressure. B) make its policy actions difficult to interpret. C) be accountable only to other banks. D) be run by one key policy maker.

53) There is a strong consensus among economists that monetary policy is more effective when it is formulated A) by an individual rather than a committee. B) in secrecy without the reasoning behind it being revealed for many years. C) in a manner that keeps financial markets guessing. D) independently of political pressure.

54)

The idea that central banks should be independent of political pressure is an idea that A) has been around since there were central banks. B) is relatively new. C) every central bank was founded upon. D) became quite popular in the early 1900s.

55)

To be independent, a central bank must have

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A) policies that can be overturned only by the president. B) control of its own budget. C) board members who are appointed for very short terms. D) the chairperson serve as a member of the president's cabinet.

56)

The operational components required for truly independent central banks include A) a budget controlled by Congress. B) the ability to have policies reversed by Congress or the president. C) monetary policies that cannot be reversed by anyone outside of the central bank. D) the chairperson of the bank being answerable only to the president.

57)

The interest rate decisions made by the Federal Open Market Committee A) can be overridden by the president. B) can be overridden by the Secretary of the Treasury. C) can be overridden by the U.S. Senate by a two-thirds majority. D) cannot be overridden by anyone outside of the Federal Reserve.

58)

One argument for an independent central bank is that

A) successful monetary policy requires a long time horizon, usually well beyond the next election of most public officials. B) without independence, competent people would not take a position in a central bank. C) the central bank usually hires more competent individuals than the Treasury Department or other finance ministries. D) central bankers have a short-run focus that usually corrects problems faster.

59)

Compared to an independent central bank, elected officials are likely to

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A) favor long-run stability over short-term prosperity. B) sacrifice short-term growth to keep future inflation low. C) choose monetary policies that are overly accommodative. D) prefer interest rates to vary more often.

60)

Empirical research seems to verify that

A) countries that have less independent central banks experience lower rates of inflation. B) countries with high rates of inflation seem to have central banks with low levels of independence. C) there is no relationship between the independence of central banks and rates of inflation. D) the rate of inflation seems to vary directly with the amount of central bank independence.

61) Beginning in July of 2018, President Donald Trump openly and frequently criticized the Federal Reserve and its Chairman Jay Powell. Blatantly undermining the independence of the Fed in this way would likely A) add a risk premium, driving down prices of U.S. assets. B) cause the Fed to change course and move in the opposite direction of Trump’s wishes. C) result in the Fed carrying out the monetary policy recommended by President Trump. D) illustrate the strength of the U.S. economy and encourage investment from abroad.

62)

In the United States, monetary policy is formed by

A) an individual advised by a close group of people. B) committee. C) the president and approved by Congress. D) the Chairman of the Federal Reserve and can only be overturned by the presidents of the Regional Federal Reserve Banks.

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63)

Most central banks of industrialized countries have monetary policy formed by A) an individual, usually the minister of finance. B) their version of Congress. C) a committee made up of members of their central bank. D) an individual, usually the person heading the central bank at the time.

64)

In the United States, one problem with central bank independence is that

A) it is almost impossible to obtain because Congress controls the budget of the Federal Reserve. B) in a representative democracy, monetary policymakers must be held accountable to the public. C) central bank independence has not produced favorable results. D) the central bank can control policy, but the U.S. Treasury controls the money supply.

65)

Central bank accountability means that central bankers A) will report on the progress of goals that are established by politicians. B) are not accountable to any elected officials. C) are only accountable to the banks in their respective countries. D) must hold press conferences to explain their monetary policy views.

66) During the financial crisis of 2007–2009 the U.S. Federal Reserve used its powers in all but which one of the following ways? A) lending to nonbanks B) accepting very illiquid collateral against its loans C) lowering bank reserve requirements D) lowering its policy rate to zero

67) In a survey of forecasters toward the end of the financial crisis of 2007–2009, forecast inflation rates for the next decade in the United States were Version 1

A) 0 percent. B) 2 percent. C) 4 percent. D) 7 percent.

68)

To say monetary policy is transparent implies that A) anyone could figure out what the correct policy should be. B) monetary policy should not be so difficult that most people couldn't understand it. C) policy makers offer plausible explanations for their decisions along with supporting

data. D) when faced with the same problem, policy makers will always react the same way.

69)

The means for assuring accountability and transparency A) may differ across the central banks of different countries. B) are the same for all successful central banks. C) involve setting specific numerical targets so there is no confusion as to what the goal

is. D) are opposite to each other so that increasing one means decreasing the other.

70) In the United Kingdom accountability and transparency for its central bank is achieved by setting A) a numerical target for unemployment each year. B) a numerical target for economic growth. C) numerical targets for economic growth and the exchange rate. D) an explicit numerical target for inflation.

71) The central bank for the euro area tries to achieve accountability and transparency through

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A) a standard numerical objective for inflation over the medium term. B) a specific target for unemployment and economic growth. C) following the monetary policy guidance of the European Parliament. D) a specific target for the dollar euro exchange rate.

72)

Setting an explicit numerical inflation target is most associated with the goal(s) of A) transparency. B) accountability. C) both transparency and accountability. D) neither transparency nor accountability; it's about moral hazard.

73)

In the United States, the Federal Reserve is asked to A) deliver on a specific inflation target set by Congress. B) meet an explicit target for economic growth. C) meet a specific target for unemployment each year. D) deliver price stability as one of a number of objectives.

74)

Today, most central banks announce their policy actions A) one year after the policy is put in place. B) almost immediately. C) within a three- to five-year "window". D) usually six months after the policy is put in place.

75)

The Federal Reserve's policy regarding announcing its policy decisions has

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A) always been to announce it immediately because this was part of the original Federal Reserve Act of 1913. B) only recently gone to immediate announcement; until 1994 these policy decisions were secret. C) been to release the decisions immediately since its early failure at preventing the Great Depression. D) changed so that now the Fed does not release its decisions publicly.

76)

One reason given for more central bankers releasing decisions publicly is that

A) for monetary policy to work, people must be taken by surprise. B) most people do not understand monetary policy so it really doesn't do any harm to release the decisions publicly. C) it gives central banks across the world a chance to coordinate their policies. D) monetary policy is more effective when households and businesses can understand and anticipate it.

77)

Central bank statements in developed countries

A) are similar both in length and in the speed with which policy changes are announced. B) differ both in length and in the speed with which policy changes are announced. C) are similar in length but differ in the speed with which policy changes are announced. D) differ in length but are similar in the speed with which policy changes are announced.

78)

The monetary policy framework is

A) the law that created the Federal Reserve System. B) the idea that central banks should be interconnected across countries. C) a way to prioritize and implement the central bank’s objectives when they are in conflict. D) a growing belief that there should be one central bank headquartered at the World Bank.

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79)

One reason for having a monetary policy framework is that it

A) makes clear what specific goals the central bankers are pursuing. B) provides leeway for central bankers to change their goals without communicating the change and disrupting financial markets. C) provides central bankers the secrecy needed to perform their jobs effectively. D) can make goal setting vague enough so that the central bankers can always claim success.

80)

A monetary policy framework is used to clarify all of the following except which one? A) the likely response when policy goals are in conflict with one another B) the goal that is currently receiving the most attention C) how goals will be measured D) why zero inflation is not desirable

81)

One problem for the Federal Reserve regarding setting policy stems from the fact that A) there are multiple goals that may be inconsistent with each other. B) there are more policy instruments than goals. C) Congress sets very tight goal ranges that the central bankers must hit. D) the membership of its governing board changes so often.

82)

Whenever central bankers face more than one goal, the policy framework requires A) central bankers to always focus on inflation first. B) central bankers to focus on all goals, no matter what. C) economic growth to be the top priority. D) central bankers to make their priorities clear.

83)

The ability to control inflation expectations is most closely related to a central bank's

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A) transparency. B) credibility. C) accountability. D) willingness to communicate.

84)

One thing that is true about economic policy in the United States is that A) fiscal and monetary policy never conflict. B) monetary and fiscal policy need not, but may, conflict. C) monetary policy ultimately controls fiscal policy since the Fed controls the money

supply. D) fiscal policy ultimately controls monetary policy since Congress can control the Fed's budget.

85)

In the United States, monetary policymakers

A) tend to have a long view while fiscal policymakers tend to ignore the long-run inflationary ramifications of their actions. B) focus most of their attention on the money supply and the exchange rate while fiscal policymakers tend to focus on inflation and unemployment. C) tend to focus less on pleasing constituents while fiscal policymakers are more willing to sacrifice the short run for the long run. D) observe monetary policy independence because it is enshrined in the U.S. Constitution.

86)

For fiscal policymakers, one of the results of an independent central bank is that

A) to finance government spending, the Treasury has to order more currency from the central bank. B) fiscal policymakers always have to borrow to increase spending. C) fiscal policymakers cannot borrow unless the Federal Reserve prints more money. D) increased government spending has to be financed with either higher taxes or increased government borrowing.

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87) Fiscal policymakers may actually welcome some inflation for all of the following reasons except which one? A) It potentially raises tax revenues. B) It reduces the real value of the national debt allowing governments to "default" on a portion of their debt. C) Interest payments tend to be fixed so the real interest payments are reduced. D) It weakens the independence of the central bank.

88) If a government were to find that it cannot raise taxes any further, and it cannot borrow any further from financial markets, the government A) cannot increase its spending any further. B) can increase spending by having the central banks purchase its bonds. C) is in default. D) can decrease the amount of money in circulation.

89) The autonomy of modern central banks means that governments cannot increase their spending by A) raising taxes. B) issuing bonds. C) printing money. D) either issuing bonds or printing money; both represent debt.

90) Which one of the following is evidence of the link between persistent increases in public debt and slower long-run growth? A) fiscal dominance B) a declining equilibrium real interest rate C) increased concern about debt sustainability D) a budget surplus that is less than the risk premium times the level of debt

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91)

What is needed in order to keep inflation low over the long run? A) fiscal policy that dominates monetary policy B) time consistency of both monetary and fiscal policy C) primacy of monetary policy regardless of fiscal policy D) restrictive monetary policy coupled with expansionary fiscal policy

92)

All of the following are true about central bank independence except that it A) is usually given at the pleasure of governments. B) can be eliminated by governments in a time of crisis. C) is usually guaranteed by a country's constitution. D) can be subverted by the actions of fiscal policymakers.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 93) If we look back in history, why has the role of creating money fallen to central banks?

94) If governments operated like businesses, meaning their goal was to maximize profits, why would they likely never give up the power to print money to any other institution?

95) Discuss how a government ceding the right to control the amount of currency to a central bank is a way to treat a potential moral hazard problem.

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96)

What are the three main functions a central bank performs in its role as a banker's bank?

97) Explain why it is correct to say the Federal Reserve functions as the government's bank but it is incorrect to say it controls the government's budget.

98)

Describe two things that modern central bankers do not do.

99)

What are the specific objectives of most central bankers?

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100) Discuss how the goals of central bankers can be linked to a specific type of risk and the ability or inability of individuals to eliminate this risk.

101) Imagine you own a retail mail order business. In January, you produce your catalog, where items and prices are listed, and you use the same catalog all year. The central bank in your country increases the money supply by an amount to cause inflation to average one percent each month. Ignoring any seasonality in sales (like the holiday season), what should happen to your sales as the year progresses and why?

102) What may be the reasons that explain the observation that during periods of hyperinflation economic growth actually slows or even contracts?

103)

Explain why inflation degrades the information content of prices.

104) If one of the specific goals that central bankers focus on is economic growth, should they aim for the highest short-term growth rate the economy can achieve? Explain.

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105) In the country of Fantasyland, the current per capita real income is 20,000 units of output, and the current average growth rate is 2.0 percent. What will the standard of living be in this country in 20 years? What will be the difference in the standard of living twenty years from now if Fantasyland grows at a rate of 3.5 percent and we assume population is constant?

106) One of the specific goals for central bankers is financial system stability. Considering the United States, for example, would this imply that the Federal Reserve would always take action to prevent any single bank from failing? Explain.

107) Use the concept of time consistency to explain the irony of how limiting the discretion of policymakers can lead to better outcomes for society.

108) How do the specific goals of interest rate stability and exchange rate stability differ in importance from the other specific goals mentioned for central bankers?

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109) What are the potential problems that can result if central bankers set a target of a zero rate of inflation?

110) Why might the central bankers in emerging market economies focus more attention on a stable exchange rate than, say, the Federal Reserve or the European Central Bank?

111) Today there is a clear consensus about the best way to design a central bank. What are the criteria for a successful central bank?

112) The chairman of the Fed gives a speech and hints that, at the next meeting of the Open Market Committee, the issues of a rapidly growing economy and preliminary indications of rising prices will have to be addressed. You are in the market for a new house and your mortgage broker calls to tell you that the interest rate on the $100,000, 30-year mortgage you applied for has just increased by a quarter of a percent. Why did the rate increase even though the Fed has not announced any rate change?

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113) What do you think is meant by the statement that "successful monetary policy requires competent people and the right institutional environment"?

114)

What are the operational components of central bank independence?

115) The apparent result of central bank independence has been better performing economies. Given this result, why do you think it took so long for many countries to create independent central banks?

116) The Federal Reserve didn't always communicate its actions to the public like it does today. As recently as the mid-1990s, secrecy ruled. Why do you think the Fed and most central banks now are more public about their actions and the reasons for them?

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117) Provide an example where monetary policymakers in the United States would be put in a position of conflicting goals and as a result forced to make a tradeoff.

118) Imagine a central banker who takes office believing that, ultimately, the best way to stimulate an economy is to keep people guessing. This means the policymaker will often, but not always, announce one change but then actually do something else. What do you think of the central bank's chances for achieving its objectives and why?

119) Using the United States as an example, explain why rising budget deficits on the part of a federal government creates a potential point of conflict between fiscal and monetary policymakers.

120) Why might Congress actually prefer the higher rate of inflation that might result from deficit spending to higher taxes and/or a cut in government spending?

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121) Beginning in July, 2018, President Donald Trump began to blast the Federal Reserve and Chairman Jay Powell in the press and on social media. Consider what this could have caused in the economy. For example, suppose this led to a sacrifice of the independence of the Federal Reserve from the government and eventually caused the Fed to lose credibility with the public. Then, when the COVID-19 pandemic hit in early 2020, suppose the American public did not believe the Fed’s message that the country would not suffer from spiraling inflation—and, soon thereafter, inflation began to spiral. Use a supply and demand model for the bond market to illustrate the impact this would have on bond prices and interest rates in the United States.

122) owe.

Explain why inflation is a way for governments to default on a portion of the debts they

123) Predict how monetary policymaking would change, if at all, if members of the Board of Governors of the Federal Reserve were popularly elected to two-year terms and could run for reelection.

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Answer Key Test name: Chap 15_6e 1) B 2) C 3) C 4) C 5) D 6) A 7) C 8) A 9) A 10) A 11) B 12) B 13) C 14) A 15) C 16) B 17) C 18) D 19) A 20) C 21) B 22) B 23) C 24) A 25) C 26) A Version 1

27) A 28) B 29) B 30) C 31) C 32) B 33) D 34) C 35) B 36) A 37) C 38) B 39) D 40) A 41) C 42) C 43) C 44) A 45) C 46) A 47) C 48) D 49) B 50) D 51) B 52) A 53) D 54) B 55) B 56) C Version 1

57) D 58) A 59) C 60) B 61) A 62) B 63) C 64) B 65) A 66) C 67) B 68) C 69) A 70) D 71) A 72) C 73) D 74) B 75) B 76) D 77) D 78) C 79) A 80) D 81) A 82) D 83) B 84) B 85) A 86) D Version 1

87) D 88) B 89) C 90) C 91) B 92) C 93) Historically, central bank money has been seen as more trustworthy than the money issued by emperors, kings, or queens. Oftentimes rulers would have a strong incentive to default on their notes (debts) rendering the currencies they issued as worthless. Early central banks, on the other hand, kept adequate reserves (usually gold) to redeem their notes. 94) Printing money can be a very profitable enterprise. The actual cost of printing currency is a few cents per bill; however, the bills can be used to purchase real goods and services. 95) Government officials have a variety of options available to finance their expenditures; these include taxation, borrowing and printing currency. The printing of currency, though inflationary, would allow these officials to avoid the short-term problems of raising taxes and/or borrowing, which may reduce their chances of holding on to their office, and by printing currency, the problem of inflation may not occur until they are out of office. This creates a potential moral hazard for elected officials, which is removed by giving the power to print currency to an independent central bank. 96) The three functions are to provide loans during times of financial stress; to manage the payments system; and, to oversee commercial banks and the financial system.

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97) In its role as the government's bank, the Federal Reserve System (Fed) assists in the finances of the government and controls the availability of money and credit. The actual budget of the government is determined through fiscal policy where the Treasury administers the budget that is determined by Congress and the president. The Fed acts as the Treasury's bank. 98) A modern central bank does not control securities markets, though it may monitor and participate in bond and stock markets. Second, the central bank does not control the government's budget. In the United States the budget is determined by Congress and the president. The Fed is only involved because it acts as the Treasury's bank. 99) Most central bankers pursue five specific objectives, though not necessarily simultaneously to the same degree. These include low and stable inflation, high and stable real growth (together with high employment), stable financial markets and institutions, stable interest rates, and a stable exchange rate. 100) Recall that individuals face two types of risk in their investment decisions, idiosyncratic risk and systematic risk. Idiosyncratic risk can be eliminated through diversification. However, systematic risk affects everyone and cannot be eliminated through diversification. The specific goals that central bankers pursue are meant to provide a more stable economic environment that reduces the systematic risk faced by society. 101) As the year progresses sales should increase. Each month, items are becoming one percent cheaper in real terms since the nominal prices stated in the catalog are not changing. By December the products are approximately twelve percent less expensive than when the catalog was first issued. This is an example of where inflation makes separating a true increase in demand for goods from a general increase in prices difficult. Version 1

102) Periods of hyperinflation or highly unstable prices almost always result from having too much money available. During these periods individuals are trying to cope with the crisis and not putting their efforts into producing goods and services efficiently. In fact from an earlier chapter we learned that one of the roles for money is to serve as a means of exchange, which facilitates exchange and minimizes the time individuals need to spend searching or creating the double coincidence of wants. When hyperinflation or unstable prices occur this causes people to revert to bartering or real goods and services, which means more time spent trading and less time spent producing. In addition, lending and borrowing presents far more risk during periods of unstable prices so less investment in the economy will occur which will also reduce economic growth. 103) For markets to work efficiently, prices must provide information that individuals and firms need to ensure that resources are allocated to their most productive uses. But when all prices rise together (inflation), understanding the reasons for price changes becomes difficult and decisions will likely be more inefficient as people try to guess why any particular price rose. The more variable the rate of inflation, the more that it undermines the information content of prices. 104) Central bankers do have economic growth as one of their goals, but the goal really focuses on the maximum sustainable growth rate or what is sometimes referred to as full potential growth rate. A sustainable growth rate is one that can be achieved using the resources available in a normal way. The growth of output then is determined by the growth of the inputs and technology (or as you learned in principles of economics, the concept of the production function). If central bankers try to push growth above the sustainable level the likely result would be rising inflation.

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105) We can use a financial calculator or exponents to determine the answers. For example, if we enter 20,000 as the current present value, and use a growth rate of 2 percent as an interest rate and the time period of 20 years, our future value will be 29,719 units. At a growth rate of 3.5 percent, the future value will be 39,796 or almost double. This shows the large impact that relatively small differences in the growth rate can have over long periods of time. 106) Not likely. What the Fed would be concerned with is the financial system. For example, as we learned in the previous chapter, if the bank was in the category of too-big-to-fail, then yes, the Fed would likely take action to merge that bank into another one or take other steps to prevent a bank panic. On the other hand, if the bank was insolvent and small, the Fed may let the bank fail and not get that involved. What the Fed or any central banker is concerned with is to prevent a disaster that jeopardizes the functioning of the entire system. 107) A time-consistent policy is one where a future policymaker lacks the opportunity or the incentive to renege. Economic behavior depends on the ability of a policymaker to commit credibly to a future course of action. There are important circumstances where long-run economic outcomes are worse if policymakers have the option to make period-byperiod choices without constraint. Effective policy must include a strategy for the future with a commitment that influences expectations and behavior today. The strategy has to be more than a mere “promise,” which will lack credibility unless there is some mechanism to ensure that policymakers make good on their word. Institutions and practices must make it costly for future policymakers to renege. The more effective this framework, the more likely that policy will prove effective. Ironically, tying the hands of future policymakers can lead to a better outcome.

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108) As the text mentions, interest rate and exchange rate stability are secondary to the goals of stable growth, low inflation, and financial stability. The main reason offered is that interest rate and exchange rate changes are a means to obtain the other goals. While no central banker wants volatile interest rates, often, changes in interest rates will be used to achieve one or more of the other goals. 109) A zero-inflation target has a few problems. First, trying to hit a zero-inflation target risks deflation occurring. Deflation has a lot of problems including making debts more difficult to repay, which can lead to an increase in loan defaults and an adverse impact on the health of banks. Deflation also increases information problems for lenders, so it will be more difficult for borrowers to obtain loans. In addition, a zero rate of inflation would require a firm to actually cut nominal wages if it needs to reduce the real wage. If the inflation rate is positive, as long as nominal wages are constant or are increasing at a lower rate than inflation, real wages will fall. Finally, most economists agree that inflation in most indexes is overstated, so a target rate for inflation of zero is likely deflation. 110) For emerging market economies the level of imports and exports could represent a large percent of their total economy, and, as a result, unstable exchange rates could cause significant swings in the level of output and growth creating a large amount of systematic risk. In the United States and Europe, while the volume of international trade is large in absolute terms it is a smaller percentage of the total economy so the goal of stable exchange rates may be subordinated to other goals. 111) To be successful, a central bank must (1) be independent of political pressures, (2) make decisions by committee, (3) be accountable to the public and transparent in communicating its policy actions, and (4) operate within an explicit framework that clearly states its goals and makes clear the tradeoffs among them. Version 1

112) The rate increased because, based on the recent speech, many people in the financial market are anticipating an interest rate increase by the Fed and they don't want to see the value of their assets (the mortgages they made) decrease once the rate increases. 113) The people part of this argument is obvious. If monetary policy is going to be successful you need to have very bright people who are astute in economic policy matters. But perhaps more important is to have an institutional environment where these competent people can have the greatest impact. During the last 15 to 20 years many central banks have gained greater independence from political pressure and have increased their transparency and accountability with the result being better performing economies. 114) There are two operational components of central bank independence. The first is that monetary policymakers must be free to control their own budgets. Second, the bank's policies must not be reversible by people outside the central bank. Long terms of office also foster central bank independence by insulating bank officials from political pressure. 115) One reason is that central banks were created by people who had power and these people were not likely to give up this power easily, especially the power to create money. If we focus on the United States as an example, it may be that Congress realized that being a body of elected officials, they would always have a difficult time using policy in the correct way (moral hazard) so it would be better to give significant policymaking power to an independent group that did not have to worry about being reelected. It may be that it takes experience with high inflation for countries to come to this realization.

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116) In principles of economics we learn that information enables prices to adjust faster and if prices adjust markets are more efficient. In a sense that is what is happening here. If the central bank is going to be a stabilizing force it should provide information on a timely basis so that financial markets can adjust faster and minimize the volatility that otherwise would occur. Rapid adjustment in financial and other markets speeds the response of the economy to monetary policy, making it more effective. 117) We can borrow one from the text. By mid-2004 the economy had recovered completely from the recession of 2001. Businesses were increasing production and hiring new workers. But as the economy boomed the inflation rate started to rise. The FOMC accordingly began to raise the target interest rate. It turned out that the FOMC would ultimately make 17 increases and inflation remained low. The goal of keeping inflation low and stable can be inconsistent with the goal of avoiding a recession because monetary tightening means higher interest rates, which reduce the availability of money and credit at the risk of slowing growth. 118) This violates one of the requirements of a well-designed policy framework and that is credibility. If policymakers aren't credible their actions will not become stabilizing but destabilizing, and if the goal of economic policy is to reduce systematic risk, this noncredibility isn't going to work. Systematic risk will actually increase and we are likely to see a less stable economy with a slower growth rate as people spend considerable time and effort trying to guess what the policymakers are likely to do.

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119) Members of Congress and the president have a short-term view of policy. Their time horizon is usually the next election. As a result, when it comes to budget matters, they would prefer not to raise taxes and at the same time; any member of Congress will not want to reduce spending in his or her district or state, even if this deficit spending may raise interest rates and/or the inflation rate. As a result, one could argue that Congress would be prone to run budget deficits, preferring to push the problem of paying for government programs well into the future. Monetary policymakers, on the other hand, have a long time horizon and worry about inflation. On the matter of budget finance it is often the situation that Congress, the president, and the Chairman of the Fed can have opposing views on its significance and how it should be dealt with. 120) Raising taxes and/or cutting spending are usually not alternatives favored by policymakers who are elected. On the other hand, inflation can actually benefit a government with large debts. First of all, if the interest on the debts is in fixed nominal rates, an increase in the inflation rate actually reduces the real interest rate the government pays. Also, with higher rates of inflation, the real value of the debts decreases; in a sense, inflation allows the government to partially default on their debts.

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121) Spiraling inflation is volatile. Higher inflation risk increases the riskiness of bonds while higher inflation decreases the purchasing power of coupon payments and the nominal face value of bonds. Therefore, demand for bonds decreases which is illustrated as a shift from D0 to D1 in the following graph. The supply curve will increase in this market as an increase in expected inflation lowers the real cost of borrowing, and this is shown below as a shift from S0 to S1. As a result, the equilibrium price of bonds is lower in E1 and interest rates are higher. The impact on the equilibrium quantity of bonds is indeterminate without information about which curve shifts more. This example illustrates the importance of credibility. Without it, interest rates rise, investment falls, and economic growth slows.

122) If a government forces the central bank to buy its bonds the quantity of money in circulation increases, sparking inflation. This rise in inflation benefits fiscal policymakers because it reduces the value of the bonds the government has already sold, making them easier to repay. In effect, because payment will occur in units of money that have lost value, the government has defaulted on a portion of the debts it owes.

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123) There would likely be many changes and none of them necessarily favorable. The most basic change would be the time horizon of monetary policy. Currently monetary policymakers have a long time horizon. With a two-year term and re-election, this focus is likely to change to a very short time horizon. Another potentially harmful impact is that elected officials are subject to pressure from special interest groups. Currently, Fed Board members are somewhat immune from special interest groups because they do not need to worry about reelection, they do not need to build up campaign funds nor worry about campaign promises that were made. This would all change with the prospect of having to run for election and campaign. Many arguments have been made that in a democracy having something as important as monetary policy in the hands of non-elected officials presents problems, but those problems pale compared to the ones that might exist if monetary policymaking was in the hands of elected officials.

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CHAPTER 16 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) The Federal Reserve was created in A) 1929. B) 1913. C) 1909. D) 1945.

The Federal Reserve System is composed of A) five branches with clear responsibilities. B) six branches with overlapping responsibilities. C) three branches with overlapping responsibilities. D) twelve branches with clear responsibilities.

Member banks of the Federal Reserve System include A) only nationally chartered banks. B) all state chartered banks with assets exceeding $100 million. C) nationally chartered banks and state chartered banks that decide to join. D) nationally chartered banks and all state chartered banks.

4) The three branches of the Federal Reserve System include each of the following, except which one? A) the Board of Governors. B) the Federal Deposit Insurance Corporation. C) the Federal Open Market Committee. D) the twelve regional Federal Reserve Banks.

Considering state chartered banks,

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A) most elect to join the Federal Reserve System. B) those with assets exceeding $100 million must join the Federal Reserve System. C) most elect not to join the system. D) only those that join the system must abide by reserve requirements.

Prior to 1980,

A) member banks of the Federal Reserve did not have to hold non-interest-bearing reserve deposits at the Fed. B) nonmember banks had to hold non-interest-bearing reserve deposits at the Fed. C) nonmember banks did not have to hold non-interest-bearing reserve deposits at the Fed. D) all banks, member or not, had to hold non-interest-bearing reserve deposits at the Fed.

7) Currently the requirement of holding a non-interest-bearing reserve account at the Fed must be met by A) all banks, member or not. B) only member banks. C) member banks and nonmember banks with over $100 million in assets. D) only nationally chartered banks.

One reason it took so long to have a central bank in the United States is that

A) it was not needed. B) states feared centralization of power. C) state currencies worked fine. D) the primarily agrarian economy made it difficult for financial difficulties to become widespread.

9) Prior to the creation of the Federal Reserve System in the United States, how did financial panics typically begin? Version 1

A) shortage of gold B) stock market crash C) bank run on an urban bank D) crop failure or a bumper crop that drove the market price down

10)

The number of regional Federal Reserve Banks is A) nine. B) seven. C) five. D) twelve.

11)

The Federal Reserve Bank of New York is unique from other Reserve banks because it is A) the only regional Bank that serves just one state. B) the only regional Bank located in a financial center. C) where the Federal Reserve System's portfolio is managed. D) the oldest and therefore the largest.

12)

The lines drawn to establish Federal Reserve Districts were based A) solely on population distribution in 1914. B) solely on economic forces that existed in 1914. C) on economic and political forces that existed in 1914. D) on economic and political forces as well as population distribution in 1914.

13)

Considering the Federal Reserve Districts, which one of the following is true? A) With the exception of New York, no district coincides with a single state. B) No district coincides with a single state. C) Some districts are made up of single states. D) The districts are divided with equal population.

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14)

The Reserve Banks of the Federal Reserve System are owned by A) the taxpayers in their districts. B) the U.S. Treasury. C) the Board of Governors. D) the commercial banks in their districts.

15) Fed?

How many members belong to the board of directors for each of the Reserve Banks of the

A) 7 B) 9 C) 12 D) 14

16)

Each of the Reserve Banks has a president who is A) appointed by the bank's board of directors but approved by the board of governors. B) appointed by the board of governors but approved by the bank's board of directors. C) elected by the commercial banks in their district. D) selected from the Board of Directors.

17)

Each president of a Reserve Bank serves for a A) fourteen-year term. B) five-year term. C) seven-year term. D) two-year renewable term.

18) Which one of the following is a false statement about the structure of the Federal Reserve System?

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A) Banker and business interests are reflected. B) State and regional interests are reflected. C) Government (public) and private interests are reflected. D) Exporter and importer interests are reflected.

19) In its role as bank for the U.S. government, the Federal Reserve performs all of the following services except which one?

A) issuing new currency B) making discount loans C) maintaining the U.S. Treasury's bank account D) managing U.S. Treasury borrowings

20) In its role as the bankers' bank, the Federal Reserve performs all of the following services except which one? A) collecting and making available data on business conditions B) making discount loans C) managing U.S. Treasury borrowings D) clearing paper checks and transferring funds electronically

21)

Which one of the following cities does not have a Federal Reserve Bank located in it? A) Denver B) Atlanta C) San Francisco D) Chicago

22)

Which one of the following cities has a Federal Reserve Bank located in it?

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A) Denver B) Philadelphia C) Detroit D) Miami

23) The Federal Reserve District that covers the largest geographic area is serviced by the Reserve Bank located in A) Chicago. B) Richmond. C) Atlanta. D) San Francisco.

24) The services that the Federal Reserve provides to foreign central banks and other international organizations are handled A) directly by the Board of Governors in Washington, D.C. B) by any of the Reserve Banks. C) only by the Reserve Bank in New York. D) only by the Reserve Bank in San Francisco.

25)

The largest Federal Reserve District geographically is serviced by the Reserve Bank in A) San Francisco. B) Chicago. C) New York. D) the city closest to the depositor.

26)

Buying and selling U.S. Treasury Securities for the Fed's own portfolio is called

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A) managing the float. B) discount buying. C) open market operations. D) reserve adjustment.

27) Each of the following is a monetary policy action conducted by any of the regional Federal Reserve banks except which action? A) conducting open market operations from their banks B) participating in FOMC meetings C) participating in setting the discount rate D) making discount loans

28)

How many members are on the Board of Governors of the Federal Reserve System? A) twelve, one for each district B) seven C) nine D) fourteen

29)

Current law regarding the Fed's Board of Governors stipulates that A) no more than three governors can come from the same district. B) no more than two governors can come from the same district. C) every district must have at least one governor on the board. D) no more than one governor can come from the same district.

30)

The Governors of the Federal Reserve System are appointed by the

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A) member banks from their home district. B) Board of Directors of the Reserve Bank from their home district. C) President of the United States. D) Chairman of the Federal Reserve System.

31)

The Governors of the Federal Reserve System serve terms of A) four years that can be renewed. B) fourteen years. C) four years, the same as the U.S. President, and the terms are not renewable. D) seven years.

32)

To make sure the U.S. President cannot unduly influence the Board of Governors A) the terms of the governors are staggered. B) the law prevents a president from appointing more than one governor. C) the terms of the governors are ten years long. D) only three governors can be replaced in any one year.

33)

The Chairman of the Board of Governors A) serves a four-year term that cannot be renewed. B) is appointed by the U.S. President, selected from the Board of Governors. C) serves the same four-year term as the U.S. President. D) serves an eight-year term.

34) The Board of Governors of the Fed performs each of the following functions except which one?

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A) analyzing financial and economic conditions B) setting the reserve requirement C) approving bank merger applications D) making discount loans

35) The Federal Reserve Act explicitly requires that the Board of Governors represents each of the following except which one? A) commercial interests B) foreign interests C) financial interests D) agricultural interests

36)

Members of the Board of Governors of the Fed A) can be reappointed after their term expires. B) must leave office when there is a new administration elected. C) serve one nonrenewable, 14-year term. D) are appointed for life, though they can resign at any time.

37)

The Federal Reserve's Open Market Committee currently meets A) monthly. B) biweekly. C) eight times a year. D) once every quarter, unless a crisis warrants more frequent meetings.

38)

The Federal Open Market Committee began operating in

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A) 1913. B) 1929. C) 1914. D) 1936.

39)

The number of voting members on the Federal Open Market Committee is A) seven. B) eight. C) twelve. D) nineteen.

40)

Which one of the following is (are) not a permanent voting member(s) on the FOMC? A) the seven Governors of the Fed B) the Secretary of the Treasury C) the President of the Federal Reserve Bank of New York D) the chair of the Board of Governors

41)

The Chairman of the FOMC is the A) Secretary of the Treasury. B) Vice Chairman of the Board of Governors. C) Chairman of the Board of Governors. D) President of the New York Fed.

42)

The interest rate that the FOMC currently chooses to control is the A) federal funds rate. B) 30-year Treasury bond rate. C) discount rate. D) prime rate.

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43)

The federal funds rate is the interest rate A) the Fed charges banks who borrow from it. B) banks charge each other for overnight loans on excess reserves held at the Fed. C) the U.S. Treasury charges banks that need emergency funds. D) the FDIC charges banks that need to borrow from it to meet depositor demands.

44)

The federal funds rate is stated as A) a real interest rate. B) a nominal interest rate. C) a rate that is automatically indexed to inflation. D) the current rate less the expected rate of inflation.

45)

The FOMC controls the real interest rate A) if inflation changes quickly. B) if inflation doesn't change quickly. C) only if it adjusts the federal funds rate to match the changes in the rate of inflation. D) only on an annual basis.

46) Changes in the federal funds rate influence the economy's growth rate through all of the following except by A) making it more or less attractive to save. B) making it more or less expensive to borrow. C) making investment spending more or less attractive. D) altering the real interest rate when inflation is changing quickly.

47)

The primary purpose of meetings of the FOMC is to

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A) set the required reserve rate. B) set the discount rate. C) decide on how to influence financial conditions. D) set the prime rate.

48)

The policy directive that is produced from the FOMC meeting

A) details the exact amount of U.S. Treasury securities the System Open Market Account Manager is to purchase or sell. B) sets the specific discount rate for the next eight weeks. C) sets the specific range that the target interest rate can fall within. D) instructs the staff of the New York Fed on how to manage the Fed’s balance sheet.

49) The attendees at the FOMC meetings receive information prior to the meetings that is contained in books with colorful names. The information that is released to the public prior to the meetings is from the A) Bluebook only. B) Beigebook only. C) Bluebook and Greenbook, but not the Tealbook. D) Beigebook and Bluebook but not the Greenbook.

50)

Which one of the following is responsible for invoking the Fed’s emergency powers? A) FOMC B) Board of Governors C) Fed Chairman D) a majority of the Federal Reserve Bank presidents

51) Which of the books used at the FOMC meetings contains anecdotal information collected by the Federal Reserve Banks?

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A) the Bluebook B) the Beigebook C) the Tealbook D) both the Beigebook and Bluebook

52) Which of the books used at the FOMC meetings contains the Board staff's economic forecast for the next few years? A) the Bluebook B) the Beigebook C) the Tealbook D) both the Beigebook and Bluebook

53) Which of the books used at the FOMC meetings contains a discussion of financial markets and current policy options? A) the Tealbook B) the Beigebook C) the Greenbook D) both the Beigebook and Greenbook

54) Which of the books used at the FOMC meetings is/are treated as secret documents and not released to the public until after a number of years have passed? A) the Bluebook and the Beigebook B) the Beigebook and the Greenbook C) the Tealbook D) the Bluebook and the Greenbook

55) Which of the books used at the FOMC meetings can be characterized as less quantitative than the others?

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A) the Tealbook B) the Beigebook C) the Greenbook D) the Economic Forecast Reports

56)

The information contained in the Fed's Tealbook is released to the public A) immediately after the FOMC meeting in which it is used. B) within two weeks after the FOMC meeting in which it is used. C) the material in the teal book is never released to the public. D) five years after the FOMC meeting in which it is used.

57)

A typical FOMC meeting would best be described as

A) an informal meeting with significant give and take among participants. B) an informal meeting with the Chairman as a passive observer. C) a fairly formal session with not much give and take. D) a press conference, where the financial press can ask questions regarding the Fed's view of the economy.

58)

The real power in the FOMC lies with A) the President of the New York Fed Bank. B) the System Open Market Manager. C) the Chairman of the Board of Governors. D) no single individual; all participants have an equal share of the power.

59)

Once the FOMC meetings adjourn, the public is made aware of the FOMC's decision

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A) immediately after the meeting. B) 48 hours after the meeting adjourns. C) within five business days. D) 24 hours after the meeting adjourns.

60)

Once the FOMC announces the result of its meeting, the attendees

A) must brief the financial news immediately after and answer questions posed to them. B) observe a 24-hour blackout period following the meeting during which they do not speak publicly about the economic outlook or current monetary policy. C) observe a blackout period that lasts for a week following the meeting during which they do not speak publicly about the economic outlook or current monetary policy. D) never discuss the policy issues addressed in the meetings.

61) Criteria used to judge a central bank's independence include each of the following except which one? A) budgetary independence B) long terms for members C) cabinet or ministry level of authority D) irreversible decisions

62)

The Fed's revenue comes

A) from congressional appropriation. B) from the Department of Commerce. C) from internally generated funds from interest on securities it holds and fees charged to banks for payments system services. D) solely from taxes placed on member banks.

63)

Most of the Fed's income is

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A) paid to member banks in the form of a dividend. B) sent to the FDIC to shore up the depositor insurance fund. C) returned to the U.S. Treasury. D) used to build the Fed's portfolio of securities.

64)

The interest rate changes that result from the FOMC meetings can only be altered by A) Congress. B) the Secretary of the Treasury during an economic crisis. C) the FOMC. D) by the U.S. President during a time of crisis.

65)

A large step toward independence occurred for the Fed in 1935 when the

A) Fed went from two to twelve districts. B) Secretary of the Treasury and the Comptroller of the Currency were removed from the Board of Governors. C) Chairman of the Board of Governors was no longer a cabinet position. D) Fed was given the ability to control its own budget.

66)

During World War II, the Fed accommodated the war effort by A) significantly curtailing credit in the economy. B) keeping bond prices high and interest rates low. C) selling any Treasury securities the public did not purchase. D) curtailing credit and keeping bond prices high.

67)

The Fed's independence can only be revoked by

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A) the U.S. President. B) the Secretary of the Treasury. C) Congress. D) changing the U.S. Constitution.

68) The likelihood that the Fed will implement a change that will seriously harm the economy is minimized by the fact that A) only bright, well-intentioned people are appointed to key roles at the Fed. B) Congress can remove the Chairman of the Fed at any time. C) the Board of Governors ultimately must answer to the U.S. President since he can replace them. D) there is decision making by committee.

69)

The objectives set for the Fed by Congress are A) very specific, which adds to the Fed's accountability. B) by design, quite vague, allowing the Fed to really set its own goals. C) specific regarding inflation, but vague on all other goals. D) specific on the growth rate for the economy, but vague on all other objectives.

70) One valuable lesson investors should learn from the stock market behavior during the late 1990s and early 2000s is that the Fed A) can control the stock market. B) can reduce the idiosyncratic risk of investing but not the systematic risk. C) can eliminate the risk from investing. D) cannot prevent a stock market decline.

71)

The U.S. dollar is to the fifty states as the euro is to the

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A) European Central Bank B) states of the European Monetary Union C) National Central Banks D) European System of Central Banks

72)

The agreement to form a European monetary union was formalized in the Treaty of A) Maastricht. B) Paris. C) Amsterdam. D) Milan.

73)

By 2020, the euro had become the currency of A) every country in Europe. B) 19 countries in Europe. C) 25 countries in Europe. D) all European countries except Great Britain.

74) Comparing the European and the U.S. central bank systems, the National Central Banks that make up part of the European System of Central Banks resembles the A) U.S. Treasury. B) Board of Governors. C) FOMC. D) regional Federal Reserve Banks.

75) Comparing the European and the U.S. central bank systems, the Executive Board of the European system resembles the

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A) FOMC. B) Board of Governors. C) Presidents of the regional Federal Reserve Banks. D) Chairman of the Board of Governors of the Fed.

76) Comparing the European and the U.S. central bank systems, the Governing Council of the European system resembles the A) Board of Governors. B) Presidents of the Regional Federal Reserve Banks. C) FOMC. D) Chairman of the Board of Governors of the Fed.

77)

Executive board members of the European System of Central Banks are appointed by A) a committee made up of bank presidents in the member countries. B) a committee made up of heads of state of member countries. C) the finance ministers of member countries. D) the directors of the National Central Banks.

78)

The Treaty of Maastricht was signed in

A) 1992. B) 1982. C) 2000. D) 2010.

79)

Member countries of the Eurosystem agree to

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A) pursue independent domestic monetary policies based on what is best for their own country, but not all member countries have adopted the euro as their currency. B) share a common monetary policy and fiscal policy. C) use the euro as their currency, but each country still pursues an independent monetary policy. D) share a common monetary policy and use the euro as their currency.

80)

In the meetings of the Governing Council of the European Central Bank, formal votes are A) taken and published immediately. B) not taken, since formal voting could get in the way of good policy. C) taken but not published for five years. D) taken and released two years after the meetings.

81)

Sweden is A) a member of the European Union but not a member of the Eurosystem. B) a member of the Eurosystem but not a member of the European Union. C) not a member of the Eurosystem or the European Union. D) a member of both the European Union and the Eurosystem.

82)

France, Germany, and Italy are

A) all members of the European Union and the Eurosystem. B) all members of the Eurosystem but not the European Union. C) all members of the European Union but not the Eurosystem. D) not members of either the Eurosystem or the European Union; they have their own economic union.

83)

As of May, 2019, the euro had become the currency for

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A) 7 countries. B) 12 countries. C) 19 countries. D) 25 countries.

84) The European Central Bank has ensured independence by appointing Executive Board members for A) life. B) eight-year, nonrenewable terms. C) 14-year terms. D) 20-year terms.

85)

The European Central Bank has ensured independence by

A) explicitly forbidding the Governing Council from taking instructions from any government. B) making sure the ECB's financial interests supports member countries' political organizations. C) by appointing the Executive board members for life. D) not taking votes on policy matters.

86) Price stability is declared to be the primary objective of the European System of Central Banks by which agreement? A) Peace of Lodi B) Treaty of Paris C) Treaty of Maastricht D) Treaty of Amsterdam

87) The ECB's Governing Council has price stability as a primary objective and has defined price stability as

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A) a zero rate of inflation. B) an inflation rate less than 5 percent. C) an inflation rate below, but close to, 2 percent over the medium term. D) an inflation rate in the 3 to 5 percent range.

88)

The method used by the ECB to measure inflation for meeting its objectives

A) is based on wholesale rather than retail prices. B) gives greater relative weight to smaller countries. C) uses an average of retail price inflation in all the member countries with no adjustment for GDP differences. D) could result in a contractionary monetary policy being used in a country where inflation is already very low.

89) The index used by the ECB’s Governing Council to measure inflation is a euro-area-wide measure of consumer prices called the A) Stability-Oriented Price Index. B) European Consumer Price Index. C) European Community Index of Prices. D) Harmonized Index of Consumer Prices.

90) The make-up of the Governing Council of the European Central Bank and the methods used to calculate price stability for the monetary system could potentially result in which one of the following shortcomings? A) small countries having no influence on the decisions of the Council B) monetary policy that is well suited for some countries but ill-suited for others C) a unified monetary policy appropriate for the median country, which will be a country with a large economy D) monetary policy that emphasizes unemployment over price stability

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91) Based on the rankings of members of the Eurosystem by nominal GDP in 2018, the median country is likely to be A) Italy. B) very large. C) fairly small. D) growing more rapidly than the others.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 92) Why did it take almost 150 years before the United States had a permanent central bank?

93)

What are the three branches that make up the Federal Reserve System?

94)

Why are so few state chartered banks members of the Federal Reserve System?

95) How are the locations of the twelve regional Federal Reserve Banks and the corresponding districts explained?

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96) The Federal Reserve is the U.S. government's bank. Identify the functions the Fed performs in this role.

97) Why is it technically incorrect to say that the board of directors of the regional Fed banks set the discount rate that each bank charges?

98) Why can't two Governors of the Fed come from the same district? Does this limitation make sense today?

99)

Who makes up the voting members of the Federal Reserve's Open Market Committee?

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100)

In what ways do the regional Federal Reserve Banks influence monetary policy?

101) If it is the real rate of interest that savers and borrowers respond to, how does the Fed impact a real rate by targeting a nominal rate of interest?

102) Why can it be argued that, while interest rate decisions are made by the FOMC, which is a committee, the real power of the committee lies with the Chairman of the Federal Reserve System?

103) How can the FOMC utilize an inflation-targeting framework and also satisfy its dual mandate? As part of your answer, describe the Fed’s dual mandate.

104) What are the three criteria that are used to judge a central bank's independence and how does the Fed stack up to each of these criteria?

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105) Given the democratic political structure of the United States, make an argument against the independence granted the Federal Reserve.

106) In the mid-1930s, the Federal Reserve became more independent from political pressure. What significant changes occurred then to increase the Fed's independence?

107) How is accountability achieved for the Federal Reserve? What makes assessing performance in this area difficult?

108) Is it correct to say that the Federal Reserve can improve the performance of the stock market but it cannot prevent a stock market crash?

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109) Considering the three branches that make up the Federal Reserve System, identify the corresponding branches that make up the Eurosystem. Be sure to state which part of the Eurosystem corresponds to which part of the Federal Reserve System.

110) Describe four important differences between the Fed and the European Central Bank (ECB).

111) What is the difference between the European System of Central Banks and the Eurosystem?

112) Explain why the decision to join the Eurosystem presents serious domestic monetary policy issues.

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113) What argument can you offer to justify the policy prohibiting formal voting during the Eurosystem’s Governing Council meetings?

114) How does cooperation with fiscal policymakers differ between the FOMC of the Fed and the Governing Council of the ECB?

115) In assessing whether the ECB’s communications strategy is sufficient, there are two questions that need to be addressed. These are whether the information that is released minimizes the extent to which people will be surprised by future policy actions and whether the system holds policymakers accountable for their decisions. How does the ECB rate in terms of these issues?

116) Describe how the Treaty of Maastricht mastered the time-consistency problems of monetary policy but not of fiscal and prudential policy. Provide examples of policy changes that could help.

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117) In terms of the decisions coming from the Eurosystem's Governing Council, explain why, at times, relatively small countries may be at a distinct disadvantage in terms of monetary policy targets but perhaps have undue influence in terms of the actual policies.

118) If the current number of participating countries in the Eurosystem is nineteen as of 2019 and the number of large countries is four (Germany, France, Italy, and Spain), are policies likely to favor small or large countries? Explain.

119) Read the following partial transcript of the FOMC statement from September 18, 2019 (https://www.federalreserve.gov/newsevents/pressreleases/monetary20190918a.htm). Then, answer the questions that follow.

120) Explain how a regulation requiring banks to keep a given percentage of deposits in an account paying below market interest rates at the Fed is really a tax on banks.

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121) Discuss whether a large private organization could function in the role of a lender of last resort, and if it could, what potential problem(s) might arise.

122) The system of government in the United States has historically been one of checks and balances. Provide examples of these checks and balances as they pertain to the Board of Governors of the Federal Reserve and their relationship to the executive and legislative branches of government.

123) Briefly explain the economic rationale for Brexit. In other words, why would Great Britain choose to leave the European Union? And, why did they not adopt the euro and not adopt the ECB as their central bank even when they were a member of the EU? Was this the right choice?

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Answer Key Test name: Chap 16_6e 1) B 2) C 3) C 4) B 5) C 6) C 7) A 8) B 9) D 10) D 11) C 12) D 13) B 14) D 15) B 16) A 17) B 18) D 19) B 20) C 21) A 22) B 23) D 24) C 25) A 26) C Version 1

27) A 28) B 29) D 30) C 31) B 32) A 33) B 34) D 35) B 36) C 37) C 38) D 39) C 40) B 41) C 42) A 43) B 44) B 45) B 46) D 47) C 48) D 49) B 50) B 51) B 52) C 53) A 54) C 55) B 56) D Version 1

57) C 58) C 59) A 60) C 61) C 62) C 63) C 64) C 65) B 66) B 67) C 68) D 69) B 70) D 71) B 72) A 73) B 74) D 75) B 76) C 77) B 78) A 79) D 80) B 81) A 82) A 83) C 84) B 85) A 86) C Version 1

87) C 88) D 89) D 90) B 91) C 92) Many Americans in the 19th century had a fear of a strong centralized government. Considering the modes and cost of transportation at that time, most people never ventured beyond their local towns or states. As a result, there was a strong desire to keep federal government and the centralization of power to a minimum and it was mainly due to the frequent and devastating bank panics that the Federal Reserve was finally created. 93) The three branches of the Federal Reserve System are the Board of Governors of the Fed, the twelve regional Federal Reserve Banks, and the Federal Open Market Committee. 94) The reason for the low percentage of state banks belonging to the Fed goes back to the years prior to 1980, when only member banks had to hold reserves in the form of deposits at the Fed in the non-interestbearing accounts. Nonmember banks could hold reserves in interest bearing securities, such as U.S. Treasury bills. In effect, this placed a tax on Fed membership.

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95) The explanation has three parts. First is population since the location of the regional banks and districting of the country very closely resemble the distribution of the population in 1914, with much of the population located east of the Mississippi river. The second explanation is economic forces because lawmakers realized it would be important to not have any one state coincide with a district so that they could ensure a broad range of both geographic as well as industrial interests. The third reason is political. One of the authors of the Federal Reserve Act was from Richmond, Virginia, the location of a regional bank, and the Speaker of the House came from Missouri, the site of two regional banks. 96) As the bank for the U.S. government, the Fed issues new currency and destroys old currency. It maintains the U.S. Treasury's bank account, paying checks and processing electronic payments. Finally, it manages the U.S. Treasury's borrowings; it issues, transfers, and redeems Treasury bills, notes, and bonds. 97) While the Federal Reserve Act specifies that the discount rate is to be set by the board of directors of each Reserve Bank and approved by the Board of Governors, the boards of directors virtually have no say over the discount rate. The discount rate is automatically set at a premium over the target federal funds rate, the overnight interest rate established by the FOMC. Once the FOMC makes its decision, there is nothing left for the boards of each bank to do. 98) The authors of the Federal Reserve Act wanted to make sure that all regions of the country received adequate representation at the Fed. This limits the power that any one region can have at the highest level of the Fed. If this was a critical issue, however, one could certainly argue with the current districting of the Fed. With over one-third of the country being served by one bank, perhaps it should be a requirement that at least one governor has to come from this region. Version 1

99) The voting members of the FOMC include the seven Governors of the Federal Reserve System and the President of the New York Federal Reserve Bank; these are the permanent members. The four Reserve Bank Presidents take turns serving. 100) The regional banks influence monetary policy primarily through their participation in the FOMC meetings. While the regional bank presidents make up five votes (including the president of the New York bank who is a permanent member), all regional bank presidents participate in the meeting. The regional banks in the past set the discount rate for their regions, but as the text discussed, the discount rate is now set above the FOMC target rate, so once the FOMC has done its job, the discount rate is really determined. 101) Currently, the Fed controls the federal funds rate which is a market rate because it is determined in the market for excess reserves. It is also a nominal interest rate. The Fed can have some control over the real interest rate as long as we assume that inflation does not change quickly. If the Fed can alter the nominal federal funds rate faster than inflation adjusts, then the Fed, in effect, controls the real rate of interest.

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102) We can begin with the Board of Governors; they work together daily and they make up the majority of the voting members of the FOMC. The committee members receive information contained in two books, the Beige Book and the Tealbook. The Beige Book is made available to the public. The Tealbook contains analysis of current economic conditions, the Fed staff’s forecasts, and a set of policy options. The chairman waits for everyone else in the meeting to speak before making policy recommendations and when the Committee votes, the Chairman votes first. Dissenters to the final decision are identified but usually wait to explain their position until after the Friday following the meeting. Finally, the Board of Governors controls the Reserve Bank budgets and the salaries of their presidents. So, the real power of the FOMC lies with the Chairman. 103) The Fed’s dual mandate is to promote the goals of maximum employment, stable prices, and moderate long-term interest rates. The strategic shift to an inflation-targeting framework led the Fed to quantify the inflation goal over the longer term to be an annual rise of 2 percent in the price index for personal consumption expenditures. The FOMC does not set a specific standing goal for longer-run “normal” economic growth, for maximum employment, or for the “normal” level of unemployment because the Fed does not control these outcomes. They do provide anonymous estimates of these in their quarterly reports. Also, the inflation-targeting strategy does specify a “balanced approach” whenever the FOMC faces a tradeoff between its goals of minimizing deviations of inflation and deviations of employment from targets. So, even in the inflation-targeting framework, the Fed is mindful of the dual mandate.

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104) The three criteria described in the text include budgetary independence, irreversible decisions, and long terms for central bankers. The Fed meets each of these criteria. The Fed's income is so large that the vast majority of it is actually returned to the Treasury, so the Fed cannot be held up by Congressional appropriations. The interest rate or monetary policy decisions of the FOMC can only be reversed by the FOMC. Finally, the Governors serve fourteen-year terms, the Chairman a four-year term that does not coincide with the U.S. President's term, and even the Regional Bank presidents have five-year terms. 105) One could argue that the significance and impact of monetary policy is so large that it should not be entrusted to people who are not elected by the populace. The officials making fiscal policy have to answer to the voters, while on the other hand people who are formulating monetary policy are insulated from the voters and this is at odds with the concept of a representative democracy. 106) There were really two major changes. One was the removal of the Secretary of the Treasury and the Comptroller of the Currency from the Board of Governors. Both of these positions are politically appointed and could exert administration/political influence on the Board of the Fed. The other significant change was the creation of the FOMC, which really gave control of monetary policy to the Fed.

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107) The Congress of the United States has set the Fed's objectives. Congress certainly has the power to alter the structure and the independence of the Fed. In a sense, the Fed, then, is accountable to Congress to meet these objectives. Also, the FOMC releases huge amounts of information to the public while the Federal Reserve Board delivers a twice-yearly “Monetary Policy Report to the Congress” which is accompanied by the chair’s appearance before Congress to discuss the state of the nation’s economy. Other communications are also provided through public speeches and Congressional testimony and appear on various Fed websites. The problem lies in the vagueness of the objectives. Congress has given the Fed objectives that are quite vague and result in ambiguity. Some people see the ambiguity as an advantage in that it really does give the Fed more freedom to set their own goals. 108) The Federal Reserve contributes to the efficiency of the stock market primarily by reducing systematic risk, which reduces the cost across all investing. However, the Fed does not control the stock market. It sets interest rates and makes sure that banks have funds to honor their commitments. The Fed is not large or powerful enough to eliminate risk that is inherent in an investment. So, this is likely a correct assessment. 109) The Eurosystem has a six-member Executive Board, which would resemble the Board of Governors of the Federal Reserve System. The National Central Banks of the Eurosystem would resemble the twelve Regional Banks of the Federal Reserve System. The Governing Council of the Eurosystem, which is made up of the Executive Council and the governors of the central banks in the euro area, resembles the Federal Reserve's Federal Open Market Committee.

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110) First, the implementation of monetary policy for the ECB is accomplished at all of the National Central Banks (NCBs) rather than being centralized as it is in the United States (at the Federal Reserve Bank of New York). Second, the ECB's budget is controlled by the NCBs, not the other way around. This arrangement means that the NCBs control the finances of the Executive Board and its headquarters in Frankfurt. Third, in contrast to the Fed, the ECB provides liquidity mostly by lending to banks, rather than through open market purchases of securities. Fourth, the ECB typically accepts a much wider range of collateral against loans than the Fed does. 111) The European System of Central Banks is made up of the European Central Bank (ECB), located in Frankfurt, Germany, and the National Central Banks (NCBs) in the member countries of the European Union. The Eurosystem is made up of the ECB and the NCBs of the countries that have agreed to share a common currency, the euro, and a common monetary policy. 112) To join the Eurosystem requires a country to agree to use a common currency, the euro, and to share a common monetary policy. This means a country surrenders control over its own domestic monetary policy. A country is no longer able to issue its own currency in an attempt to control its domestic interest rate. This places a country in the potentially unenviable position of having to pursue a policy that is beneficial for the Eurosystem but harmful to its own country.

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113) The answer lies with the fact that the members of the Governing Council are charged with setting policy that is beneficial for the euro area as a whole and it may be that the pursuit of this policy goes against what may actually be beneficial for their own country. A formal vote which would reveal how each member voted could be politically troublesome if not embarrassing for any member to have to explain to residents of their own country. So, the goals of the Governing Council are likely easier to obtain if members do not have to worry about how the specific votes would be interpreted in their own countries. 114) There is no explicit mechanism for cooperation between the two groups in the United States, and the Fed is not authorized to purchase most state and municipal debt. The ECB has stated requirements for member countries’ deficits and debt levels, but these are frequently violated. They also selectively purchase sovereign debt of memberstates. 115) On the first issue, uncertainties arise when conflicting opinions are expressed, but this information helps the public understand the range and complexity of policy debate in the Governing Council. On the second issue, most indications are that the system is working and that there is accountability. The ECB is forced to justify its actions to the euro-area public, explaining its policies and responding to criticism in more than a dozen languages.

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116) The treaty provided the ECB with a legal foundation that makes it highly independent, but it also requires the support of other authorities. It cannot secure price stability over the long term if fiscal policymakers do not control the rise of public debt, and it cannot ensure economic stability if prudential regulators allow a systemwide capital shortfall that fosters bank runs. The treaty did not create the institutions that would provide the support needed by the monetary union’s central bank. Common banking supervision, resolution arrangements, and deposit insurance that all cover the entire euro area so that depositors don’t care if their deposits are in a bank in Athens, Frankfurt, or Madrid would help. Some progress has been made in establishing a common banking supervision and a common resolution framework. 117) One example to show how the smaller countries can be at a disadvantage comes from the setting of targets. For example, the ECB sets a specific numerical target for inflation and the measure of inflation is the Harmonized Index of Consumer Prices (HICP), where the inflation of each country is weighted by the relative size of each country's GDP. So a small country that may be experiencing a high rate of inflation finds that their experience does not impact the overall system's rate very much and may not bring about any policy to address the problem their particular country is experiencing. On the other hand, one has to wonder if what a small country is experiencing will influence their representative to the Governing Council to push for measures that will have a positive impact on their country at the expense of the Eurosystem as a whole. Here a small country can have a lot of influence on the policies that impact the Eurosystem.

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118) The Governing Council is made up of the Executive Board and the Governor of the NCB of each participating country. If there are nineteen participating countries and four are large, this leaves at fifteen members of the Council from small countries. And that isn’t all, as half of the six Executive Board members are typically from small countries. The consequence of this is a bias toward the smaller countries since the median country would tend to be fairly small. Fortunately, the experience so far has shown that the Governing Council has done its job of representing the euro area and has not shown a bias to smaller countries.

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119) Information received since the Federal Open Market Committee met in July indicates that the labor market remains strong and that economic activity has been rising at a moderate rate. Job gains have been solid, on average, in recent months, and the unemployment rate has remained low. Although household spending has been rising at a strong pace, business fixed investment and exports have weakened. On a 12month basis, overall inflation and inflation for items other than food and energy are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed. Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. In light of the implications of global developments for the economic outlook as well as muted inflation pressures, the Committee decided to lower the target range for the federal funds rate to 1-3/4 to 2 percent. This action supports the Committee's view that sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective are the most likely outcomes, but uncertainties about this outlook remain. As the Committee contemplates the future path of the target range for the federal funds rate, it will continue to monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective. In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international Version 1

developments.What has happened since the last meeting? How has the economy performed with respect to the Fed’s dual mandate? What decision was made at this meeting? What forward guidance is provided in this statement? What factors does the FOMC plan to consider in upcoming policy decisions? Since the last meeting, the labor market has remained strong and economic activity has been rising at a moderate rate. Unemployment has remained low, and inflation has been running below 2 percent. The Committee lowered the target range for the federal funds rate to 1-3/4 to 2 percent. Forward guidance suggests that there will be sustained expansion of economic activity, strong labor market conditions, and inflation near the 2 percent objective, but there are also uncertainties. The Committee will assess realized and expected economic conditions relative to its dual mandate and will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

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120) Perhaps the best way to explain this is with an example. We will assume, for simplicity that all banks pay a nominal interest rate to depositors of 5 percent and charge all borrowers 10 percent. At first it appears that the banks' cost of acquiring funds is 5 percent and their spread is also 5 percent. Now, if the Fed installs a 10 percent required reserve rate with reserves kept either in currency in the banks or on deposit at the Fed in an account paying 4½ percent, for every one dollar deposited the banks can only lend 90 cents. For example, a $100 deposit requires a $5 annual interest payment to the depositors and receives $0.45 interest on the $10 in reserve deposits. The banks, however, can only lend $90 of the deposit so in effect is paying $4.55 to obtain $90 of loanable funds, or an effective cost of funds of 5.06 percent, not the 5 percent. As a result, the banks' profits are reduced or in effect a tax has been placed on the bank. 121) A private organization could function in the role of a lender of last resort, and prior to the creation of the Fed a few tried. There are a couple of potential problems that come to mind. First, any private organization that would serve this role would have to have significant financial wherewithal which means they are likely to have significant monopoly power, and monopoly power in the hands of a private firm is seldom efficient. Second, a private firm acting in this role would certainly have potential conflict of interest issues. Do they loan to everyone, or to just anyone that may not be a potential threat to them? How do they determine which criteria to use in deciding who does or doesn't obtain a loan? Finally, in what is perhaps the largest problem, while a private organization might have the wherewithal to manage the failure of a single institution, it is very unlikely to have the resources to stem a financial panic. Only the central bank, with its ability to issue currency and reserves in unlimited amounts can credibly stop a system-wide collapse. Version 1

122) The U.S. President selects the individuals to fill the roles of governors; however, the United States Senate confirms these appointments. This offsets the potential problem of the president appointing someone who may be incompetent. To offset the potential problem of a president seeking to stack the board during his term, the governors’ terms are long, 14 years, and they are staggered, with each term expiring every two years. Congress does maintain control over the board in the sense that they ultimately can alter the Federal Reserve Act to significantly reduce the size and/or power of the board. Having pointed this out, however, it should also be noted that the Board does operate with a lot of autonomy, which is by design. The Fed is given the autonomy to serve the nation's best interest, free of excessive political intervention coming from either the President or Congress and free of the pressures that come from having to serve an electorate. 123) Brexit is the British exit from the EU which happened on January 31, 2020. The process began in 2016 when citizens of the United Kingdom voted to leave the EU. They decided that the benefits of unification did not outweigh the accompanying restrictions. Even as economic activity slows amid uncertainty, the country voted against globalization and for presumed advantages from maintaining monetary independence. Now, they are not constrained to the common monetary policy required for membership in the EU. In evaluating whether this was a good choice for the United Kingdom, consider current evidence. Time will tell as more evidence is made available.

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CHAPTER 17 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) On the morning of September 11, 2001, terrorists attacked the United States and caused enormous disruptions. In assessing the performance of the Fed and the impact on financial systems in hindsight, this is a story of A) inaction by the Federal Reserve. B) great success by the Federal Reserve. C) appropriate actions taken too late by the Federal Reserve. D) catastrophic outcomes due to a lack of backup systems at the Federal Reserve.

2) The Federal Reserve failed to keep the financial system operational during the 1930s because it A) kept the discount window open. B) provided too much liquidity to banks. C) failed to recognize the link between changes in the Fed’s balance sheet and the growth rate of money. D) failed to supply enough cash to the economy, and commercial bank accounts at the Fed plummeted.

The collapse of the Thai currency, the baht, was partially due to A) inaction by the Federal Reserve. B) actions taken by the European Central Bank. C) information kept hidden by the central bank of Thailand. D) central bankers and the Minister of Finance publishing too much information.

4) Each of the following items would appear as assets on the central bank's balance sheet except which one?

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A) loans B) securities C) foreign exchange reserves D) currency

Which one of the following is a liability on the central bank's balance sheet? A) loans B) currency C) securities D) foreign exchange reserves

6) Each of the following items would appear as liabilities on the central bank's balance sheet except which one? A) loans B) currency C) the government's account D) accounts of the commercial banks

The main asset held by a central bank in its role as the bankers’ bank is A) foreign exchange reserves. B) currency. C) loans. D) securities.

A liability of the central bank in functioning as the bankers' bank is

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A) accounts of commercial banks. B) securities. C) loans. D) currency.

On the Federal Reserve's balance sheet, securities would include A) private and public debt. B) mainly U.S. Treasury and municipal bonds. C) U.S. Treasury securities. D) bonds issued by commercial banks.

10) If the Federal Reserve is to be independent, then the quantity of securities it purchases must be determined by A) the Federal Reserve itself. B) Congress. C) the amount the public does not want to purchase at the going price. D) the Treasury.

11)

A central bank holds foreign exchange reserves for A) diversification purposes. B) foreign exchange interventions. C) safekeeping. D) diversification and safekeeping.

12)

The quantity of securities held by the Federal Reserve is controlled through

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A) the U.S. Treasury. B) the Fed's annual budget. C) open market operations. D) the purchases made by the regional Reserve Banks.

13)

In the United States, loans made by Federal Reserve to banks are A) discount loans. B) reserves. C) discount loans and reserves. D) discount loans and foreign exchange reserves.

14)

Discount loans are A) initiated by the Federal Reserve. B) made when banks need relatively small amounts of cash for the long term. C) made when banks need relatively large amounts of cash for the long term. D) made when banks need relatively small amounts of cash for the short term.

15)

Bonds issued by a foreign government in its own currency would A) not be held by the Fed. B) be held by the Fed as part of its securities. C) be held by the Fed as part of its foreign exchange reserves. D) be held by the Fed as part of its loans.

16)

Bonds issued by the U.S. Treasury would A) not be held by the Fed. B) be held by the Fed as part of its securities. C) be held by the Fed as part of its foreign exchange reserves. D) be held by the Fed as part of its loans.

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17)

Liabilities of commercial banks show up on the Fed's balance sheet as part of its A) liabilities. B) securities. C) foreign exchange reserves. D) loans.

18) As a portion of total assets measured in billions of dollars, the largest asset on the Fed's balance sheet is A) gold. B) securities. C) foreign exchange reserves. D) loans.

19)

Gold is A) used to back U.S. currency. B) extremely important as an asset for the Fed. C) a small portion of the Fed's assets. D) very important for monetary policy in the United States.

20) As a portion of total assets measured in billions of dollars, the smallest asset on the Fed's balance sheet is A) gold. B) securities. C) foreign exchange reserves. D) loans.

21)

Reserves are

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A) assets of the central bank and liabilities of the U.S. Treasury. B) assets of the central bank and liabilities of commercial banks. C) liabilities of commercial banks and assets of the U.S. Treasury. D) assets of commercial banks and liabilities of the central bank.

22)

Reserves are A) assets of the central bank and liabilities of commercial banks. B) assets of commercial banks and liabilities of the central bank. C) liabilities of commercial and central banks. D) assets and liabilities for the central bank.

23)

Vault cash is A) equal to the total amount of reserves and is an asset of the central bank. B) not reserves but is a liability of the central bank. C) a part of reserves and an asset of commercial banks. D) not reserves but is an asset of central banks.

24)

Vault cash is not included in the central bank's liability category of currency because A) only non-bank currency is in the liability category of currency. B) it really is only electronic funds. C) it is in the asset category of reserves. D) it is the liability of the U.S. Treasury.

25)

Vault cash is not included in the central bank's liability category of currency because it A) counts as currency. B) is not part of reserves. C) is not available to meet depositors’ withdrawal demands. D) serves the insurance function for which reserves are designed.

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26) Monetary policy operations for central banks are run through changes in which liability category? A) government's accounts B) currency C) reserves D) gold

27)

Most responsible central banks publish their balance sheet A) weekly. B) monthly. C) quarterly. D) annually.

28)

The experience of the Marcos presidency in the Philippines in 1986 showed that A) publishing central bank balance sheets ensures their accuracy. B) desperation is positively correlated with sound monetary policy. C) transparency is unimportant for building citizens’ trust in the central bank. D) it is important to keep the central bank independent from political pressure.

29)

The monetary base is the sum of A) reserves and M2. B) M1 and reserves. C) currency in the hands of the public, reserves, and M1. D) currency in the hands of the public and reserves in the banking system.

30)

The monetary base is the sum of

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A) reserves and currency in the hands of the public. B) reserves and M2. C) currency in the hands of the public and M2. D) currency in the hands of the public M1.

31)

The monetary base is also known as A) M1. B) M2. C) high-powered money. D) free reserves.

32)

In dollar amounts, A) the monetary base is larger than M2, and M1 is less than M2. B) M1 is smaller than the monetary base, and M2 is larger than both. C) the monetary base is larger than M1 and M2. D) the monetary base is smaller than M1, and M2 is larger than M1.

33)

One trait a central bank has over other businesses, including banks, is that it A) receives all of its funding from the government. B) can control the size of its balance sheet. C) doesn't have stockholders. D) doesn't have a board of directors.

34) Suppose the Federal Reserve purchases a U.S. Treasury bond for $1 million by writing a check. When the check returns, the Fed's balance sheet will show

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A) an increase in assets and a decrease in liabilities of $1 million. B) only an increase in assets of $1 million. C) only an increase in liabilities of $1million. D) an increase in assets and liabilities of $1 million.

35) When a business purchases a $25,000 computer system by writing a check, the business's balance sheet will A) show an increase in assets and liabilities of $25,000. B) only show an increase in assets of $25,000. C) only show an increase in liabilities of $25,000. D) still show the same total amount of assets as before the purchase.

36) When a business purchases a $50,000 computer system by writing a check, the business's balance sheet will A) only show an increase in liabilities of $50,000. B) show an increase in assets and liabilities for $50,000. C) not reflect any increase in assets or liabilities, only a change in the composition of assets. D) only show an increase in assets of $50,000.

37)

A central bank's purchase of securities made by writing checks on itself will A) decrease the size of its balance sheet. B) have no impact at all on the balance sheet. C) increase the size of their balance sheet. D) only change the composition of its assets.

38)

A central bank's sale of securities from its portfolio will

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A) decrease the size of its balance sheet. B) have no impact at all on the balance sheet. C) only change the composition of its liabilities. D) only change the composition of its assets.

39) Consider a $2 billion open market purchase of U.S. Treasury securities by the Federal Reserve. The Fed's balance sheet will show A) only an increase in the asset of securities of $2 billion. B) only show an increase in the liability of reserves of $2 billion. C) no change in the size of the balance sheet, just the composition of assets will change from cash to securities. D) an increase in the asset category of securities and the liability category of reserves by $2 billion.

40) Consider a $2 billion open market purchase of U.S. Treasury securities by the Federal Reserve. The banking system's balance sheet will specifically show A) only an increase in liabilities of $2 billion. B) only a decrease in assets of $2 billion. C) no net change in assets or liabilities, only a change in the composition of assets with securities decreasing and reserves increasing by $2 billion, respectively. D) no net change in assets or liabilities, only a change in the composition of assets with securities increasing and reserves decreasing by $2 billion, respectively.

41) An open market sale of U.S. Treasury securities by the Fed will cause the Fed's balance sheet to show A) a decrease in the asset of securities and a decrease in the liability of reserves. B) an increase in the liability of reserves. C) no change in the size of the balance sheet, just the composition of assets will change from securities to cash. D) an increase in the asset category of securities and the liability category of reserves.

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42) An open market sale of U.S. Treasury securities by the Fed will cause the banking system's balance sheet to show A) only an increase in liabilities. B) only a decrease in assets. C) no net change in assets or liabilities, only a change in the composition of assets with securities decreasing and reserves increasing. D) no net change in assets or liabilities, only a change in the composition of assets with securities increasing and reserves decreasing.

43) The Fed purchases German bonds from commercial banks. Which one of the following best describes the impact on the Fed's and the banking system's balance sheets resulting from this transaction? A) The Fed's assets and liabilities increase. The banking system’s assets and liabilities decrease. B) The Fed's assets and liabilities increase. For the banking system, the value of assets and liabilities do not change, only the composition of assets changes. C) The Fed's assets and liabilities do not change, only the compositions of the assets change. For the banking system, assets and liabilities increase. D) The Fed's assets increase and its liabilities decrease. For the banking system, the value of assets and liabilities do not change, only the composition of assets changes.

44) The Fed sells German bonds to commercial banks. Which one of the following best describes the impact on the Fed's and the banking system's balance sheets resulting from this transaction? A) The Fed's assets and liabilities increase. The banking system’s assets and liabilities decrease. B) The Fed's assets and liabilities increase. For the banking system, the value of assets and liabilities do not change, only the composition of assets changes. C) The Fed's assets and liabilities do not change, only the compositions of the assets change. For the banking system, assets and liabilities increase. D) The Fed's assets and liabilities decrease. For the banking system, the value of assets and liabilities do not change, only the composition of assets changes.

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45)

To obtain a discount loan from the Fed, a commercial bank must A) show that it will fail if it does not obtain the loan. B) prove that the loan will be used to make loans. C) provide collateral. D) agree to more frequent examinations.

46)

When the Fed makes a discount loan, the impact on the Fed's balance sheet will reflect A) no change in liabilities but an increase in assets. B) a decrease in assets and liabilities. C) an increase in assets and liabilities. D) an increase in assets and a decrease in liabilities.

47)

When the Fed makes a discount loan, the impact on the banking system's balance sheet is A) an increase in liabilities with no change in assets. B) an increase in assets and a decrease in liabilities. C) a decrease in assets and an increase in liabilities. D) the same as that of an open market purchase.

48) When the Fed makes a discount loan, the impact on the banking system's balance sheet will reflect A) an increase in liabilities with no change in assets. B) an increase in assets and a decrease in liabilities. C) a decrease in assets and an increase in liabilities. D) an increase in assets and liabilities.

49) During the 2007–2009 financial crisis, which one of the following temporarily became the largest component of assets on the Fed’s balance sheet?

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A) foreign exchange reserves B) U.S. Treasury securities C) mortgage-backed securities D) loans

50) Which of the following combinations each has the same impact on the Fed's balance sheet? A) an open market purchase and an increase in loans by the Fed to banks B) an open market sale and an increase in foreign exchange reserves C) an open market purchase and a decrease in foreign exchange reserves D) an increase in loans by the Fed to banks and a decrease in foreign exchange reserves

51) Mary decides to withdraw $500 out of her checking account. The impact of this transaction on the banking system's balance sheet will be to A) only reduce checkable deposits by $500. B) increase reserves and reduce checkable deposits by $500, respectively. C) only reduce reserves by the required reserve rate times $500. D) decrease reserves and checkable deposits by $500, respectively.

52) Tom decides to withdraw $300 out of his checking account. The impact of this transaction on the Fed's balance sheet will be A) no change in total assets or total liabilities, but an increase in the liability of currency and a decrease in the liability of reserves by $300, respectively. B) no change in total assets but the liability of currency increases by $300. C) total assets decrease by $300 and the liability of currency increases by $300. D) no change in either total assets or total liabilities.

53)

When an individual withdraws funds from a checking account the bank's balance sheet

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A) shrinks, and the size of the Fed's balance sheet is not affected. B) shrinks and so does the Fed's balance sheet. C) shrinks, and the size of the Fed's balance sheet increases. D) stays the same in size, and the size of the Fed's balance sheet shrinks.

54) Harry gets $1,000 in currency from his grandfather when he graduates from college. He deposits these funds into his checking account. Considering Harry's personal balance sheet, his assets A) increased by $1,000 when he deposited the $1,000 into his checking account. B) increased when he received the $1,000 in currency from his grandfather. C) and liabilities increased by $1,000 when he deposited the funds into his checking account. D) increased by $1,000 and his liabilities decreased by $1,000 when he deposited the funds into his checking account.

55) Harry gets $1,000 in currency from his grandfather when he graduates from college. He deposits these funds into his checking account. What is the impact of Harry’s deposit on the monetary base? The monetary base A) did not change. B) increased by $1,000. C) decreased by $1,000. D) increased by more than $1,000.

56) Over the two-year period during which the financial crisis occurred, the amount of assets in the Federal Reserve balance sheet increased by A) 2.5 times. B) 3 times. C) 4.5 times. D) 6 times.

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57) will

If Bank A sells a $100,000 U.S. Treasury bond to the Fed, Bank A's required reserves

A) not change. B) increase by $100,000. C) increase but by less than $100,000. D) decrease.

58)

If Bank A sells a $100,000 U.S. Treasury bond to the Fed, Bank A's total reserves will A) increase by $100,000. B) increase by less than $100,000. C) decrease. D) not change.

59)

If Bank A sells a $100,000 U.S. Treasury bond to the Fed, Bank A's excess reserves will A) increase by less than $100,000. B) not change. C) decrease by less than $100,000. D) increase by $100,000.

60) its

The most a bank could lend at any time without altering its assets is an amount equal to

A) checkable deposits. B) reserves. C) excess reserves. D) net worth.

61) Bank A has checkable deposits of $100 million, vault cash equaling $1 million and deposits at the Fed equaling $14 million. If the required reserve rate is ten percent, what is the maximum amount Bank A could lend?

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A) $85 million B) $15 million C) $14 million D) $5 million

62) Bank A has checkable deposits of $140 million, vault cash equaling $1 million, and deposits at the Fed equaling $14 million. If the required reserve rate is 10 percent, what is the amount of excess reserves Bank A is holding? A) It does not have any excess reserves. B) $15 million C) $2 million D) $1 million

63) A customer of Bank A writes a $20,000 check for a new car, which the car dealer deposits in his bank, Bank B. How does this transaction change reserves at Bank A and Bank B? A) Bank A's reserves decrease by $20,000 and Bank B's reserves increase by $20,000. B) Neither Bank A's nor B's reserves will change. C) Bank B's reserves will decrease and Bank A's reserves will increase by $20,000. D) Banks A's reserves will decrease by the required reserve rate times $20,000 and Banks B's reserves will increase by (1 – required reserve rate) times $20,000.

64) If the required reserve rate is 10 percent and banks do not hold any excess reserves and there are no changes in currency holdings, a $1 million open market purchase by the Fed will result in deposit creation of A) $9 million. B) $90 million. C) $10 million. D) $900,000.

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65) If the required reserve rate is expressed by rD and deposits by D, the formula for calculating the amount of required reserves is A) (1/r D )D. B) 1/r D. C) (r D )D. D) D/r D.

66) If required reserves are expressed by RR, the required reserve rate by rD, and deposits by D, the simple deposit expansion multiplier is expressed as A) R D × D. B) (1/r D )D. C) RR × D. D) 1/r D.

67) If the Fed were to increase the required reserve rate from 10 percent to 20 percent, the simple deposit expansion multiplier would A) double. B) increase by 10 percent. C) decrease by a factor of ten. D) be half as large as it was before the increase.

68) If the Fed were to decrease the required reserve rate from 10 percent to 5 percent, the simple deposit expansion multiplier would A) double. B) decrease by 5 percent. C) increase by a factor of five. D) be half as large as it was before the reduction.

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69) If the required reserve rate is ten percent and banks do not hold any excess reserves and there are no changes in currency holdings, a $1 million open market purchase by the Fed will result in which change in loans? A) no change B) a decrease of $1 million C) an increase of $10 million D) an increase of $1 million

70) If we focus on the banking system and assume no change in the public's currency holdings, a loss of reserves by any one bank must A) equal the loss of reserves by the entire system. B) be equal to the net loss of reserves for the banking system. C) result in a multiple loss to the banking system. D) result in no change in reserves for the banking system.

71) If we assume a 10 percent required reserve rate, banks hold no excess reserves, and there is no change in currency holdings, an open market sale of $5 million of U.S. Treasury securities by the Fed will result in deposits A) decreasing by $50 million. B) increasing by $5 million. C) increasing by $50 million. D) not changing.

72) The simple deposit expansion multiplier is really too simple for understanding the link between changes in a central bank's balance sheet and the quantity of money in the economy because it A) ignores how central banks could change their balance sheet. B) assumes banks hold excess reserves. C) ignores the fact people might change their currency holdings. D) assumes there are no changes in vault cash.

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73) Assume that the required reserve rate is 10 percent, banks want to hold excess reserves in an amount that equals 3 percent of deposits, and the public withdraws 10 percent of every deposit in cash. An open market purchase of $1 million by the Fed will see banking system deposits increase by A) more than $1 million but less than $10 million. B) exactly $1 million. C) less than $1 million. D) more than $10 million but less than $20 million.

74)

If people increase their currency holdings, all else the same, the monetary base A) does not change but the quantity of M2 will decrease. B) increases as does the quantity of M2. C) decreases as does the quantity of M2. D) does not change and neither does M2.

75) If there were an increase in the number of bank failures, we should expect the amount of excess reserves in the banking system to A) decrease. B) increase. C) not change. D) decrease since failing banks lost theirs.

76) If M = quantity of money, m = money multiplier, MB = monetary base, C = currency, D = deposits, R = reserves, RR = required reserves, and ER = excess reserves, then C + R would equal A) M. B) R. C) MB. D) ER.

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77) If M = quantity of money, m = money multiplier, MB = monetary base, C = currency, D = deposits, R = reserves, RR = required reserves, and ER = excess reserves, then RR would equal A) MB. B) D – C. C) M/MB. D) R – ER.

78) If M = quantity of money, m = money multiplier, MB = monetary base, C = currency, D = deposits, R = reserves, RR = required reserves, and ER = excess reserves, then m would equal A) R/ER. B) M/MB. C) C + D. D) D – C

79)

The money multiplier is much lower today than it was 25 years ago because A) people are holding less currency today. B) the currency-to-deposit ratio is much higher today. C) credit cards are more widely used. D) there is less currency available today.

80)

During the Great Depression, the monetary base in the United States A) decreased significantly. B) increased. C) remained constant. D) was highly erratic.

81)

One thing the Fed has learned over the past 25 years is that

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A) the money multiplier is fairly constant no matter what changes are made to the monetary base. B) the money multiplier is unstable over time. C) it should focus its attention on targeting M2. D) the money multiplier has a trend rate of growth that is fairly constant.

82)

During the 1990s, the money multipliers for M1 and M2 A) decreased. B) remained fairly constant even though the economy grew. C) the M1 multiplier decreased while the M2 multiplier increased dramatically. D) increased dramatically as the economy grew.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 83) Contrast the Fed's actions in response to the terrorist attacks of September 2001 and its response to the financial crisis of the Great Depression. Specifically, why was the Fed successful at dealing with the crisis in 2001 and not as successful with the crisis of the early 1930s?

84) Why do some economists credit the Fed with having prevented another depression in the Financial Crisis of 2007–09? How was dramatic inflation avoided?

85) The assets that appear on the central bank's balance sheet include the category of loans. Who are central banks lending to and are these loans associated with the central bank functioning as the government's bank? Explain.

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86) The Federal Reserve's balance sheet includes an item labeled currency. Is this an asset or a liability of the Fed, and does it include all currency that is printed? Explain.

87) If the central banks of most countries do not set the exchange rates, why do they hold foreign exchange as one of their assets?

88)

Why do most central banks publish their balance sheets so frequently?

89) Suppose a student writes a check in the amount of $300 to the college bookstore for textbooks. Discuss briefly the impact on the student's balance sheet, their bank's balance sheet, and the balance sheet of the Fed.

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90) Explain the impact on the Fed's balance sheet from a $10 million open market purchase of U.S. Treasury Securities. Be sure to identify which categories of assets and liabilities change and by what amounts.

91) Follow a $1 billion purchase of U.S. Treasury bonds by the Fed from commercial banks. Discuss the changes that occur to the balance sheet of the banking system and the balance sheet of the Fed.

92) If the Fed sells euros valued at $100 million to commercial banks, will this change the size of the Fed's liabilities and assets? Explain.

93) Given the prevalence of electronic payment mechanisms like credit cards and debit cards and the safety of checks, why is the amount of currency in the hands of the public increasing?

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94) What are two economic benefits for keeping paper money around instead of eliminating it and replacing it with electronic money?

95) The Treasury usually requires most businesses to regularly deposit taxes withheld from employees into accounts at designated commercial banks. On a regular basis, the funds in these accounts are transferred to the Treasury's account at the Fed. Discuss what is happening to the balance sheet of the banking system as the businesses are making deposits and these tax accounts are increasing. What happens to the banking system's balance sheet when the funds are transferred to the Fed?

96) You receive a $1,000 gift from your grandmother when you graduate from college. Your grandmother withdrew the $1,000 from her checking account and gave you ten $100 bills. You deposit the ten bills into your checking account. Discuss the impact of these transactions on your grandmother's balance sheet, your balance sheet, and the Fed's balance sheet.

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97) In “normal times,” when the economy is expanding and absent any financial strains, what is the appropriate mix of the Fed’s asset holdings?

98) What happens to the monetary base if people, fearing a bank run, convert their checking deposits into currency holdings?

99) How far below zero can nominal interest rates go? What would happen if policymakers tried to simulate the economy by reducing interest rates below the effective lower bound (ELB) threshold? What would that mean for the economy?

100) Suppose the required reserve rate set by the Fed is 10 percent of all checkable deposits. A bank sells $1 million of U.S. Treasury securities it owns to the Fed. Describe what this transaction does to the bank's total reserves, its required reserves, and its excess reserves.

101) If reserves pay interest below the market federal funds rate, why would a bank hold any excess reserves?

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102) When people travel during the summer and use prepaid travel cards to access some of their checking account deposits, how does this affect the monetary base?

103) Why is it more correct to say that the Fed (the central bank) controls the monetary base than to say it controls the amount of reserves?

104) If we assume the required reserve rate is 10 percent (0.1), the public does not change their currency holdings, and banks do not hold any excess reserves, what will be the change in deposits resulting from a $150 million open market purchase by the Fed?

105) <p>Why would it be correct to say that, if we assume that people do not change their currency holdings and banks do not hold any excess reserves, the equation really could be stated as

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106) You are given the following information: Total banking system reserves equal $58.65 billion. The total banking system checkable deposits subject to reserve requirements are $510 billion. The required reserves are $51 billion. What is the required reserve rate, and what is the excess reserve rate?

107) What would be the amount of deposits D, given that the monetary base MB = $750 billion, the required reserve rate (rD) = 0.1, the excess reserve rate (rE) = 0.005, and non-bank currency to deposits (C/D) = 1.2?

108) You are given the following information: Total Reserves (R) in the banking system amount to $48 billion, of which $45.8 billion are required. Currency in the hands of the public amounts to $692.5 billion while checkable deposits amount to $650 billion. Calculate the money multiplier.

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109) Who controls the impact of a change in the money supply on the economy? Use the formula for the money multiplier to answer this question.

110) Fill in the empty cells in the following table to summarize the factors affecting the quantity of money in the economy. Then, explain your reasoning.

Factor Required reserve-todeposit ratio Currency-to-deposit ratio Excess reserve-todeposit ratio Monetary base

Who Controls It

Change Increase

Impact on M

Increase Increase Increase

111) What was the main reason the Fed stopped announcing growth targets for money aggregates in the early 2000s?

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112) During the financial crisis of 2007–2009, the deposit expansion multiplier plummeted to a fraction of its normal value. Why?

113) Explain why the Fed making more discount loans to banks, or an open market purchase, or an increase in foreign exchange reserves all have the same effect on its balance sheet. What is that effect on the monetary base?

114) Considering changes to the monetary base, are discount loans and federal funds borrowing equivalent? Explain.

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Answer Key Test name: Chap 17_6e 1) B 2) C 3) C 4) D 5) B 6) A 7) C 8) A 9) C 10) A 11) B 12) C 13) A 14) D 15) C 16) B 17) D 18) B 19) C 20) A 21) D 22) B 23) C 24) A 25) D 26) C Version 1

27) A 28) D 29) D 30) A 31) C 32) D 33) C 34) D 35) D 36) C 37) C 38) A 39) D 40) D 41) A 42) D 43) B 44) D 45) C 46) C 47) D 48) D 49) C 50) A 51) D 52) A 53) A 54) B 55) A 56) A Version 1

57) A 58) A 59) D 60) C 61) D 62) D 63) A 64) C 65) C 66) D 67) D 68) A 69) C 70) D 71) A 72) C 73) A 74) A 75) B 76) C 77) D 78) B 79) B 80) B 81) B 82) A

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83) The primary difference is that in the early 1930s Fed officials didn't fully understand how their actions affected the supply of credit in the economy. The Fed failed to recognize the link between changes in its balance sheet and the growth rate of money. It believed that as long as the account balances of commercial banks at the Federal Reserve Banks were growing that credit and money were easily available. It was wrong. The financial system collapsed in the 1930s because Fed officials had failed to provide the liquidity that sound banks needed to stay in business. This is exactly what it did right in 2001, announcing that the discount window was available to meet liquidity needs. 84) Even though other government policies that include fiscal stimulus, deposit insurance and bank recapitalizations played important roles in guiding the economy through the Great Recession, some economists credit the Fed with preventing another depression by implementing an extraordinary cycle of monetary easing. Comparing the evolution of reserves in the U.S. banking system over the two periods of the Great Depression and the Great Recession can help illustrate this. The Fed held aggregate reserves roughly constant from 1928 to 1933 while nearly 40% of U.S. banks failed. M2 plunged while the M2 money multiplier fell by nearly half. There were historic plunges in prices, output, and employment. Although the M2 money multiplier fell by even more after 2008, there was far less damage because the Fed boosted the supply of reserves from $45 billion to over $800 billion in a matter of weeks in late 2008. The Fed continued the quantitative easing for four more years. These efforts, combined with those previously mentioned, kept M2 from collapsing. While many thought that the massive increase in reserves would lead to an uncontrolled inflation, it turns out that when a financial crisis impairs the banking system, increase in reserves typically do not translate into broad money creation and so are not inflationary. Version 1

85) The loans are usually made to commercial banks. Using the example of the Federal Reserve, these would be discount loans. This is not a central bank functioning as the government's bank; these loans are made as the central bank functions as the bankers' bank. 86) The currency is a liability since it is an asset of whoever is holding it. As a result, the currency in this category only includes nonbank currency, or the currency that is in the hands of the public. It does not include vault cash, which is part of the banking system's reserves. 87) Central banks hold foreign exchange reserves for those rare instances when the central bank intervenes in the foreign exchange market. The instances of intervention are rare, especially for the Federal Reserve. 88) This is part of a central bank's disclosure and transparency. Because central banks can control the size of their balance sheets, it is important to reveal to the public what the central bank is doing. This is the main tool people can use to find out if central banks are doing their job properly. Delays in publishing the balance sheet can also delay the discovery of a potential problem. 89) For the check writer, the balance sheet does not change in size and liabilities do not change at all. All that changes is the composition of assets. The student has an increase in the asset called textbooks for $300 and an equal decrease in the asset of bank deposits. For the student's bank, its liabilities of customer deposits decrease by $300, and the asset of reserves decreases by the same amount. For the Fed, the transaction will not impact the size of its balance sheet since the reduction in the reserves of one bank will be offset by an increase in reserves of another once the check is processed.

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90) The purchase of the Treasury securities will increase the asset category called Securities by the amount of $10 million, which is usually the largest asset category for most central banks. The liability category of Reserves will also increase by $10 million. This is done as the Fed will credit the appropriate bank(s) reserve account(s) to pay for the securities. This reflects the Fed's ability to pay for assets by simply creating liabilities. 91) The balance sheet of the banking system doesn't change in size. The liabilities of the banking system do not change, and the total assets don't change. The composition of assets changes, with the asset of securities decreasing by $1 billion and the asset of reserves increasing by $1 billion. For the Fed, the balance sheet increases by $1 billion on both sides. The asset of securities increases by $1 billion and the liability of reserves increases by $1 billion. 92) The liabilities of the Fed will decrease by $100 million. The sale of euros to commercial banks will deplete the reserves of commercial banks as the Fed debits these reserve accounts. On the asset side, the Fed's assets are also decreased by $100 million as the asset category of foreign exchange reserves is now $100 million smaller. 93) There are a couple of reasons. For one, a lot of illegal transactions are carried out using currency. However, if this were the only reason, currency would probably be banned. Most people have transactions they carry out where they prefer to be anonymous. While checks and electronic payments are relatively safe, they do transfer a lot of information to the receiver, including account numbers, names, addresses, etc.

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94) First, governments receive seignorage—the ability to acquire real goods and services in exchange for fiat currency—for issuing notes and coins. The income from this probably exceeds by a significant margin the revenue that could be gained from reducing tax evasion by eliminating paper money. Second, paper currency provides anonymity which is a source of freedom. Even though people sometimes misuse that freedom for criminal gain, in a society with only electronic currency, the government could use the resulting detailed knowledge of payments to exert tyrannical control. Cash provides an option for desired anonymity in payments. Paper currency is at the heart of how we organize our society. 95) As the deposits are made by businesses, the liabilities of the Banking system are increased since these deposits are assets for the Treasury and liabilities of the banks. The asset side of the balance sheet is also increasing as these funds are adding to reserves. Once the funds are transferred to the Fed, the liabilities are decreased by the amount of the transfer but assets are also decreased as the reserve account of the appropriate banks will be debited by the Fed.

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96) Let's start with the grandmother. The only change for her is on the asset side of her balance sheet; when she converted bank deposits to currency her assets didn't change, just the composition, with deposits decreasing by $1,000 and currency increasing by $1,000. Once she presents the gift to you, her assets (currency) will decrease by $1,000, but your asset of currency increases by $1,000. With your deposit of the $1,000 of currency into the bank, the composition of your assets changes from currency to deposits. Now for the Fed, when grandmother converts the $1,000 deposit into currency, the Fed's balance sheet changes only in terms of composition. The reserves decreased by $1,000 and the currency increased by $1,000. With your deposit of the $1000 of currency into the bank, the liability of currency decreased by $1,000 and the liability of reserves increased by $1,000. 97) A simple answer is that the Fed should aim for a balance sheet that has minimal liquidity, maturity, and credit risk. In practical terms, this means a securities portfolio composed largely of Treasury bills and short-term notes with an average maturity that is very short. These holdings are as riskless as possible, and the actions of the Fed would distort financial markets as little as possible. Of course, this says nothing about the quantity of holdings which is more difficult to define. 98) The monetary base itself does not change. The monetary base is made up of nonbank (public) currency and reserves. When people withdrawal funds from their checking accounts banking system reserves decrease but are immediately replaced by increases in currency so the amount in the monetary base is not changed.

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99) The answer for how far below zero the rate can go is “somewhat.” As of early 2020, this level is beyond that still-unknown level and it is a point at which our handling of cash could revert to the early days of goldsmiths when they issued receipts to those who paid them a fee to place gold in their vaults. If depositors are paying banks to hold cash for them, the cash is not excess reserves and not available to be lent out. Thus, the deposit expansion multiplier does not operate. If policymakers tried to reducing interest rates below the ELB threshold in order to simulate the economy, banks would store customers’ cash for a small fee and let them use it to make payments. Instead of providing further economic stimulus, such as rate cut would reduce the supply of bank credit and tighten monetary conditions—just the opposite of the desired result. 100) The sale of the securities will immediately increase the bank's reserves by the value of the sale, which in this case is $1 million. Since the bank's liabilities have not changed, the required reserves for the bank have not changed. As a result, the $1 million increase in reserves is all excess reserves. 101) There can be an opportunity cost to not having them. For example, if customer liquidity (cash) demands are higher than expected, a bank would face the cost of having to quickly become liquid. That could mean selling securities or other assets or borrowing to meet those needs. Another possibility involves uncertainty regarding interest rates. If a banker believes interest rates may rise in the near future, it may be profitable to hold reserves rather than to purchase assets at a lower interest rate than what could have been obtained by waiting.

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102) The monetary base is the sum of reserves and currency in the hands of the public. So, to answer the question we need to consider what happens to public currency and what happens to reserves. Since prepaid travel cards do not alter public currency nor do they deplete the banking system of reserves, the conversion of checkable deposits to prepaid travel cards does not alter the monetary base. 103) The Fed, or any central bank, can create and destroy the monetary base by changing the size of its balance sheet. What it can't control is the currency holdings of the public. If people decide to hold more currency then the banking system will be depleted of reserves, but the monetary base does not change since it is the sum of reserves and public currency holdings. 104) We can use the following equation:

where ΔD = the change in deposits, rD = the required reserve rate, and ΔRR is the change in required reserves. When the Fed purchases $150 million of securities in the open market, these become banking system reserves. Since one of our assumptions is that the banking system does not hold any excess reserves, banks will expand deposits (make loans) until the $150 million injection of reserves is being used as required reserves. Inserting the values of 0.1 for rD and $150 million for ΔRR, we find ΔD = $1.5 billion. 105) M1 consists of public (non-bank) currency and checkable deposits ( D). Any ΔM1 =ΔC + ΔD; since the ΔC = 0, any ΔM1 = ΔD.

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106) Given the required reserves equal $51 billion and there are $510 billion in deposits, we can use the formula where D = deposits and RR = required reserves and rD = the required reserve rate. Substituting in the amounts we find rD = 0.1 or ten percent. We can take the same approach to solving for the excess reserves. First, let’s call the total amount of reserves R and note that R = RR + ER where ER is the amount in excess reserves. In this case, ER = R − RR or $7.65 billion. Now if we let rE represent the excess reserve rate, we can solve for it using the following equation. and, substituting in the actual values, we find that rE = 0.015 or 1.5 percent. 107) We can solve for D using the following equation: ; substituting in the values given, we obtain $574.7 billion. 108) We can answer this by using the following formula,

We need to calculate C/ D; this we can obtain by using information given in the question. C = $692.5 (we'll leave off the billions) and D = $650; so C/ D = $692.5/$650 = 1.065. Next we'll calculate rD which can be found by rD = RR/D where RR represents the required reserves. We find rD = $45.8/$650 or 0.07. Next, we can find rE by first determining the amount in excess reserves, ER. ER = R − RR or ER = $48 − $45.8 = $2.2. rE = ER/D = $2.2/$650 = 0.0033. We have all of the values we need to solve for m. Substituting the values we obtained into the equation shown, we find that m = 2.065/1.138 or m = 2.35.

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109) We can answer this by using the following formula for m, the money multiplier.

C/D is the currency-to-deposit ratio, and this is controlled by the nonbank public as they weigh the costs and benefits of holding cash. rD = RR/D which is the required reserve ratio and is set by the Fed. rE = ER/D which is the excess reserve ratio and is determined by banks as they weigh the costs and benefits of holding excess reserves. The amount of money in the economy is determined by the following: Money = Money Multiplier × Monetary Base The monetary base is controlled by the Fed. Therefore, the quantity of money in the economy depends on decisions made by the Fed, the banking system, and the nonbank public. 110) The answers are provided in the table, and the answers come from analyzing the money multiplier. Use the following formula for m, the money multiplier.

C/D is the currency-to-deposit ratio, and this is controlled by the nonbank public as they weigh the costs and benefits of holding cash. rD = RR/D which is the required reserve ratio and is set by the Fed. rE = ER/D which is the excess reserve ratio and is determined by banks as they weigh the costs and benefits of holding excess reserves. If any of these variables increase, ceteris paribus, money is held out of the expansion process and this will decrease the impact on the money supply. The amount of money in the economy is determined by the following: Money = Money Multiplier × Monetary Base The monetary base is controlled by the Fed. If the monetary base increases, ceteris paribus, this has a direct, positive impact on the quantity of money in the economy. Factor Required reserve-todeposit ratio Currency-to-deposit ratio Excess reserve-todeposit ratio Monetary base

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Who Controls It Central bank

Change Increase

Impact on M Decrease

Nonbank public

Increase

Decrease

Commercial banks

Increase

Decrease

Central bank

Increase

111) The main reason is that the link between the monetary base and the supply of M2 and M3 seemed to break down in the sense that it was no longer constant or predictable. This meant that the money multiplier is unstable or unpredictable. Control of the monetary base does not give central bankers control over the money aggregates over a two- or threeyear period, which is usually the horizon used for short-term policy making. Also, the legal requirement to establish and to announce ranges for money growth had expired. 112) Banks dramatically increased their excess reserve levels for two reasons. First, they were concerned that customers would demand withdrawals. Second, banks were concerned that they would not be able to borrow from other banks. 113) If the Fed increases its discount loans to banks, makes an open market purchase of Treasury securities, or increases its foreign exchange reserves, the impact on its balance sheet will be the same. In each case the Fed's assets and liabilities will both increase; the level of reserves increases, and the monetary base expands. All three of these actions have the same effect because they all result in an increase in the reserves available to the banking system, which, therefore, means an increase in the base.

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114) When a bank borrows in the federal funds market, reserves are just being moved from one bank to another so the monetary base does not change, and the banking system does not have the ability to create or destroy the monetary base. When a bank borrows directly from the Fed by obtaining a discount loan, this increases the Fed's balance sheet, adding the asset of the loan and the liability of the reserves to their balance sheet. The injection of the reserves does increase the monetary base and can have an impact on the money supply. So, in terms of the impact on the monetary base, a discount loan and borrowing in the federal funds market are not equivalent.

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CHAPTER 18 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) The primary monetary policy tool most used by central banks today is A) the quantity of M1. B) interest rates. C) the quantity of M2. D) the size of the money multiplier.

One way the Fed can inject reserves into the banking system is to increase A) the size of the Fed's balance sheet through purchasing securities. B) the discount rate. C) loans to nonbank corporations. D) the size of the Fed's balance sheet through selling securities.

The Fed can control A) the amount of reserves, but cannot control the monetary base. B) the composition of the monetary base, but cannot affect the market interest rate. C) the size of the monetary base but not the price of its components. D) either the size of the monetary base or the price of its components.

The effective lower bound for nominal interest rates is A) zero. B) an unknown level below zero. C) a rate consistent with two percent inflation. D) a rate consistent with the full employment output level of economic activity.

As of 2020, the largest expansion of the Fed’s balance peaked in what year?

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A) 1933 B) 2008 C) 2015 D) 2019

6) The conventional policy tools available to the Fed include each of the following, except which one? A) currency-to-deposit ratio B) discount rate C) target federal funds rate range D) reserve requirement

Which of the following is a conventional tool of monetary policy? A) target federal funds rate range B) deposit rate C) currency-to-deposit ratio D) deposit rate and target federal funds rate range

The FOMC A) sets the federal funds rate. B) uses the discount rate is its primary policy tool. C) sets the target federal funds rate range. D) sets the dealer's spread as the difference between the target and actual federal funds

rate.

The market for reserves derives from the fact that

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A) reserves pay a relatively high return. B) desired reserves do not always equal actual reserves. C) the Fed refuses to lend to banks. D) banks do not want excess reserves.

10)

The fact that there is a market for federal funds enables banks to A) make fewer loans than they would otherwise. B) borrow more from the Fed. C) hold a lower level of excess reserves than they would otherwise hold. D) hold less in required reserves.

11) tool?

Which one of the following would be categorized as an unconventional monetary policy

A) the interest rate on excess reserves (IOER) B) targeted asset purchases C) federal funds rate target range D) deposit rate

12)

Federal funds loans are A) secured loans between banks and the Fed. B) unsecured loans. C) collateralized loans between banks. D) guaranteed by the FDIC.

13)

Until 2008, the Fed could make the market federal funds rate equal the target rate by

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A) mandating that all loans be transacted at the target rate. B) setting the discount rate below the federal funds rate. C) entering the federal funds market as a borrower or a lender. D) paying higher interest on reserves.

14)

Reserve demand becomes horizontal at the IOER rate because

A) banks will not make loans at less than the IOER rate. B) banks must earn more than the IOER rate to lend. C) the reserve supply is always set by the Fed so that the federal funds rate is greater than the IOER rate. D) the IOER rate is the upper bound of the target federal funds rate.

15)

Since the Great Recession in the United States, reserves have been so abundant that the

A) federal funds rate is not easily manipulated with open market operations. B) Fed cannot affect the federal funds rate. C) Fed prefers to target the discount rate. D) IOER (interest rate on excess reserves) is ineffective.

16)

The principal tool the Fed uses to keep the federal funds rate close to the target is

A) the required reserve rate. B) discount lending. C) open market operations. D) the IOER (interest rate on excess reserves).

17) If the market federal funds rate were below the target rate, the response from the Fed would likely be to

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A) raise the IOER (interest rate on excess reserves). B) purchase U.S. Treasury securities. C) sell U.S. Treasury securities. D) raise the discount rate.

18) If the market federal funds rate were above the target rate, the response from the Fed would likely be to

A) purchase U.S. Treasury securities. B) sell U.S. Treasury securities. C) lower the IOER (interest rate on excess reserves). D) lower the discount rate.

19) If the demand for reserves remains constant and the market federal funds rate is below the target rate, the Fed would

A) increase the IOER (interest on excess reserves). B) decrease the IOER (interest on excess reserves). C) do nothing and let the market work. D) increase the supply of reserves.

20) If the current market federal funds rate is in the target rate range and the demand for reserves decreases, the likely response in the federal funds market will be that the market federal funds rate will A) decrease. B) equal the target rate. C) will increase. D) not change because the reserve supply is so high that the market federal funds rate will be unchanged.

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21) If the current market federal funds rate equals the target rate and the demand for reserves increases, the likely response in the federal funds market will be A) a decrease in the market federal funds rate. B) a market federal funds rate that will equal the target rate. C) an increase in the market federal funds rate. D) no change; reserve supply is so high that the market federal funds rate will be unchanged.

22) Consider the following graph. If the Fed increases the IOER from IOER Rate0 to IOER Rate1, they are implementing what type of policy?

A) expansionary monetary policy to increase lending throughout the economy B) tighter monetary controls where there is an increase in the rate at which banks are willing to lend C) loosening of controls such that banks are less aggressively bidding for funds to deposit with the Fed D) no change in monetary policy since reserve supply is so high that the market federal funds rate will be unchanged

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23)

The Fed can do which of the following in the economy? A) change interest rates but not the supply of money B) change the supply of money but not the interest rates C) change both interest rates and the supply of money D) change neither interest rates nor the supply of money

24)

The daily reserve supply curve is A) upward-sloping. B) downward-sloping. C) vertical. D) horizontal.

25)

If the Fed sees no need to engage in expansionary monetary policy, then A) the Fed will likely shrink its balance sheet rapidly. B) eventually, the Fed will shrink its balance sheet by letting securities it holds expire. C) it will be impossible for the Fed to shrink its balance sheet. D) the Fed is likely to increase the size of its balance sheet.

26)

Discount lending by the Fed A) is the key component of monetary policy. B) is more important today than in years past. C) is usually small except in times of crisis. D) amounts to five billion dollars in volume during an average week.

27)

Discount lending is part of the Fed's function of

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A) lender of last resort. B) open market operations. C) the government's bank. D) regulation of banking.

28)

When the Fed wants to tighten monetary policy, the staff of the Fed is likely to

A) increase discount loans. B) increase IOER (interest rate on excess reserves). C) purchase U.S. Treasury Securities. D) sell U.S. Treasury Securities.

29) Since 2012, what does the ECB frequently use to inject reserves into the banking systems of countries that use the euro? A) discount loans B) repurchase agreements C) an outright purchase of securities D) an outright sale of securities

30)

The interest rate on excess reserves is A) the upper bound of the federal funds target rate range. B) the lower bound of the federal funds target rate range. C) unrelated to the federal funds target rate range. D) equal to the target federal funds rate.

31)

How did the Federal Reserve change its discount lending practices in 2002?

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A) For most of its history the Federal Reserve has loaned reserves to banks at a rate equal to the target federal funds rate; after 2002, the rate would be below the target federal funds rate. B) The changes made in 2002 have made it more difficult for the Fed to meet its interest-rate stability objective. C) Before 2002, the Fed discouraged banks from borrowing at the discount window and actually created volatility in the market for reserves. D) Since 2002, the Fed controls the quantity of credit extended as well as its price.

32)

The Fed will make a discount loan to a bank during a crisis A) no matter what condition the bank is in. B) only if the bank is sound financially and can provide collateral for the loan. C) but if the bank doesn't have collateral the interest rate is higher. D) only if the bank would fail without the loan.

33)

For most of the Fed's history, the Fed A) loaned reserves at an interest rate below the target federal funds rate. B) provided far more loans to banks than they did to each other. C) was very lenient in making discount loans. D) tied the discount rate to the rate on Treasury securities.

34)

The fact that, for most of its history, the Fed was reluctant to make discount loans A) at times was a destabilizing force for financial markets. B) proved to be a very stabilizing force for financial markets. C) pushed the discount rate above the target federal funds rate. D) resulted in only banks in very strong financial shape borrowing from the Fed.

35)

The types of loans the Fed makes consist of each of the following, except which one?

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A) primary credit B) conditional credit C) seasonal credit D) secondary credit

36)

Primary credit extended by the Fed is

A) for banks needing long-term loans to work out financial problems. B) the highest interest rate loans offered by the Fed. C) short-term, usually overnight loans. D) loans offered at the prime interest rate for periods exceeding 30 days but less than one year.

37)

The interest rate on primary credit extended by the Fed is A) below the IOER. B) above the IOER. C) equal to the IOER. D) consistently uncorrelated with the IOER.

38)

Secondary credit provided by the Fed is designed for banks that A) qualify for a lower interest than what is available under primary credit. B) are in trouble and cannot obtain a loan from anyone else. C) want to borrow without putting up collateral. D) are foreign.

39)

The interest rate the Fed charges for secondary credit is

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A) above the primary discount rate. B) below the market federal funds rate. C) below the primary discount rate. D) equal to the market federal funds rate.

40)

Seasonal credit provided by the Fed is not as common as it used to be because A) there are fewer banks in these areas. B) other sources for long-term loans have developed for banks in these areas. C) it has been replaced by secondary credit. D) much of the credit was not repaid.

41)

The Fed is reluctant to change the required reserve rate because

A) changes in the rate have a small impact on the actual quantity of money. B) the money multiplier is not impacted by the required reserve rate. C) the time lag between changing the required reserve rate and changes in the money supply can be too long. D) small changes in the required reserve rate can have too big of an impact on the money multiplier and the level of deposits.

42)

In 1936, when the Fed doubled the reserve requirements, bank executives

A) allowed their excess reserves to decline. B) increased excess reserves to the new proposed level in advance of the change in requirements. C) maintained the level of excess reserves desired by the Fed. D) increased lending from remaining reserves, causing inflation.

43)

Today, reserve requirements are

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A) set in a way that makes reserve demand highly unpredictable. B) changed whenever the target federal funds rate is changed. C) changed instead of making changes in the discount rate. D) not often used as a direct tool of monetary policy.

44) For the European Central Bank (ECB), the equivalent of the FOMC's target federal funds rate is the A) target discount rate. B) European target federal funds rate. C) target refinancing rate. D) London Inter-Bank Offer Rate.

45)

The European Central Bank’s equivalent of the Fed's open market operations (OMO) is

A) very similar to the Fed's OMO in that they are highly centralized. B) dissimilar to the Fed's OMO in that the operations are conducted at all 19 of the National Central Banks simultaneously. C) similar to the Fed's OMO in that they accept only U.S. Treasury securities in their refinancing operations. D) dissimilar to the Fed's OMO because fewer banks participate in the auctions of the securities.

46)

The European Central Bank's Marginal Lending Facility is used to provide A) short-term loans to banks at rates below the target refinancing rate. B) long-term loans to banks at rates above the target refinancing rate. C) short-term loans at rates above the target refinancing rate. D) long-term loans to banks at rates below the target refinancing rate.

47)

The ECB's

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A) marginal lending facility was the model for the Fed's redesign of its procedures for lending to banks. B) success in controlling reserves by paying interest on them has led the Fed to do the same. C) weekly auctions include only a few of the largest banks in Europe. D) marginal lending facility was modeled after the Fed's redesign of its procedures for lending to banks.

48)

Within the European Central Bank, banks with excess reserves A) can deposit them with the ECB and earn an interest rate below the target refinancing

rate. B) earn no interest on excess reserves, similar to the system in the United States. C) must deposit the excess with the ECB's Deposit Facility. D) lend them to other banks through overnight loans.

49) As of 2019, even though the ECB charges a fee for accepting excess reserves, banks have not switched from holding reserves to holding cash in their vaults. Were they to make that switch, the policy impact of the negative deposit rate would become A) negligible. B) expansionary. C) contractionary. D) indeterminate.

50) Prior to the euro-area crisis, the ECB’s deposit facility contained nearly all of the excess reserves in the Eurosystem’s banks. What has changed this in recent years?

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A) The deposit facility interest rate fell. B) Commercial banks increased their lending to other commercial banks. C) ECB policy changed, which made it more difficult to keep reserves in the deposit facility. D) As the ECB began selling large quantities of sovereign bonds, banks’ excess reserve levels fell dramatically.

51) One key difference between reserve requirements for the Fed and the European Central Bank (ECB) is that the ECB's reserve requirements are A) at a much higher rate than the Fed's. B) more difficult for banks to predict. C) determined annually. D) based on all of a bank’s liabilities.

52)

The European equivalent of the U.S. market federal funds rate is called the A) overnight cash rate. B) target refinancing rate. C) European discount rate. D) overnight repurchase rate.

53)

The FOMC

A) and the ECB are equally successful at keeping the target rate in range. B) has always been more successful than the ECB at keeping the market rate closer to the target. C) was more successful than the ECB at keeping the market rate closer to the target rate until the Fed began paying interest on reserves. D) was less successful than the ECB at keeping the market rate closer to the target rate until the Fed began paying interest on reserves.

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54) Over the years, most monetary policy experts would agree with each of the following statements, except which one? A) The reserve requirement is not useful as an operational instrument. B) Central bank lending is necessary to ensure financial stability. C) Short-term interest rates are the best tool to use to stabilize short-term fluctuations in prices and output. D) Transparency in policy making hinders accountability.

55)

A good monetary policy instrument is A) observable only to monetary policy officials. B) tightly linked to monetary policy objectives. C) controllable and rigid. D) difficult to change.

56) The reserve requirement does not meet all of the criteria of a good monetary policy tool, because it A) is not controllable. B) is not observable. C) cannot be quickly changed. D) has a predictable impact on the economy.

57) From 1979 to 1982, the Fed targeted bank reserves as the monetary policy tool. One side effect of this strategy was that A) the inflation rate increased to over 18 percent in 1983. B) many banks failed that otherwise may not have. C) interest rates rose very high. D) inflation remained high for most of the 1980s.

58) In the period of 1979 to 1982, if the Fed had set an interest rate target that was equal to the actual market interest rates that occurred, the Version 1

A) economy would have been better off. B) target would not have been politically acceptable. C) target would have been a federal funds rate of 0 percent. D) inflation rate would have risen further.

59) If reserve demand is volatile, in order for the central bank to keep interest rates from being volatile, it must A) target the quantity of reserves. B) set targets for both interest rates and the quantity of reserves. C) not target the interest rates. D) let the quantity of reserves fluctuate.

60) During the 1990s many countries developed a monetary policy framework that focused on inflation targeting. This is an example of policymakers focusing A) directly on an objective. B) on multiple numerical targets. C) exclusively on an intermediate target that will effectively result in the final objective. D) on development of a new intermediate target that will effectively result in the final objective.

61) Often, central banks that employ inflation targeting have a hierarchical mandate that means that A) hitting the inflation target is the first priority after all other stated objectives are reached. B) hitting the inflation target is the only objective. C) the inflation target is the second most important goal after economic growth, which is always the most important goal for monetary policymakers. D) hitting the inflation target comes first, and everything else comes second.

62)

Inflation targeting does all of the following, except which one?

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A) increase policymakers' credibility B) increase policymakers' accountability C) communicate policymakers' objectives clearly and openly D) hinder economic growth

63)

The Taylor rule is

A) the formula for setting monetary policy that is followed explicitly by the FOMC. B) an approximation that seeks to explain how the FOMC sets their target. C) an explicit tool used by the ECB but not the Fed. D) a rule adopted by Congress to make the Fed's monetary policy more accountable to the public.

64) The components of the formula for the Taylor rule include each of the following, except which one? A) target federal funds rate B) current inflation rate C) 30-year U.S. Treasury bond rate D) inflation gap

65)

The Taylor rule allows the real long-term interest rate to A) fluctuate with the natural rate of interest. B) be zero. C) be 5 percent less the inflation rate. D) be 1 percent.

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66)

Use the following formula for the Taylor rule to determine the target federal funds rate.

target federal funds rate = natural rate of interest + current inflation + ½(inflation gap) +½(output gap) where the current rate of inflation is 5percent, the natural rate of interest is 2percent, the target rate of inflation is 2percent, and output is 3percent above its potential, the target federal funds rate is A) 6.5percent. B) 2.5percent. C) 3.5percent. D) 10percent.

67)

Use the following formula for the Taylor rule to determine the target federal funds rate.

target federal funds rate = natural rate of interest + current inflation + ½(inflation gap) +½(output gap) where the current rate of inflation is 4percent, natural rate of interest is 2percent, target rate of inflation is 2percent, and output is 3percent above its potential, the target federal funds rate is A) 7percent. B) 8.5percent. C) 5percent. D) 4.5percent.

68)

Use the following formula for the Taylor rule

target federal funds rate = natural rate of interest + current inflation + ½(inflation gap) +½(output gap) to determine what would happen if output in the economy were to fall by an additional one percent below potential. Then, the target federal funds rate would

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A) increase by 1.5percent. B) decrease by 1.5percent. C) remain at 2.5percent. D) decrease by 0.5percent.

69)

Use the following formula for the Taylor rule

target federal funds rate = natural rate of interest + current inflation + ½(inflation gap) +½(output gap) to determine what would happen if the inflation rate in the economy were to fall by 2percent below the target inflation rate. Then, the target federal funds rate would A) decrease by 3.0percent. B) remain at 2.5percent. C) decrease by 1.0percent. D) increase by 1.0percent.

70)

Use the following formula for the Taylor rule

target federal funds rate = natural rate of interest + current inflation + ½(inflation gap) +½(output gap) to determine the change in the target federal funds rate for every one percent decrease in the rate of inflation. This will A) raise the target federal funds rate by 1.5percent. B) lower the target federal funds rate by 0.5percent. C) lower the target federal funds rate by 1.5percent. D) raise the target federal funds rate by 0.5percent.

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71)

Use the following formula for the Taylor rule

target federal funds rate = natural rate of interest + current inflation + ½(inflation gap) +½(output gap) to determine the change in the target federal funds rate for every one percent increase in the rate of inflation. This will A) increase the real federal funds rate by 1.5percent. B) increase the target federal funds rate by 1.5percent. C) increase the real federal funds rate by 0.5percent. D) increase the target federal funds rate by 1.5percent and increase the real federal funds rate by 0.5percent.

72)

The measure for the actual rate of inflation used in the Taylor rule is the A) personal consumption expenditure index. B) GDP deflator. C) consumer price index. D) producer price index.

73) Recent research by Fed researchers put the natural rate of interest at what level as of late 2018? A) −1 percent B) 1/2 percent C) 0 percent D) 2 percent

74) tool?

Which one of the following would not be considered an unconventional monetary policy

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A) discount rate B) policy duration commitment C) quantitative easing D) credit easing

75)

Unconventional monetary policy tools include all of the following, except which one? A) quantitative easing B) forward guidance C) targeted asset purchases D) reserve requirement

76)

The key to the success of forward guidance as a monetary policy tool is A) timing. B) a favorable exchange rate. C) transparency. D) credibility.

77)

Forward guidance includes

A) statements today about policy targets in the future. B) expansion of the supply of aggregate reserves beyond the amount needed to maintain the policy rate target. C) asset purchases that shift the composition of the Fed’s balance sheet. D) statements of policy changes and dates those changes will take effect.

78)

Quantitative easing is

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A) statements today about policy targets in the future. B) expansion of the supply of aggregate reserves beyond the amount needed to maintain the policy rate target. C) asset purchases that shift the composition of the Fed’s balance sheet. D) expansion of the demand for aggregate reserves to drive down the IOER.

79)

Targeted asset purchases are

A) statements today about policy targets in the future. B) expansion of the supply of aggregate reserves beyond the amount needed to maintain the policy rate target. C) asset purchases that shift the composition of the Fed’s balance sheet. D) asset purchases that increase the reserves held by the federal government.

80)

Unconventional policy tools are useful when A) lowering the target interest rate to zero is not sufficient to stimulate the economy. B) conventional policy tools result in shifts in the economy that are too large. C) conventional policy tools support only growth in the economy. D) restrictive monetary policy is necessary.

81)

Raising interest rates following the use of unconventional policy tools depends on

A) the size and composition of the central bank’s balance sheet. B) the toolbox available to the central bank. C) both the size and composition of the central bank’s balance sheet and the toolbox available to the central bank. D) neither the size and composition of the central bank’s balance sheet and the toolbox available to the central bank.

82) While GDP was once a key cyclical indicator, its usefulness has declined substantially for all of the following reasons except which one?

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A) lack of timeliness B) requires seasonal adjustment C) constant revisions for decades D) contains too much information

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 83) As stated by the textbook authors, “Central bankers have a long list of goals and a short list of tools they can use to achieve them.” What are the goals and what are the tools available to central bankers? What primary tool do most central bankers use today? Why?

84) In 2001, the FOMC lowered the target federal funds rate 11 times, cutting the rate from 6½ percent to 1¾ percent. Why didn't the Fed just cut the rate by larger amounts early on?

85) State and briefly define the leading conventional tools of monetary policy available to the Federal Reserve.

86) Why is it necessary to distinguish between the target federal funds rate range and the market federal funds rate?

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87) Could the Fed impact the amount of borrowing in the federal funds market without changing their target for the federal funds rate? Explain.

88) What is the difference between the zero lower bound (ZLB) and the effective lower bound (ELB) for nominal interest rates?

89) Compare the supply curve in the market for bank reserves prior to 2008 with the supply curve following the financial crisis. Include a graph or two as part of your answer.

90)

Is discount lending used to keep banks from failing? Explain your answer.

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91) Discuss why the discount rate may be considered a penalty rate of interest charged to banks.

92) Since 2002, the Fed has set the primary discount rate above the IOER rate. Why is this likely to prevent spikes in the market federal funds similar to the ones that occurred in previous years?

93) What is the difference between primary and secondary credit offered by the Fed, and who would use secondary credit?

94) What is the consensus among economists and other monetary policy experts regarding the usefulness of the monetary policy instruments available to central banks in normal times?

95)

Explain the three desirable features of a good monetary policy instrument.

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96) Why is publicly announcing a numerical inflation target an important part of an inflation targeting strategy for a central bank?

97) In terms of desirable features of a monetary policy instrument, explain why the size of the staff at the Fed is not a good policy instrument. Be sure to address which feature(s) it fits and which one(s) it doesn't.

98) The Fed could use reserve requirements as a monetary policy instrument. In terms of desirable features for policy instruments, assess the viability of using reserve requirements.

99) Discuss why the Fed can independently set both a quantity (aggregate reserves) and a price (interest rate) target unlike other monopolies.

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100) We saw in Chapter 18 that many central banks have turned to a policy framework of inflation targeting. Discuss whether this would be effective in a country experiencing deflation.

101) Discuss the key criteria for success and the advantages of a central bank adopting the framework of inflation targeting.

102) Is the Taylor rule the specific formula followed by the FOMC to set federal funds rate targets? Explain.

103) Consider the following Taylor rule. target federal funds rate = natural rate of interest + current inflation + 2x(inflation gap) + x(output gap) What do the relative sizes of the coefficients on the inflation and output gaps (2x, x) reveal?

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104) Consider the following Taylor rule. target federal funds rate = natural rate of interest + current inflation + ½(inflation gap) + ½(output gap) Since the coefficients on the inflation and output gaps are equal, does this mean the central bank will respond to a one percent increase in inflation with the same change in the target rate as they would initiate from a one percent increase in the output gap? Explain

105) Consider the following Taylor rule. target federal funds rate = natural rate of interest + current inflation + ½(inflation gap) + ½(output gap) Explain what happens to the real interest rate and why it happens, each time inflation increases by 1 percent.

106) The targeted federal funds rate set by policymakers deviated from the Taylor rule in 1992–93, 2002–05, and 2008–13. Specifically, the FOMC set the target below the Taylor rule measure. What do these periods have in common that might help explain this?

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107) What is your response to the following statement? "The Taylor rule shows a strong correlation between the target rate actually set by the FOMC and the one predicted by the rule. Since the Taylor rule would provide accountability, credibility, and transparency, the FOMC committee should be dissolved and replaced by a form of the Taylor rule."

108) Under what conditions might it be appropriate for a central bank to employ unconventional monetary policy tools?

109) What were the three unconventional policy approaches used by the Fed during the financial crisis of 2007–2009?

110)

How does a policy of forward guidance influence the economy and inflation?

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111)

How do targeted asset purchases alter the outlook for the economy and inflation?

112)

What are the advantages from the 2002 change in the Fed's lending policy?

113) Imagine the inflation rate begins to rise rapidly. The FOMC meets, and it is believed that the target interest rate needed to stem the inflation could easily exceed 20 percent. Many members of the committee believe the Fed cannot announce this high of a target for political reasons. Discuss what the FOMC could do in terms of targets and what change occurred in 2002 that is going to make their job a bit more difficult.

114) Discuss what experience concerning required reserves occurred during the Great Depression that contributes to the decision today not to use required reserves as an active tool of monetary policy.

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Answer Key Test name: Chap 18_6e 1) B 2) A 3) D 4) B 5) C 6) A 7) A 8) C 9) B 10) C 11) B 12) B 13) C 14) A 15) A 16) D 17) A 18) C 19) A 20) D 21) D 22) B 23) C 24) C 25) B 26) C Version 1

27) A 28) B 29) C 30) A 31) C 32) B 33) A 34) A 35) B 36) C 37) B 38) B 39) A 40) B 41) D 42) B 43) D 44) C 45) B 46) C 47) A 48) A 49) C 50) A 51) D 52) A 53) D 54) D 55) B 56) C Version 1

57) C 58) B 59) D 60) A 61) D 62) D 63) B 64) C 65) A 66) D 67) B 68) D 69) A 70) C 71) D 72) A 73) B 74) A 75) D 76) D 77) A 78) B 79) C 80) A 81) C 82) D

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83) Central bank goals include stabilizing prices, output, the financial system, exchange rates, and interest rates. In terms of tools, they control their own balance sheet and have a monopoly on the supply of currency and reserves. Policymakers can change the size of the monetary base by buying and selling assets—primarily government securities in the case of the Fed—and by making loans to banks. They can also alter the mix of assets they hold. Today, the primary tool used by central banks is interest rates. The Fed influences the market federal funds rate by adjusting the interest rate it pays on excess reserves that banks hold at the central bank (the IOER rate). When interest rates are above zero and reserves are abundant, the target range for the federal funds rate and the IOER rate are the primary tools of monetary policy. Quantitative easing following the Great Recession increased the supply of reserves to a point at which small open market operations have no effect on the federal funds rate. However, the Fed can change the IOER rate and influence bank behavior and other interest rates. This is why interest rates have become the primary policy tool in today’s world. Adjusting the size and composition of their balance sheet is a tool used during financial crisis or when policymakers judge conventional interest rate policy to be inadequate. In addition, they can use communications with the public to influence expectations about future interest rate policy. 84) There are at least a couple of parts to this answer. One part is that the FOMC does not know how the economy will react to each cut. If the cuts are too aggressive and the economy picks up dramatically, the FOMC could be sowing the seeds for high rates of inflation in the long run. The other is that changes in interest rates by the FOMC have to work through the links from the operating instrument to the ultimate objective, and this takes time. The FOMC likely wanted to see how the economy would respond to small cuts before taking further action.

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85) The tools are: (1) the target federal funds rate range, the range for the interest rate at which banks make overnight loans to each other; (2) the interest rate on excess reserves (IOER), the interest rate paid by the Fed on reserves that banks hold in their accounts at the central bank in excess of reserve requirements; (3) the discount rate, the interest rate the Fed charges on the loans it makes to banks; and (4) the reserve requirement, the level of reserves (vault cash or deposits at the Fed) a bank is required to hold. 86) The need to distinguish the two comes from the fact that while the FOMC can set a target range that they would like to see for the federal funds rate, the actual rate is determined in the market, meaning it is set by supply and demand. The Fed alters the supply of reserves, usually early in the day. However, the demand for reserves is not certain and can change. So, the actual market federal funds rate can and does deviate from the target. 87) Once the Fed sets a target federal funds rate, the actual quantity of funds that will be borrowed (loaned) will be determined by the demand for reserves. The Fed does not enter the market from the demand side so their impact here is really nonexistent. The fact that they will make discount loans at a rate 100 basis points above the target federal funds rate keeps a ceiling on how high the market rate will go which does impact the amount of borrowing. But, this discount rate is really set once the Fed announces the target. The reality is that once the Fed sets the target, then the demand for reserves, which they do not control, will determine the quantity of reserves that will be borrowed in the federal funds market.

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88) The term zero lower bound for nominal interest rates has been in common use for some time because of the widespread belief that commercial banks could always hold cash in lieu of reserves, and so central banks could not reduce policy rates below zero. Recent experience shows that, due to the transactions costs of holding cash— which include storage, transportation, and insurance—it is possible to lower rates below zero, but there is still an effective lower bound at which intermediaries and their customers will switch to holding cash. So, the concept of a zero lower bound has now given way to the concept of the effective lower bound—below zero.

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89) The supply curve in the market for bank reserves is initially vertical until the market federal funds rate reaches the discount rate. At that point banks will borrow from the Fed rather than paying the higher interest rate in the market. At that point the supply curve becomes horizontal. Graphically, it looks something like an uppercase F without the lower horizontal piece, or an L that has been flipped upside down. Following the quantitative easing that took place in response to the financial crisis, the reserve supply became vertical because banks have significant excess reserves, making the reserve demand become perfectly elastic at the IOER rate and removing the need for the Fed to lend elastically at the discount rate. The graphs should look like Figures 18.2 and 18.3 from the textbook, as shown here.

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90) Not really. Discount loans to banks made by Fed require the bank post adequate collateral. If a bank has adequate collateral and is in good shape, under most circumstances it should be able to borrow from another bank at the federal funds rate that, since 2002, is below the discount rate. If a bank has to come to the Fed for a loan it is a bank that cannot get a loan from another bank, and if they can't provide collateral they are a bank that is likely to and probably should fail. The Fed may try to merge the bank into another bank; however, discount lending is not used to keep insolvent banks afloat. 91) The discount rate could be considered a penalty rate because it is set above the IOER rate. As a result, any bank borrowing from the Fed will pay a higher interest rate than they would pay if they used the federal funds market. A bank which then borrows from the Fed is paying a penalty for either not using the market first (though this is unlikely) or more likely, not being financially stable enough to warrant a loan from another bank.

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92) Prior to 2002 the Fed discouraged banks from borrowing from them, primarily because the discount rate was low. Now a bank would borrow from the Fed if the rate it was going to pay to the Fed were less than the market federal funds rate (assuming the bank has adequate collateral to borrow from the Fed). In those situations where the demand for reserves is high, most banks would turn to the Fed before paying a market rate that is more than 100 basis points above the target rate. To the degree that banks turn to the Fed instead of borrowing from each other, the demand for federal funds would ease and the market rate would not rise as much as it otherwise might. 93) Primary credit is what is usually considered discount loans. These are short-term (usually overnight) loans where the interest rate is set over the IOER rate. Secondary credit is available for institutions that are not financially sound enough to qualify for primary credit. The interest rate is set above primary credit, and the loans are usually sought by institutions experiencing financial difficulty, but can, with time, resolve their problems without failing and can convince the Fed that they can do so. 94) The consensus seems to be that discount lending and reserve requirements are not very useful in terms of addressing short-term economic fluctuations. While discount lending can address short-term financial instability, it isn't very useful in addressing short-term fluctuations in prices and output. Consensus seems to be that short-term interest rates are the tool to use to address fluctuations in prices and output.

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95) The desirable features of a policy instrument are (1) the instrument must be easily observable by everyone; (2) it must be controllable and quickly changed; and (3) it must be tightly linked to the policymakers' objectives. These features seem obvious. A policy tool wouldn't be very useful if you couldn't observe it, control it, or predict its impact on your objectives. 96) Publicly announcing the target underscores the central bank’s commitment to price stability and establishes credibility as long as the central bank also routinely acts to achieve the goal. Everyone will believe that inflation will be low and will act accordingly in making decisions. Long-term expectations of low inflation will anchor low longterm interest rates and promote economic growth. The goal is to convince people that monetary policy will deliver low inflation, and if central bankers are resolute, it often works. 97) The desirable features of a policy instrument are that the instrument must be easily observable by everyone, must be controllable and quickly changed, and it must be tightly linked to the policymakers' objectives. The size of the staff at the Fed certainly is observable by everyone and it is controllable and easily changed. However, it fails as an effective instrument because it is not tightly linked to the policymakers' objectives.

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98) Reserve requirements are certainly observable by everyone. The Fed could announce these publicly so everyone would know what they are. The problems arise with the features of controllability and the ability to change these quickly. They would have to be announced with enough time for banks to adjust; also, as we saw with the money multiplier, the Fed cannot control the amount of excess reserves the banks hold. If banks really believed the Fed would change the reserve requirements often, they may hold considerable excess reserves and then the link between the instrument and the ultimate objective would be seriously weakened. 99) The Fed sets monetary policy primarily through the IOER rate. This allows the Fed to raise the interest rate in the economy without altering the supply of reserves because the amount of reserve supply is greater that reserve demand at IOER. 100) For a country experiencing deflation, the central bank would obviously set a target for at least a zero rate of inflation and possibly a 1 or 2 percent positive rate. By setting this target, the central bank would expand the money supply enough and hopefully convince people that it will act to bring about the target rate so that people begin to alter their expectations for the future and build these target rates into their decisions. It could be effective if the central bank is credible.

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101) Inflation targeting is a framework where a central bank announces a specific target for inflation. The central bank then focuses its attention on using the operational instrument(s) to reach the ultimate objective of the inflation target. The advantages include accountability for the central bank since everyone knows the target and can gauge the performance of the central bankers. The key criteria for success would include selecting the right measure of inflation. It should be one that people outside of the central bank can calculate. Credibility is also key; the central bank has to make it clear that it takes the target seriously. As the text mentioned, most central banks that have used inflation targeting operate under a "hierarchical mandate" where inflation comes first and everything else comes second. 102) The simple answer is no, the FOMC does not have an explicit formula or target. Professor Taylor developed the rule by tracking, over time, the actual target rates announced by the FOMC and relating these to the real interest rate, the inflation rate, and output. By observing these values over time along with the announced target, Professor Taylor was able to develop the rule. 103) In this case the coefficient on the inflation gap is twice as large as the coefficient on the output gap so central bankers are more concerned with deviations of inflation from its target than with deviations of output from its potential. 104) The coefficient on the gaps are the same; however, the rule has a bias toward inflation in that it includes the current rate of inflation as a term. If the rate of inflation increases by 1 percent, the target interest rate actually would increase by 1.5 percent since the current inflation rate would be 1 percent higher and the additional 0.5 comes from the inflation gap times ½. If the output gap increases by 1 percent, the target interest rate will be increased by 0.5 percent.

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105) Each time inflation increases by 1 percent the target interest rate increases by 1.5 percent since the current inflation rate would be 1 percent higher and the additional 0.5 comes from the inflation gap times ½. If the target interest rate, which is a nominal rate, is increased by 1.5 percent, while the rate of inflation increased only 1 percent, this tells us that the real interest rate has increased by 0.5 percent since the real interest rate is the nominal interest rate less the rate of inflation. 106) These periods were characterized by at least one of two factors: (1) unusually stringent conditions across an array of financial markets or (2) deflationary worries that arose as nominal interest rates approached zero. In either case, when financial conditions are much stronger or much weaker than usual, policymakers seeking to stabilize the economy may set an interest rate target that differs substantially from the Taylor rule. 107) While the correlation might be high, there are at least two problems with replacing the FOMC with the rule. First, the Taylor rule cannot handle financial panics or sudden threats to financial stability, such as terrorist attacks. The other key problem is monetary policy relies on real-time data, which means data available at the time. Economic data is constantly being revised and the correlation between the target FOMC rates set and the ones predicted by the Taylor rule were observed using economic data that was revised many times. The same correlation may not exist if data available at the time the policy was formulated was used in the rule.

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108) Two specific circumstances when additional policy tools can play a useful stabilization role are (1) when lowering the target interest rate to zero (or to the ELB) is not sufficient to stimulate the economy and (2) when an impaired financial system prevents conventional interest rate policy from supporting economic growth. In both cases, unconventional monetary policy can add to the stimulus already coming from conventional policy. 109) The first was declaring a commitment to keeping interest rates low in the future (forward guidance). The second was supplying aggregate reserves beyond the quantity needed to lower the policy rate to zero or the ELB (quantitative easing). The third was altering the mix of assets in its balance sheet in order to change their relative interest rates in a way that stimulates the economy (targeted asset purchases). 110) Forward guidance is guidance today about policy target rates in the future. If the forward guidance is credible, it can influence expectations about future short-term interest rates. This will lower longterm interest rates and increase private spending. 111) By selling short term securities like U.S. Treasury bills and buying mortgage-backed securities the Fed alters its mix of default-free and credit-risk assets. This can influence both the cost and availability of credit. By its acquisition of MBS the Fed increases the overall demand for the asset, boosts its price, and lowers its yield.

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112) Prior to 2002 the Fed set a discount rate that was below the target federal funds rate and then really dissuaded banks from borrowing. A bank had to show it was credit worthy by having collateral for the loans and banks had to exhaust other sources. Often this resulted in driving the market federal funds rate well above the target rate set by the Fed. In 2002 the Fed changed their lending policy to provide loans to any bank in good financial shape and to make these loans at a rate above the market rate (100 basis points above). Now a bank that has adequate collateral has an incentive to borrow from the Fed if the market rate is more than 100 basis points above the target rate. The fact that financially healthy banks can borrow from the Fed at this higher rate should, most of the time, place an upper limit on how much the market federal funds rate exceeds the target rate, therefore lowering the volatility of the market rate around the target rate. 113) One thing the FOMC could do is instead of an interest rate target, they could set a quantity target, such as reserves or the monetary base. By doing this they do not explicitly announce a high interest rate target and can escape the responsibility for the high rates. In 2002 discount lending policy was altered to where banks can borrow primary credit from the Fed at a rate 100 basis points over the target federal funds rate. The Fed would have to announce that they are no longer targeting the federal funds rate and then possibly alter the discount lending policy to be 100 basis points over the market federal funds rate (or some average of the market rate over a period of time), or if they leave a target rate in place that turns out to be too low relative to the market rate so banks borrow heavily from the Fed, they will have to withdraw reserves from the system as banks are borrowing them using open market operations.

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114) Following the banking crisis of the early years of the Depression many banks began accumulating excess reserves, likely to have insurance in the event of a run on their bank. The Federal Reserve Board viewed the high level of excess reserves as potential fuel for a rapid expansion of deposits and loans, which could become potentially inflationary. In mid- to late August 1936 the Fed used their powers to effectively double the reserve requirement. Bank executives used the following year to rebuild their reserve balances back to where they were. Even though the monetary base was quite stable this action forced the amounts in M1 and M2 lower, which meant the money multiplier was lower, and economic activity followed the path of M1 and M2 as GDP fell more than 10 percent in 1937.

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CHAPTER 19 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) Within the United States, every city has A) a fixed exchange rate with every other city. B) a floating exchange rate with every other city. C) their own currency board. D) an independent monetary policy.

2) If capital flows freely between countries and a country has a fixed exchange rate, one thing you know is that the country A) exports more than it imports. B) must have ample gold reserves. C) cannot have a discretionary monetary policy. D) must be running large trade deficits.

Purchasing power parity implies A) a basket of goods should sell for the same price in all countries, even if trade barriers

exist. B) a basket of goods cannot sell for the same price in different countries due to the different wage rates. C) as long as all goods and services are traded freely across international boundaries, one unit of domestic currency should buy the same basket of goods anywhere in the world. D) a basket of goods will sell for the same price in all countries as long as there are no trade barriers is a free flow of capital across borders.

4) If inflation in country A exceeds inflation in country B, purchasing power parity implies that the

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A) currency of country B should depreciate relative to the currency of country A. B) inflation rate in country B will rise to match the inflation rate in country A. C) currency of country A will depreciate relative to the currency of country B. D) inflation rate in country A will fall to match the inflation rate in country B.

5) If inflation in country A exceeds inflation in country B, we can express the percentage change in the units of currency of country A per unit of currency of country B as the A) inflation rate in country B—the inflation rate in country A. B) inflation rate in country A—the inflation rate in country B. C) inflation rate in country A times the inflation rate in country B. D) inflation rate in country A divided by the inflation rate in country B.

6) If the inflation rate in country A is 3.5percent and the inflation rate in country B is 3.0 percent, we should expect the percentage change in the number of units of country A's currency per unit of country B's currency to be A) +0.5 percent. B) −0.5 percent. C) +16.7 percent. D) +6.5 percent.

7) If a U.S. dollar currently purchases 1.3 Canadian dollars and the inflation rate in Canada over the next year is 5 percent while it is 2 percent in the United States, we should expect a U.S. dollar to purchase A) 1.365 Canadian dollars. B) 1.262 Canadian dollars. C) 1.300 Canadian dollars. D) 1.339 Canadian dollars.

8) Assuming the free flow of capital across borders, if country A wants to fix its exchange rate with country B, then Version 1

A) country A's inflation rate will have to exceed country B's. B) country A's monetary policy must be conducted so the inflation rate in country A matches the inflation rate in country B. C) country A's monetary policy will be updated frequently to address domestic issues. D) the difference between country A's inflation rate and country B's inflation rate must be equal to the policy objective for stable prices.

Assuming the free flow of capital across borders, a central bank

A) can have an independent inflation policy and an exchange rate that doesn’t fluctuate. B) cannot have both a fixed exchange rate and an independent inflation policy. C) in most industrialized countries favors fixing exchange rates because their primary concern is on domestic inflation. D) in most industrialized countries focuses on fixed exchange rates.

10)

Purchasing power parity is a good theory of explaining exchange rate behavior over A) very short periods. B) periods lasting six to twelve months. C) both long and short periods. D) very long periods, such as decades.

11)

In the short run, a country's exchange rate is determined by A) monetary policy. B) purchasing power parity. C) the domestic inflation rate. D) supply and demand.

12)

International capital mobility

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A) contributes to the rigidity of exchange rates. B) contributes to the equalization of expected returns across countries. C) eliminates arbitrage opportunities. D) makes interest rates equal across countries.

13)

If the bonds of two different countries are identical, their expected returns will be equal A) if capital flows freely internationally. B) only if the exchange rate between the two countries is fixed. C) always. D) only if the inflation rate is the same in each country.

14) When arbitrage occurs across countries with a flexible exchange rate and when the bonds in each country are identical and there are no barriers to capital flows, then the A) interest rates on the bonds will be identical. B) expected returns on the bonds will be identical. C) inflation rates in each country will be identical. D) prices of the bonds will be identical.

15) Let if be the interest rate being paid on a foreign bond, and let i be the interest rate being paid for a domestic bond; let P be the price of the domestic bond and let Pf be the price of the foreign bond. If exchange rates are fixed and the bonds are equal in terms of risk, then A) if > i. B) P>[ Pf× units of domestic currency/unit of foreign currency]. C) the expected return from the foreign bond = the expected return from the domestic bond. D) the exchange rate is equal to (1 + if) .

16)

In the long run, a country's exchange rate is determined by

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A) domestic monetary policy. B) purchasing power parity. C) the domestic inflation rate. D) output market price controls.

17) Policymakers in open economies face a “trilemma” of three conditions that cannot all be realized at the same time. Which one of the following is not part of this “trilemma” of openeconomy macroeconomics? A) Fix its exchange rate. B) Implement capital controls. C) Be open to international flows. D) Control its domestic interest rate.

18) Consider the following: an investor in the United States is pondering a one-year investment. She can purchase a domestic bond for $1,000 that has an interest rate of i or she can purchase a bond in England for 1,500 British pounds (£) that pays an interest rate of if. The current exchange rate is $1.50/£1. She considers the bonds to be of equal risk. If i = if, the expected returns are not equal. What do you know? A) The exchange rate is fixed between the United States and Britain. B) The bonds initially sold for different prices. C) Arbitrage doesn't work. D) The exchange rate must be flexible.

19)

Which one of the following statements is not correct?

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A) A country cannot be open to international capital flows, control its domestic interest rate, and fix its exchange rate. B) A country can be open to international capital flows and control its own domestic interest rate, but it can't fix its exchange rate. C) A country can be open to international capital flows, control its domestic interest rate, and fix its exchange rate. D) A country can be open to international capital flows and fix its exchange rate but could not also control its own domestic interest rate.

20)

The United States would be characterized as having A) a controlled domestic interest rate, a closed capital market, and a flexible exchange

rate. B) no control over the domestic interest rate, an open capital market, and a flexible exchange rate. C) a controlled domestic interest rate, an open capital market, and a flexible exchange rate. D) a controlled domestic interest rate, an open capital market, and a fixed exchange rate.

21)

Most economists view capital controls

A) unfavorably. B) as a framework for allocating capital to its most efficient uses. C) as useful for developing countries to exploit their comparative advantages. D) as a method for quickly transmitting information to markets and institutions in other countries.

22)

Capital controls A) are controls only on capital inflows. B) are controls only on capital outflows. C) can be controls on capital inflows or outflows. D) must be controls on both capital inflows and outflows in order to be effective.

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23)

What situation occurs when everyone loses confidence in a country at the same time? A) sudden stop B) capital inflows C) currency appreciation D) flexible exchange rates

24) During the 1990s, the country of Chile required foreigners wishing to invest in the country to make a one-year, zero-interest deposit in the Chilean central bank equal to at least 20 percent of the investment. This is an example of A) a capital outflow control. B) an exchange rate mechanism. C) a capital inflow control. D) a currency board.

25)

Which one of the following would be an example of a capital outflow control? A) Mexico limiting the number of U.S. dollars an American can bring into the country B) Mexico excluding foreigners from purchasing short-term debt C) Mexico limiting the number of pesos its citizens can take out of the country D) Mexico placing a tax on nonresident purchases of domestic securities

26)

China has long operated with which type of capital controls? A) capital inflow controls B) capital outflow controls C) capital controls in both directions D) no capital controls in either direction

27) If domestic residents are restricted in their ability to purchase foreign assets, then their government is imposing

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A) controls on capital inflows. B) controls on capital outflows. C) controls on both capital inflows and outflows. D) fixed exchange rates.

28) If foreigners are restricted in their ability to sell investments in a country, then that country’s government is imposing A) controls on capital inflows. B) controls on capital outflows. C) controls on both capital inflows and outflows. D) fixed exchange rates.

29) If foreigners are restricted in their ability to buy investments in a country, then that country’s government is imposing A) controls on capital inflows. B) controls on capital outflows. C) controls on both capital inflows and outflows. D) fixed exchange rates.

30) A country announces capital outflow controls that will take effect in three months. This announcement will likely A) lead to more market competition. B) stabilize the country's exchange rate. C) attract significant amounts of foreign investors. D) result in a significant depreciation in the country's currency.

31)

A country that frequently uses capital controls

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A) will attract more investment. B) increases the risk for foreign investors. C) typically has high levels of economic freedom. D) should see lower interest rates on its domestic bonds and lower prices.

32)

If the Fed desired to fix the euro/dollar exchange rate, they would have to A) get the European Central Bank to also agree to fixed exchange rates. B) maintain ample reserves of dollars. C) be willing to exchange dollars for euros whenever anyone asked. D) impose capital controls.

33) An open-market purchase of foreign bonds to increase a central bank’s international reserves A) increases the central bank's liabilities and assets. B) decreases the central bank's assets and liabilities. C) increases the central bank's assets and decreases its liabilities. D) increases the central bank's liabilities and decreases its assets.

34) If the Fed decides to maintain a fixed euro/dollar exchange rate, when they purchase euros A) they decrease the number of dollars. B) upward pressure is put on domestic interest rates. C) the domestic money supply increases. D) domestic commercial bank reserves fall.

35)

If the Fed decides to maintain a fixed euro/dollar exchange rate when they sell euros,

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A) there will be upward pressure on domestic interest rates. B) the domestic money supply will increase. C) this will increase banking system reserves. D) they will also have to impose capital controls.

36)

If the Fed decides to control the euro/dollar exchange rate, A) they will also have to control the domestic interest rate. B) they will have to control the amount of banking system reserves. C) the market will determine the interest rate. D) they will have to control the domestic rate of inflation or it won't work.

37)

Reserves in the banking system will increase if the Fed A) buys euros or sells dollars. B) sells euros or buys dollars. C) sells euro-dominated bonds and exchanges the euros for dollars. D) sells euro-dominated bonds and keeps the euros from the sale.

38)

The Fed holds its euro reserves primarily in the form of A) euro currency. B) a weighted portfolio of European government bonds. C) German government bonds. D) international mutual funds.

39) If reserves are scarce, when the Fed enters the foreign exchange market and purchases euros in an unsterilized intervention, the impact on domestic banking reserves would be

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A) the same pattern as with capital controls. B) that domestic banking reserves would decrease. C) the same as it would be with an open market purchase. D) uncertain.

40) In a world where reserves are scarce, the impact on the foreign exchange market for dollars resulting from the Fed selling euros in an unsterilized intervention will be A) a depreciation of the dollar. B) an increase in the supply of dollars. C) an increase in the demand for dollars. D) a decrease in the interest rate in the United States.

41) If reserves are scarce and interest ratesin the United States increase relative to interest rates in Europe, then the A) demand for dollars on the foreign exchange market would increase. B) supply of dollars on the foreign exchange market would increase. C) dollar depreciates against the euro. D) number of euros offered per dollar in the foreign exchange market falls.

42) In a world where reserves are scarce, a foreign exchange intervention by a central bank affects the value of a country's currency if it A) alters banking system reserves. B) leaves foreign asset holdings unchanged. C) results in a fixed exchange rate. D) changes domestic interest rates.

43)

Any central bank policy that influences the domestic interest rate will

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A) have no effect on the exchange rate if exchange rates are flexible. B) have an effect on the exchange rate. C) not impact the supply of and demand for the domestic currency if exchange rates are flexible. D) be compatible with fixed exchange rates.

44) Assume that the Fed performs an unsterilized foreign exchange intervention in which it buys German government bonds in a world in which reserves are scarce. One result of this will be that A) the dollar appreciates. B) the euro appreciates. C) both the dollar and the euro depreciate. D) the dollar appreciates and the euro depreciates.

45) Assume that the Fed performs a sterilized foreign exchange intervention in which it buys German government bonds in a world in which reserves are abundant. One result of this will be that A) the dollar appreciates. B) the monetary base does not change. C) both the dollar and the euro depreciate. D) the dollar appreciates and the euro depreciates.

46)

Which one of the following statements is not correct?

A) A foreign exchange intervention affects the value of a country's currency by changing domestic interest rates. B) Any central bank policy that influences the domestic interest rate will affect the exchange rate. C) Higher U.S. interest rates relative to those of other countries would likely result in an appreciation of the U.S. dollar. D) Sterilized changes in foreign exchange reserves alter a country’s monetary base.

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47)

A sterilized foreign exchange intervention would

A) alter the asset side of a central bank's balance sheet but leave the domestic monetary base unchanged. B) alter the liability side of the central bank's balance sheet but leave the asset side unchanged. C) leave the central bank's balance sheet unchanged. D) not alter the central bank's holdings of international reserves.

48) If the Fed were to purchase euros for dollars and at the same time sell U.S. Treasury securities in the open market, this would be an example of A) an unsterilized foreign exchange intervention. B) the Fed not changing their balance sheet at all. C) a sterilized foreign exchange intervention. D) the Fed altering the domestic monetary base.

49)

A foreign exchange intervention that alters the domestic monetary base is A) sterilized. B) impossible. C) unsterilized. D) not likely to change domestic interest rates.

50)

A foreign exchange intervention that does not alter the domestic monetary base is A) sterilized. B) impossible. C) unsterilized. D) likely to change domestic interest rates.

51)

A sterilized foreign exchange intervention will

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A) alter domestic monetary policy. B) change commercial bank reserves. C) leave the central bank's holdings of foreign reserves unchanged. D) change the composition of the asset side of the central bank’s balance sheet.

52) In September of 2000, the Federal Reserve Bank of New York sold dollars in exchange for euro. To keep the federal funds rate on target, the Open Market desk A) sold U.S. Treasury bonds. B) bought U.S. Treasury bonds. C) bought dollars. D) sold dollars.

53) Suppose that you purchase a Korean government bond and the number of won needed to purchase one dollar increases. Your return on the bond A) decreases by the amount of the dollar's appreciation. B) decreases by more than the amount of the dollar's appreciation. C) decreases by less than the amount of the dollar's appreciation. D) increases by the amount of the dollar's appreciation.

54) A U.S. resident purchases a bond issued by the Canadian government. If the Canadian dollar appreciates relative to the U.S. dollar over the term of the bond, the U.S. investor will A) see a higher return on her investment as a result. B) see a lower return on her investment as a result. C) not see her return affected since exchange rates are flexible. D) see a return, but the direction of change cannot be determined beforehand.

55) An advantage of a fixed exchange rate regime for a country that suffers from bouts of high inflation is that

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A) it makes imports less expensive. B) it establishes a credible low inflation policy. C) it unties policymakers' hands so they can alter the reserves of the banking system as needed. D) policymakers will have increased control over domestic interest rates.

56)

A fixed exchange rate policy A) decreases central bank policy accountability and transparency. B) strengthens domestic interest rate policy. C) will likely make domestic inflation more volatile. D) imports monetary policy.

57) When Argentina fixed the exchange rate of their peso to the U.S. dollar, one outcome was that the Argentinian A) central bankers regained control of their domestic interest rate. B) central bankers were finally able to focus their attention on domestic monetary policy. C) central bankers effectively gave control of their domestic interest rate to the FOMC. D) citizens began using the U.S. dollar for all of their transactions.

58) Fixing an exchange rate between two countries makes the most sense when the countries’ macroeconomic fluctuations are A) uncorrelated. B) unsynchronized. C) positively correlated. D) negatively correlated.

59)

All of the following are associated with a fixed exchange rate policy, except which one?

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A) higher prices on exports B) importing monetary policy C) sacrificing control of the domestic inflation rate D) the need to maintain ample international reserves

60) A country with a fixed exchange rate policy and free cross-border capital flows that is experiencing an economic slowdown will find A) their central bank will reduce the domestic interest rate in order to fend off the slowdown. B) their currency will depreciate to stimulate exports. C) their corporate equities will become more attractive to foreign investors. D) monetary policy in not available as an economic stabilization tool.

61) A speculative attack on a country with a fixed exchange rate often occurs when financial market participants believe the A) currency is undervalued. B) government will have to devalue its currency. C) government has a large excess of international reserves. D) government should convert its gold reserves into foreign exchange.

62) In 1997, there was a speculative attack on the Thai baht. This resulted from the belief by speculators that the A) Thai central bank had an overabundance of U.S. dollar reserves. B) Thai central bank didn't have sufficient U.S. dollar reserves to maintain the current fixed rate. C) Thai central bank had converted its gold reserves into foreign exchange. D) Thai president and the central bank would be overthrown.

63)

A speculative attack occurs often when there is a problem of

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A) time inconsistency. B) automatic stabilizers. C) currency appreciation. D) irresponsible fiscal policy.

64)

Speculative attacks A) can only result from irresponsible fiscal policy. B) can always be stopped by the country's central bank if they act quickly. C) can be triggered even when domestic policymakers are acting responsibly. D) are illegal, and if caught, speculators are assessed large fines.

65)

A fixed exchange rate policy is A) best for countries with low and stable prices. B) appropriate for a country that lacks a central bank. C) only appropriate for countries with little international reserves. D) a monetary policy.

66)

A country would be better off fixing its exchange rate if

A) it lacks ample foreign exchange reserves. B) it has a strong reputation for controlling inflation on its own. C) it is well-integrated with the economy of the country to whose currency its currency is fixed. D) its own macroeconomic characteristics are inversely correlated with the macroeconomic characteristics of the country to whose currency its currency is fixed.

67) A country that suffers from bouts of high inflation and wants to fix its exchange rate should tie its currency to the currency of a country

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A) that is larger. B) with similar inflation performance. C) that is still on the gold standard. D) with a strong reputation for low inflation.

68) Prior to World War I, when the United States was on the gold standard, inflationin the United States averaged A) 3.5 percent per year but was highly variable. B) less than one percent per year and was highly variable. C) less than one percent per year and was stable. D) 3.5 percent per year and was stable.

69)

Most economists do not advocate a return to the gold standard because

A) doing so would be time inconsistent. B) there are no longer gold reserves to mine. C) the central bank could hold too much gold and destabilize the economy. D) it forces the central bank to fix the price of something that is crucial for economic growth.

70)

If the United States were to revert to a gold standard, trade deficits would A) result in gold reserves in the United States decreasing. B) result in lower domestic interest rates. C) quickly disappear. D) result in high inflation.

71)

If the United States were to revert to a gold standard, trade deficits would

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A) result in gold reserves in the United States increasing. B) result in higher domestic interest rates. C) quickly disappear. D) result in high inflation.

72)

Under a gold standard, a central bank A) wants to keep their gold reserves fixed. B) stabilizes the prices of goods and services. C) can have too little gold but never have too much. D) will have gold reserves depleted when exports exceed imports.

73)

Most economic historians believe that

A) if more countries had been on the gold standard the Great Depression would have been averted. B) the gold standard did not play a major role in the Great Depression. C) the gold flows played a central role in spreading the Great Depression. D) countries that held on to the gold standard recovered from the Great Depression the quickest.

74)

Fixed exchange rate regimes include each of the following, except which one? A) the Bretton Woods exchange rate system B) exchange rate pegs C) dollarization D) currency boards

75)

The Breton Woods System was an agreement that required each participating country to

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A) abolish all trade barriers. B) stay on the gold standard. C) peg their currency to the U.S. dollar. D) adopt standardized tariffs across all participating countries.

76)

Under the Bretton Woods System each participating country had to A) adopt capital controls. B) be willing to exchange their own currency for gold. C) hold ample reserves of currency of each of the participating countries. D) stand ready to exchange its own currency for U.S. dollars at a fixed exchange rate.

77)

The Bretton Woods System failed in 1971 due to A) stable and low rates of inflation in the United States. B) restricted mobility of capital across international borders. C) the desire on the part of participating countries to have an independent monetary

policy. D) the agreement forcing more policy inflexibility than had accompanied the gold standard.

78)

The International Monetary Fund was created as a part of the A) United Nations. B) Bretton Woods System. C) European Monetary Union. D) Federal Reserve System.

79) be

The International Monetary Fund's primary role under the Bretton Woods System was to

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A) the issuer of gold. B) the arbiter of trade disputes. C) the clearinghouse for international transactions. D) a short-term lender for countries with an excess of imports over exports.

80)

China has used its current account surplus to A) buy stocks on the New York Stock Exchange. B) buy German government and agency securities. C) buy U.S. government and agency securities. D) make loans to foreigners.

81)

Only two exchange rate regimes can be considered hard pegs. These are A) currency boards and dollarization. B) dollarization and managed floating. C) flexible exchange rates and currency boards. D) the gold standard and inflation targeting.

82) In Hong Kong, the monetary authority can only increase the monetary base if they accumulate more U.S. dollars because A) the currency of Hong Kong is the U.S. dollar. B) the monetary authority in Hong Kong operates a currency board where its sole objective is to fix the exchange rate between its currency and the U.S. dollar. C) the IMF required Hong Kong to peg its currency to the U.S. dollar in order to obtain a loan. D) Hong Kong has received substantial funding from the U.S. Treasury and the loans were conditional on maintaining the value of the Hong Kong currency.

83) When a country operates with a currency board, the central bank's sole objective is to maintain the

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A) flexibility of domestic monetary policy. B) domestic interest rate. C) exchange rate. D) target inflation rate.

84)

In April 1991, Argentina adopted a currency board primarily to address the problem of A) slow growth. B) high interest rates. C) large trade surpluses. D) triple-digit inflation.

85) the

The failure of the Argentinian currency board can be attributed to many factors, including

A) failure right from the start to lower inflation. B) pegging of the Argentine peso to the euro. C) prices of Argentinian exports rising significantly in the late 1990s hurting their economy. D) reduction in domestic government spending that accompanied the development of the currency board.

86) A lesson that policymakers should learn from the Argentinian experience with currency boards is that A) they never work. B) poor fiscal policies can undermine any monetary policy regime. C) the only fixed exchange rate that works is the gold standard. D) a flexible exchange rate is always preferred to a pegged exchange rate.

87)

A problem with currency boards is that the central bank loses

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A) control over fiscal policy. B) control over the government budget. C) influence over interest rates. D) the ability to supervise banks.

88)

Which one of the following best defines dollarization?

A) A country uses the U.S. dollar as well as its currency for all transactions. B) A country adopts a foreign currency for all transactions, basically eliminating its own monetary policy. C) A country eliminates its own currency for international transactions and requires that all international transactions be conducted in U.S. dollars. D) The central bank of a country agrees to exchange its own currency for U.S. dollars at a fixed exchange rate.

89) one?

The benefits to a country from dollarization include each of the following, except which

A) a lower risk premium since inflationary finance is no longer a possibility B) greater and faster integration into world markets, increasing trade and investment C) no risk of an exchange rate crisis D) increased revenue from seignorage

90)

Dollarization is associated with each of the following, except which one? A) slower integration into world markets B) adopting the monetary policy of the country whose currency is being used C) the central bank no longer having the ability to be the lender of last resort D) the loss of revenue from printing currency

91)

Monetary union, in comparison to dollarization, means that

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A) countries forgo revenues from seignorage. B) countries share in monetary policy decisions. C) the central bank no longer has the ability to be the lender of last resort. D) participating countries relinquish shared governance.

92)

Monetary union and dollarization A) are the same thing. B) have the same impact on monetary policy in all participating countries. C) involve participating countries sharing revenues from seignorage. D) are different because dollarization does not involve shared governance.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 93) While it is true that central banks of many countries intervene in the foreign exchange market, why wouldn't it be correct to say that central banks of these countries fix the exchange rates?

94) Imagine the exchange rate between the British pound (£) and the U.S. dollar ($) is fixed at $1.40/£ and capital flows freely between Great Britain and the U.S. Explain what the price of shares of stock in XYZ Inc. would be selling for in London if they are $80 per share in the United States and why.

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95) Suppose that the current peso/dollar exchange rate is 100 pesos per dollar and the current inflation rates in Mexico and the U.S. are 3 percent in each country. Assuming purchasing power parity, what will the exchange rate be if the inflation rate increases to 5 percent in Mexico and falls to 2 percent in the United States?

96) Assuming the free flow of capital, explain why the central bank of a country that has fixed its exchange rate would not find discussions of inflation on the agenda of its policy meetings.

97) Capital flows freely between two countries and the countries have fixed exchange rates. The treasury bonds of each country have similar maturities but different expected returns. What can you deduce from this information?

98) Suppose the exchange rate between the Canadian dollar and the American dollar was fixed at 1.30 Canadian dollars per U.S. dollar and investors perceived Canadian bonds to be equal in value and risk to U.S. bonds. If the U.S. bonds are selling for $1,000 and have a 5 percent interest rate, assuming capital flows freely between the two countries what will be the price and the interest rate of the Canadian bonds?

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99) Could a country be open to international capital flows, control its domestic interest rate, and fix its exchange rate? Explain.

100)

What are the cost and benefits to a country instituting capital controls?

101) Everything else equal, if the Fed decided to fix the euro/dollar exchange rate, what would be the impact on the money supplyin the United States if the euro started to decline in value and why?

102) Everything else equal, if the Fed decided to fix the euro/dollar exchange rate, what would be the impact on the interest ratein the United States if the euro started to appreciate in value and why?

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103) Using demand and supply analysis, explain why the euro/dollar exchange rate rises (the dollar appreciates) if the Fed intervenes in the foreign exchange market and sells euros.

104) You have invested in bonds in a developing economy, and you have heard rumors of an impending speculative attack. You decide to sell the bonds and convert the currency into U.S. dollars. Use the demand and supply model for U.S. dollars to illustrate what happens in the foreign exchange market and write a brief explanation.

105) Are foreign exchange market interventions the only tool available to a central bank to change the exchange rate? Explain.

106) How would the impact on the exchange rate differ if the Fed were to sell U.S. Treasury securities instead of selling an equal amount (in $ terms) of euros?

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107) What should be the impact on the U.S. interest rates if the Fed undertakes a sterilized foreign exchange intervention? Be sure to explain your answer.

108) What separates a sterilized foreign exchange market intervention from an unsterilized intervention?

109) A sterilized intervention is actually a combination of two transactions. What are they and what is the effect on the monetary base?

110) You are an American resident but have invested in a German bond (paying face value) that matures in two years, pays a 5 percent interest rate, and is denominated in euros. What could cause your rate of return to fall below 5 percent even though the bond pays off at maturity?

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111)

What are the risks to a country of fixing its exchange rate to that of another country?

112) Describe the automatic stabilizers that are lost to a country that fixes its exchange rate to another currency.

113) What makes countries with fixed exchange rates prone to speculative attacks? Why don't the central banks of these countries stop these attacks?

114)

What causes a speculative attack on a country’s currency?

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115) How can irresponsible fiscal policy contribute to a speculative attack on a country's currency that is fixed in value to another currency?

116) What are the general conditions under which a fixed exchange rate makes sense for a country?

117) How did the gold standard contribute to the spreading of the Great Depression of the 1930s?

118) What were the reasons for selecting the U.S. dollar as the currency to which the other 43 countries agreed to peg their currencies as part of the Bretton Woods System?

119)

What are the pros and cons of a currency board?

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120)

What are the main costs to a country that adopts dollarization?

121)

Is the European Monetary Union a form of dollarization? Explain.

122) rate?

What is the relationship between a nation’s monetary and fiscal policy and its exchange

123) If a country has a flexible exchange rate, will high rates of inflation, though generally harmful, price this country's goods off world markets? Explain.

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124) You live in a small country that suffers constantly from high and variable rates of inflation. You are quite sure it has something to do with the fact that the head of the central bank is the President's brother. A rival presidential candidate is advocating fixing the exchange rate between your country's currency and the dollar. What are the advantages to this proposal and how do you think the current head of the central bank will respond?

125) Completely flexible exchange rates are fairly self-explanatory, and hard pegs include dollarization and currency boards. These seem to be the extremes. Assuming free flow of capital, why do you think soft pegs are never used?

126) What were the contributing factors that led to Argentina's initial adoption of a currency board and then its subsequent failure?

127) What is a “sudden stop” and how is related to the Balance of Payments? Are these occurrences frequent?

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128) Compare the monetary policy of the 50 states that make up the United States to the exchange rate regime of dollarization.

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Answer Key Test name: Chap 19_6e 1) A 2) C 3) C 4) C 5) B 6) A 7) D 8) B 9) B 10) D 11) D 12) B 13) A 14) B 15) C 16) B 17) B 18) D 19) C 20) C 21) A 22) C 23) A 24) C 25) C 26) C Version 1

27) B 28) B 29) A 30) D 31) B 32) C 33) A 34) C 35) A 36) C 37) A 38) C 39) C 40) C 41) A 42) D 43) B 44) B 45) B 46) D 47) A 48) C 49) C 50) A 51) D 52) A 53) A 54) A 55) B 56) D Version 1

57) C 58) C 59) A 60) D 61) B 62) B 63) A 64) C 65) D 66) C 67) D 68) B 69) A 70) A 71) B 72) C 73) C 74) C 75) C 76) D 77) C 78) B 79) D 80) C 81) A 82) B 83) D 84) D 85) C 86) B Version 1

87) D 88) B 89) D 90) A 91) B 92) D 93) Central banks do intervene (though not frequently) in foreign exchange markets. They do this whenever they feel the exchange rate may not reflect the basic fundamentals of the underlying economies. While these interventions do happen, the central banks of most countries do not fix the exchange rates. For most countries the exchange rate is determined by the market forces of supply and demand. Foreign exchange market interventions do not restrict the forces of supply and demand from operating. 94) Each share would sell for 57.14 £s in Great Britain. We can get to this answer using the concepts of purchasing power parity and arbitrage. If the price were higher, say 60 £s, investors would purchase the shares in the United States for $80.00, which would only require 57.14 £s, sell the shares in London for 60 £s and make a profit of 2.86 £s or $4.00 per share, ignoring commissions and other transactions costs. When capital flows freely between countries, the process of arbitrage will result in the prices of goods equalizing across markets, ignoring transactions costs. 95) We can use the percentage change formula. Here the percentage change in the number of pesos per dollar will equal the Mexican inflation rate less the U.S. inflation rate, or 3 percent. If the original exchange rate was 100 pesos per dollar, the new exchange rate will be 3 percent more than this or 103 pesos per dollar.

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96) As we saw in the chapter, a central bank must choose between a fixed exchange rate and an independent inflation policy; it cannot have both. So once a country or its central bank decides on a fixed exchange rate, then monetary policy has to be conducted so that its inflation rate matches the inflation rate of the country with which their currency is fixed. 97) The risk must be different. The ability of capital to flow freely would have investors pursuing the higher expected return and if the risk were the same these two securities should have the same expected return. Given the expected returns aren't the same we can deduce that the risk is not the same. 98) The price of the Canadian bonds will be 1,300 Canadian dollars or 1,000 U.S. $s and the interest rate on the Canadian bonds will also be 5%. This comes from the equation: $1,000(1 + i) = $1,000(1 + i f). 99) No, if a country is open to international capital flows, monetary policymakers must choose between controlling their exchange rate or controlling their interest rate; they cannot do both. If monetary policymakers want to control their domestic interest rate and their country is open to international capital flows, they must have a flexible exchange rate. 100) The benefits to a country instituting capital controls include the ability to fix the exchange rate and pursue domestic monetary policy objectives. In addition, a country that is open to capital inflows is vulnerable to capital outflows which can be very disruptive; as a result, some countries institute capital inflow controls as well as capital outflow controls. The cost of capital controls is the loss in efficiency. When capital cannot flow to its most efficient use the loss in efficiency as well as the lost opportunities to improve diversification and equalize rates of return across international borders harm societies.

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101) If the Fed desired to fix the exchange rate between the euro and the dollar and the euro began to depreciate, the Fed would have to buy euros, which means they would be selling dollars. The sale of dollars would expand the monetary base which, through the money multiplier, could expand the money supply and have an impact (reduction) on interest rates. 102) If the Fed desired to fix the exchange rate between the euro and the dollar and the euro began to appreciate, the Fed would have to sell euros, which means they would be buying dollars. The purchase of dollars would contract the monetary base which, through the money multiplier, could contract the money supply and cause domestic interest rates to increase. 103) If the Fed intervenes in the foreign exchange market and sells euros, they are selling these euros in exchange for dollars. As dollars flow into the Fed, the monetary base is being reduced, and through the deposit expansion multiplier, the money supply is also reduced. As a result, the domestic interest rate will increase. As interest ratesin the United States increase foreigners (as well as residents) will have an increased demand for U.S. assets. This increase in demand for U.S. assets will translate to an increase in the demand for dollars as well as an increase in the supply of euros, causing the dollar to appreciate relative to the euro.

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104) See the following graph. There is an increase in demand for U.S. currency since you and perhaps other investors want to convert from the currency of the developing country to dollars. Now there is a depreciation of the currency of the developing country as it takes more units to buy a dollar. If the now increased demand for dollars in that country depletes the central bank’s reserves, this could increase the likelihood of the speculative attack. Although not shown on this graph, if investors in other parts of the world also fear this attack and subsequent depreciation, there could also be a decrease in the supply of dollars.

105) No, any central bank policy that influences the domestic interest rate will affect the exchange rate. The changes in the domestic interest rate, relative to the interest rates in other countries, will alter the demand for domestic assets, which will then cause the demand for and supply of the domestic currency to change. As the demand and supply for domestic currency changes, the exchange rate will change.

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106) It wouldn't. In either case the Fed would be selling an asset other than dollars and depleting the monetary base by pulling in dollars. As the monetary base is reduced, the deposit expansion multiplier would cause the money supply to decrease and interest rates to increase. As domestic interest rates increase, the demand for U.S. assets increases causing the demand for dollars to increase and the supply of dollars to decrease. (Also, the supply of euros will increase.) 107) A sterilized foreign exchange intervention is designed to alter the asset side of the Fed's balance sheet but to leave the monetary base unchanged. For example, the Fed could purchase euros (sell dollars) which itself would raise reserves. But as the Fed does this, it could also sell U.S. Treasury securities to reduce reserves, thereby not altering the reserves (monetary base). If the monetary base is not altered the domestic interest rates should remain the same. 108) Simply, if the foreign exchange intervention alters the monetary base it is unsterilized. If the monetary base remains the same after the intervention, the intervention is sterilized. 109) First there is the purchase or sale of foreign currency reserves, which by itself changes the central bank's liabilities. But this is immediately followed by an open market operation of exactly the same size, designed to offset the impact of the first transaction on the monetary base. Together, the two actions leave the level of reserves unchanged. An intervention is sterilized if it does not change the monetary base.

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110) The exchange rate at the time the bond matures is not the same as the exchange rate when the bond was purchased. For example, let's say that at the time the bond was purchased it carried a face value of 1,000 euros and the exchange rate was 1 euro/dollar. If the exchange rate remained constant you would have a 5 percent return. But if the exchange rate changes, to say 1.05 euros/dollar, the return on the bond for you is zero (0). 111) When a country fixes the value of its currency to that of another country it basically imports the monetary policy of the other country, which in many cases can be good. There are risks, however, in the sense that the central bank of the country that the currency is fixed to is really not concerned with what is best for the outside country and is going to formulate policy that is in the best interest of its own country. Instead of having a stabilizing effect on the country, it could do just the opposite. 112) If a country is experiencing an economic slowdown and has a floating exchange rate, the monetary policymakers are likely to lower interest rates to stimulate domestic investment and consumption spending. In addition, the lower interest rates are likely to reduce the demand for domestic financial assets, which reduces the demand for the country's currency, causing its currency to depreciate relative to the currency of other countries. The depreciated currency will increase the demand for the nation's export goods and reduce imports, causing net exports to increase. With a fixed exchange rate, this stabilizing mechanism is lost.

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113) In order to maintain a fixed exchange rate, the central bank has to be willing to buy and sell as much currency as foreign currency traders presented. This requires the central banks to have ample international reserves, which can be difficult to obtain and expensive to hold. If foreign currency speculators begin to doubt a central bank's ability to maintain the exchange rate they can attack the currency by borrowing large amounts of the currency and presenting them to the central bank for payment in a different currency which could be invested in shortterm securities of the country pertaining to that currency, These actions by the speculators drain the central bank of its international reserves and usually result in the central bank having to give up the fixed exchange rate. The reason that central banks do not stop the speculators is the speculators have ample resources. 114) Fixed exchange rates are prone to this type of crisis. If politicians are spending so much that investors begin to think that inflation is likely, they will stop believing that officials can maintain the exchange rate at its fixed level and mount a speculative attack. Also, if a country’s banking system is insufficiently capitalized or otherwise unsound, a central bank may face pressure to relax monetary policy to avoid or contain a financial crisis. If investors doubt that the central bank will keep interest rates high enough for a sufficient time to defend the currency peg, an attack may follow. Finally, even if policymakers and financial institutions are working appropriately and soundly, an attack could arise spontaneously if enough currency speculators simply decide that a central bank cannot maintain its exchange rate. They could mobilize tens of billions of dollars virtually overnight. These attacks can also be contagious.

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115) Ensuring that a currency retains its value requires making sure that domestic inflation matches the inflation of the country to which the exchange rate is pegged. If politicians in the country begin to deficit spend, which can also drive up inflation expectations, and if speculators believe the inflation rate is going to increase and that the current exchange rate cannot be maintained, a speculative attack on the currency will likely result. 116) A fixed exchange rate makes sense for a country that has a poor reputation for controlling inflation on its own. The country's economy should also be well integrated with the economy of the country they are fixing their exchange rate with, including significant trade with the country and a close positive correlation with its macroeconomic fluctuations. Finally, the country needs to have a high level of foreign exchange reserves. 117) After World War I most of the major industrialized countries of the world successfully reconstructed the gold standard. The United States and France were running large current account surpluses (trade surpluses) which saw gold flowing into the vaults of these two countries. Instead of allowing their domestic money supplies to increase, fearing inflation, the monetary authorities in both countries tightened the money supply. The results were severe since it caused the authorities in countries experiencing current account deficits (trade deficits) and gold outflows to have to tighten their monetary policies even more. The quantity of money worldwide was decreasing, and the price level had to decrease as well. The resulting deflation increased the likelihood that people would default on loans and tightened credit availability, destroying the economic and financial systems in many countries including the United States.

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118) There are probably three main reasons for selecting the U.S. dollar. First, of the victors from World War II, the United States was the largest both economically as well as militarily. Second, there were a lot of dollars available and this was crucial. If the Bretton Woods System were going to work, each participating country would have to hold substantial dollar reserves.Finally, the United States was the only industrialized country at that time whose capital stock was not decimated by the war. 119) With a currency board, the central bank's only job is to maintain the exchange rate. While that means that policymakers cannot adjust monetary policy in response to domestic economic shocks, the system does have its advantages. Prime among them is control of inflation. Forgoing the ability to stabilize domestic growth seems like a small price to pay for such control in countries that have been prone to severe inflation. However, another drawback of a currency board is that the central bank loses its role as the lender of last resort to the domestic banking system. 120) There are three main costs. First, there is the lost revenue from seignorage; printing currency only costs a few cents, but a large denominated bill can be used to purchase real goods and services making the printing of currency a profitable undertaking. Second, a country that adopts dollarization effectively limits the ability of the central bank to serve as being a lender of last resort since the central bank cannot issue currency. Third, there is the loss of domestic monetary or exchange rate policy. This is probably the smallest cost since it is the lack of confidence in monetary authorities that usually leads to dollarization.

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121) No, it isn't. Using an example from the chapter, Ecuador adopted dollarization, in effect, giving up their currency and using dollars for all transactions. Ecuador is not represented on the FOMC and the FOMC does not consider what is best for Ecuador in making their policy decisions. In addition, Ecuador and other countries that have adopted dollarization do not share in the revenue from seignorage. With the European monetary union, while each country uses the same currency, the euro, each country's interest is represented in policy meetings and each country shares in the revenue from seignorage. 122) Poor fiscal prospects for a nation can lead to a lack of confidence in that nation’s currency. This is especially true for emerging countries but during the financial crisis of 2007–2009 it was even true for industrialized nations. A nation’s monetary and fiscal policymakers can calm the global fears by acting in a timely and responsible manner to manage a nation’s economy. 123) Lacking any type of fixed exchange rate regime, a country that experiences high rates of inflation and also a high level of exports may actually welcome flexible exchange rates. The high level of domestic inflation, relative to other countries, will cause the country's currency to depreciate, however it is this depreciation that will keep the country's products competitive on world markets. Purchasing power parity and flexible exchange rates are ways that countries experiencing high rates of inflation can continually sell their goods on world markets. If the exchange rate between two countries was fixed and a country experienced high levels of domestic inflation, their products would become less competitive on world markets and export industries would suffer. This also points to the fact that flexible exchange rates in a country that relies heavily on imports can be devastating when the country experiences high rates of domestic inflation.

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124) The idea is a good one from the standpoint that fixing the currency value to that of another country means adopting the monetary policy of the other country. The problem in this country is that there is obviously not an independent central bank and this lack of independence is causing high and volatile inflation. By fixing the exchange rate to the dollar your country will be adopting the monetary policy of the United States, which has the advantages of both offering lower and (it is hoped) more stable inflation, but also creating independence between the President and the central bank. As a result, the current head of the central bank in this country will lose a lot of their power and is likely not to favor the move to fixing the exchange rate. 125) A soft peg is likely to be a range within which the central bank agrees to keep the exchange rate. The problems with soft pegs include a lack of credibility and then the likelihood for speculative attack. If the peg isn't hard, the central bank can always alter the range as it is convenient. Also, since speculators know the peg isn't fixed and can be altered, the currency would become attractive for attack. As a result, it seems that the only alternatives are to have a completely flexible exchange rate where the monetary authorities do not commit to any peg and the market sets the exchange rate or a completely hard peg where a fixed exchange rate is maintained and the market determines the interest rate.

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126) The main event that led to its adoption was triple digit inflation that plagued the economy. Once Argentina adopted the currency board it limited the central bank's ability to expand the domestic money supply based on the dollar reserves the central bank held. The first three years of the currency board saw the rate of inflation fall dramatically. Ten years after its adoption the currency board failed and the Argentinian peso was allowed to float. While there is not a definitive reason given for the failure, most economists agree on a few key reasons. These include the ability of the provincial governments to issue their own bonds in small denominations to meet their obligations this was analogous to printing currency. The fiscal authorities were also irresponsible since they let the growth rate of government spending exceed the growth rate of the economy. As a result, many lenders became weary of lending to the government. Finally, many economists question the choice of the peso dollar peg since the Argentinian economy is not that integrated with the U.S. economy and as the dollar appreciated in the 1990s it made the peso appreciate which hurt Argentinian exports.

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127) A sudden stop is a Balance of Payments crisis that occurs when the inward flow of capital needed to finance a current account deficit (or to offset gross capital outflows) abruptly halts. The sudden stop typically reflects foreign creditors’ doubt about the likelihood of full and timely repayment. If concerns become acute, risk premia can skyrocket, eventually halting financing altogether. These crises are a frequent occurrence and tend to occur in waves. They persist on average for about a year and are associated with a shift from capital inflows to outflows averaging about 3percent of GDP. The real economic consequences of this are severe, with GDP falling on average by about 4percent in the first year as investment plunges. Today, governments and international financial authorities understand a great deal more about sudden stops than they did a few decades ago.

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128) In the United States, each of the 50 states has basically turned over monetary policy to the Federal Reserve and its FOMC. Each state could have its own monetary policy (print its own currency) and through that policy try to have its own target interest rate. The problem lies in the fact that if capital could flow between the states, the states would either have to have a fixed exchange rate, which means giving up domestic monetary policy, or have flexible exchange rates. Also, as the 50 states use the same currency the integration into markets across the states is far greater allowing for greater efficiency. When a country adopts the exchange rate regime of dollarization, it basically gives up its own currency and uses the currency of another country, much like the states in the United States. The advantages include greater integration into world markets, no worries regarding exchange rate devaluations and lower risk premiums. Finally, each state in the United States has surrendered monetary policy to the FOMC. A country that adopts dollarization basically gives up its own monetary policy and takes the monetary policy of the country whose currency is being used, like it or not!

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CHAPTER 20 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) History shows that A) money growth rates equal inflation rates. B) money growth and inflation are not related. C) countries with low rates of money growth have high rates of inflation. D) countries with high rates of money growth have high rates of inflation.

2) In 1998 (and until 2003), the ECB explicitly assigned money a prominent role in its stability-oriented strategy by A) stating their inflation goal as a number. B) tying interest rate and exchange rate policy together explicitly. C) establishing a ceiling value for the broadest monetary aggregate. D) announcing a quantitative reference value for the growth rate of a broad monetary aggregate.

3) As of 2020, officials at which central bank(s) use monetary targets as part of monetary policy? A) Fed B) ECB C) both the Fed and ECB D) neither the Fed nor the ECB

Economic researchers have found A) no examples of countries with high rates of money growth and low inflation rates. B) many examples of countries with low rates of money growth and high inflation rates. C) many examples of countries with high rates of money growth and low inflation rates. D) no relationship between rates of money growth and inflation rates.

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5) In studying the average annual inflation and money growth in 160 countries over the three decades that began in 1980, it is startling to see that researchers found many countries that had experienced rates of inflation that averaged A) 0 percent a year. B) 20 percent a year. C) more than 200 percent a year. D) more than 1,000 percent a year.

When the currency loses value, causing people to spend it more quickly, this A) has the same effect on inflation as an increase in money growth. B) has the same effect on inflation as a decrease in money growth. C) causes higher inflation but not as much as an increase in money growth would. D) causes even higher inflation than an increase in money growth would.

7) Over the long run if central banks want to avoid high rates of inflation, they need to be concerned with the A) unemployment rate. B) money growth rate. C) real economic growth rate. D) productivity of labor.

Which one of the following statements is most correct? A) Money growth is the result of inflation. B) The current rate of inflation is the result of money growth. C) There is no clear link between high, sustained inflation and the monetary aggregates. D) It is impossible to have high, sustained inflation without monetary accommodation.

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9) Consider the following ratio: the average annual inflation rate/the average annual money growth rate. If a country's rate of money growth consistently exceeds the rate of inflation the ratio would be A) less than one. B) greater than one. C) infinity. D) exactly one.

10) Researchers discovered that countries with the same annual average growth rate for money of 10 percent have average annual rates of inflation that A) are also 10 percent. B) vary between 1 and 8 percent. C) vary between 8 and 10 percent. D) are about the same but higher than 10 percent.

11) If money were valued in terms of how many minutes a person needs to work to buy a dollar, an increase in the number of minutes of work needed would be A) a decline in the price of money. B) an increase in the price of money. C) no change in the real price of money, just an increase in the nominal price. D) no change in the real or nominal price of money.

12)

Inflation can be thought of as A) a decrease in the price of money. B) an increase in the price of money. C) no change in the price of money, just a change in the supply of money. D) no change in the price of money, just a change in the demand for money.

13) If we look at the value of money in terms of how many units of a good it takes to buy one dollar, then inflation means Version 1

A) it would take more goods to buy the same dollar. B) it would take fewer goods to buy the same dollar. C) the same number of goods would buy fewer dollars. D) it would take fewer dollars to buy the same goods.

14)

The velocity of money A) is always constant. B) increases if more purchases are made. C) increases if each unit of money is used less frequently. D) increases if each unit of money is used more frequently.

15)

The velocity of money equals nominal GDP A) times the price level. B) times the money supply. C) divided by the price level. D) divided by the money supply.

16) If M = the money supply, Y = real output, P = the price level, and V = velocity, which one of the following equals the velocity of money? A) ( Y × M)/ P B) ( P × M)/ Y C) ( P × Y)/ M D) ( P × Y) + M

17)

If the equation of exchange is MV = PY, the Y represents

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A) nominal GDP. B) real GDP. C) potential output. D) economic growth.

18)

If M2 is four times larger than M1, the velocity of M1 should be A) one-fourth of the velocity of M2. B) equal to the velocity of M2. C) equal to four. D) four times larger than the velocity of M2.

19) Using the equation of exchange, if real output and the money supply stay the same and the price level increases A) real GDP increases. B) velocity of money increases. C) nominal GDP remains constant. D) the direction of the change in velocity is unknown.

20)

Which one of the following expresses the equation of exchange? A) MY = PV B) MV = Y C) MV = PY D) MP = VY

21) Using the equation of exchange, if inflation is 1.5 percent, real output grows by 3.0 percent, and the growth rate of money is 5.0 percent, the change in the velocity of money is

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A) zero; velocity is constant. B) −0.5 percent. C) +4.5 percent. D) +0.5 percent.

22) Using the equation of exchange, if real GDP increases by 3.0 percent, the velocity of money grows by 1.0percent and the growth rate of money is 3.0 percent; what is the rate of inflation? A) +1.0 percent B) −1.0 percent C) It is constant or a 0 percent change. D) It is the same as the growth rate of money, or 3.0 percent.

23) Using the equation of exchange, if inflation is 1 percent, the velocity of money grows by 1.0percent and the growth rate of money is 3.0 percent; what is real growth? A) +3.0 percent B) 1 percent C) 4.0 percent D) −1.0 percent

24) If, on average, a dollar is spentfour times each year to purchase real output, the velocity of money is A) one-fourth. B) four. C) the money supply divided by four. D) nominal GDP divided by four.

25) If we look at the equation for money demand that summarizes Irving Fisher’s quantity theory of money, which one of the following statements is true?

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A) Velocity does not play any role in the equation. B) Money demand is not a factor of nominal income. C) The price level does not impact money demand. D) There isn't an explicit role for the interest rate in the equation.

26) Based on the analysis of the equation of exchange, Irving Fisher derived the quantity theory of money which states that changes in the aggregate price level A) are the result of unstable velocity. B) are caused solely by changes in velocity. C) are caused solely by changes in the quantity of money. D) always offset changes in the product of (velocity x real GDP).

27)

Key assumptions behind the quantity theory of money include that the A) money supply is fixed. B) velocity of money is constant. C) percentage change in the price level equals the percentage change in real GDP. D) change in nominal GDP is zero.

28)

Milton Friedman's assertion that "inflation is a monetary phenomenon" is based on the A) quantity theory of money. B) assumption of constant nominal GDP growth. C) assumption that the price level grows at the same rate as real GDP. D) assumption that the central bank increases the money supply by a constant rate every

year.

29) If we let Md reflect money demand, in equilibrium in the money market, we can write the equation for money demand as

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A) Md = VY. B) Md = PY. C) Md = (1/ V) PY. D) Md = V( Y/P).

30)

Equilibrium in the money market would be expressed by which one of the following? A) M s = (1/ V) Y B) M s = Md C) Ms = (1/ V) P D) Md = (1/ V) P

31)

The quantity theory of money can explain which one of the following? A) If the %Δ Y > 0 and the %Δ V = 0, then %Δ P < %Δ M. B) If the %Δ V = 0 and the %Δ M = 0, then %Δ P must be = 0. C) If %Δ Y = 0 and %Δ V = 0, then %Δ P > %Δ M. D) If the %Δ P > 0, then %Δ M must also be > 0.

32) The quantity theory of money along with the assumption of constant velocity can explain which one of the following? A) If real growth equals money growth, the price level is falling. B) If real growth is higher than money growth, the price level must be rising. C) Higher levels of real growth are accompanied by higher levels of inflation. D) At a given level of money growth, the higher the level of real growth the lower the level of inflation will be.

33) by

A rate of inflation that exceeds the growth rate of money for a country could be explained

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A) a growing real economy. B) a constant velocity of money. C) an increasing velocity of money. D) a decreasing velocity of money.

34) Nobel-laureate economist Milton Friedman suggested that policymakers strive to ensure that the monetary aggregates grow at a rate A) equal to the rate of inflation. B) equal to the rate of real growth plus the desired level of inflation. C) equal to the rate of real growth less the desired level of inflation. D) that is constant in terms of dollar amounts.

35) Control of money growth to stabilize inflation only works if velocity is constant. In practice, changes in velocity A) can safely be ignored in countries with relatively low inflation rates. B) are important when inflation is low. C) must be taken into account no matter what the inflation rate. D) can always safely be ignored.

36)

Empirical data reveal the velocity of M2 to be A) relatively stable in the long run. B) highly volatile in the long run. C) stable only when measured annually. D) higher than the velocity of M1.

37)

The velocity of M2 is

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A) relatively stable across all time periods. B) less stable than the velocity of M1. C) more volatile in the short run than the long run. D) unstable in the long run.

38)

If money growth and real output growth are both zero, the change in the price level will A) also be zero. B) equal the percentage change in velocity. C) be indeterminate. D) be the inverse of the percentage change in velocity.

39)

During economic slowdowns (recessions), the velocity of money tends to A) remain relatively stable. B) increase slightly. C) increase dramatically. D) decrease.

40)

When nominal interest rates are high, the velocity of money should A) be low. B) also be high. C) not change; the velocity of money does not vary with the interest rate. D) decrease by the same percentage that the nominal interest rate has increased.

41) In the late 1970s and early 1980s, the velocity of money increased significantly. The main reason(s) for the increase was

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A) controversial presidential elections along with high nominal interest rates. B) controversial presidential elections along with low nominal interest rates. C) the introduction of stock and bond mutual funds with draft writing privileges along with high nominal interest rates. D) the introduction of stock and bond mutual funds with draft writing privileges along with low nominal interest rates.

42)

If the nominal interest rate increases, then the A) cost of holding money decreases. B) cost of holding money increases. C) velocity of money should decrease. D) cost of holding money increases and the velocity of money should decrease.

43)

In May of 2003, the European Central Bank (ECB) decided to

A) focus almost exclusively on money growth as their target. B) downgrade the role of money growth in their policymaking strategy. C) limit the role of interest rate targeting to be second in importance to money growth targeting. D) switch from an inflation target to a money growth target.

44) The European Central Bank (ECB) originally assigned a prominent role to money in its monetary policy strategy because A) velocity was easy to predict in the newly created euro area. B) they modeled the strategy after successful policies of the German Bundesbank. C) researchers had proven that money growth is tightly linked to inflation in the short run. D) they had accurate data available about real growth and velocity growth for the euro area.

45)

Which one of the following would reflect the transactions demand for money?

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A) keeping funds in your checking account to pay your rent B) keeping funds in your savings account because the interest rate looks relatively attractive C) selling common stocks you own and increasing the money in your savings account because you think stock prices will fall soon D) buying a U.S. Treasury security using funds from your checking account

46) If real GDP stays the same but the price level increases, then nominal money demand should A) increase. B) decrease. C) remain the same. D) lead to a decrease in real money demand.

47)

The higher the nominal interest rate

A) the less money individuals will hold for any given level of transactions and the higher the velocity of money. B) the more money individuals will hold for any given level of transactions and the higher the velocity of money. C) the more money individuals will hold for any given level of transactions and the lower the velocity of money. D) the less money individuals will hold for any given level of transactions and the lower the velocity of money.

48)

The opportunity cost of holding money is the A) nominal interest rate. B) real interest rate. C) nominal interest rate less the cost of converting a bond to cash. D) rate of inflation.

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49) All other factors equal, if the costs of converting bonds and other financial securities to a means of payment increase, then A) the transactions demand for money should increase. B) the transactions demand for money should decrease. C) it shouldn't impact the transactions demand for money. D) nominal interest rates should decrease.

50) All other factors equal, as nominal interest rates decrease, checking account balances should A) increase. B) decrease. C) remain constant. D) be converted to cash.

51) If you were going to write a function for money demand, you would say that the demand for money holdings varies A) directly with both the nominal interest rate and nominal income. B) inversely with both the nominal interest rate and nominal income. C) inversely with nominal income and directly with the nominal interest rate. D) inversely with the nominal interest rate and directly with nominal income.

52) All other factors constant, as the nominal interest rate increases, the opportunity cost of money A) decreases, the velocity of money decreases, and the quantity of money people want to hold decreases. B) increases, the velocity of money decreases, and the quantity of money people want to hold decreases. C) decreases, the velocity of money increases, and the quantity of money people want to hold decreases. D) increases, the velocity of money increases, and the quantity of money people want to hold decreases.

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53)

In high inflation countries, inflation rates can exceed the rate of growth of money because A) high inflation decreases the velocity of money. B) high rates of inflation increase the opportunity cost of holding money. C) money gains value quickly with inflation. D) some countries with high inflation do not have monetary accommodation.

54)

Which one of the following would be classified as precautionary demand for money?

A) You keep $1,000 in a money market account because the return is better than a savings account at your bank. B) You apply for and receive a credit card with a $1,000 limit. C) You put $1,000 in a savings account at your bank for emergencies. D) You put $1,000 in your checking account each month to cover your regular expenses.

55)

Money held for precautionary reasons is included in the demand for money A) as part of transactions demand. B) as part of portfolio demand. C) partly as transactions demand and partly as portfolio demand. D) as a third, separate category called the precautionary demand for money.

56)

The portfolio demand for money reflects the

A) money we hold for our everyday transactions. B) portion of wealth people desire to hold in the form of money. C) money we hold to purchase stocks and bonds and other financial securities. D) money we hold for our everyday transactions and the money we hold to purchase stocks and bonds and other financial securities.

57)

People have a portfolio demand for money in part because

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A) money is part of a well-diversified financial portfolio. B) the return on money is often higher than other financial assets. C) money is needed to pay brokerage commissions. D) there is no cost to holding money which gives it a relatively high return.

58)

As a person's wealth increases, we would expect the demand for money to A) decrease. B) increase dollar for dollar with wealth. C) increase but at a rate less than dollar for dollar. D) not change; money demand does not vary with wealth, only with income.

59)

A decline in the yields earned by bonds should A) not impact the demand for money since money doesn't earn any interest. B) decrease the demand for money. C) increase the demand for money. D) increase the velocity of money.

60)

If an investor thinks interest rates are likely to rise, ceteris paribus, she would A) sell her bonds and hold more money. B) buy more bonds now and hold less money. C) not alter her bond portfolio until interest rates actually rise. D) not change her money holdings at all.

61)

Crises that occasionally hit financial markets will increase the demand for money since A) the return on money increases. B) the return on financial assets increases. C) there is no risk with holding money. D) the risk of holding money relative to other financial assets decreases.

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62)

The demand for money varies A) inversely with wealth. B) directly with the liquidity of other financial assets. C) inversely with the liquidity of other financial assets. D) not all with the liquidity of other assets since money is liquid.

63) You graduate from law school and can now begin charging clients fees for your time. What impact will this have on your demand for money? A) Your increased income will likely cause your preference for liquidity to decrease. B) Your opportunity cost of making trips to the bank will decrease. C) Your increased income will likely cause your demand for money to increase. D) Your demand for money will not be affected.

64) to

The only solution available to a country experiencing extremely high rates of inflation is

A) raise interest rates. B) peg your currency to another country's currency. C) reduce money growth. D) revert to a gold standard.

65) Stable velocity as a contributing factor to successfully using money growth as a stabilizing monetary policy tool, is more important in an environment where A) inflation is extremely high (e.g., over 100 percent). B) inflation is low (e.g., less than 10 percent). C) inflation occurs, regardless of whether the levels of inflation are high or low. D) there is deflation.

66) For the Fed to use money growth as a direct monetary policy target, which of the following needs to exist? Version 1

A) a highly variable deposit expansion multiplier B) a stable link between the monetary base and the quantity of money C) a predictable link between the quantity of money and the deposit expansion multiplier D) a stable link between the monetary base and the quantity of money and a predictable relationship between the quantity of money and the rate of inflation

67) To use money growth as a short-term monetary policy instrument, a central bank must believe that A) there is a stable link between the monetary base and the rate of inflation. B) only money matters. C) there is an unpredictable relationship between money aggregates and inflation. D) the deposit expansion multiplier is volatile and unpredictable.

68)

Empirical research has shown that

A) in the 1990s and 2000s, velocity was more sensitive to an increase in the opportunity cost of holding money than in the 1980s. B) in the 1990s and 2000s, velocity was less sensitive to an increase in the opportunity cost of holding money than in the 1980s. C) during the 1980s and 1990s, the velocity of money was not sensitive to changes in the opportunity cost of holding money. D) during the 1980s and 1990s, the velocity of money actually decreased as the opportunity cost of holding money increased.

69) Given that velocity was more sensitive to an increase in the opportunity cost of holding money in the 1990s and 2000s as compared to the 1980s, using the relationship from the 1980s to make monetary policy in the 1990s A) was not possible under new leadership. B) would not have produced the desired results. C) could have created more price stability in the 1990s. D) would have created a period of stable economic expansion in the 1990s.

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70)

Since 2015, the slope of the money demand curve has A) gotten flatter. B) gotten steeper. C) not changed in slope. D) followed the same pattern as in the 1990s.

71) To say that the relationship between the velocity of money and the opportunity cost of holding money is not stable is the same as saying A) the supply of money is not stable. B) the money market is always in disequilibrium. C) money demand is stable. D) money demand is not stable.

72)

The relationship between the velocity of money and interest rates is A) positive but not stable. B) negative but not stable. C) positive and stable. D) negative and stable.

73) the

A major contributing factor to the instability of money demand over the past 25 years is

A) introduction of financial instruments that pay higher returns than money but can be used as a means of payment. B) Fed changing the way the money aggregates are defined. C) failure of many savings and loans. D) introduction of credit cards.

74)

The Lucas critique focuses specifically on the

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A) relationship between Fed policy and the money supply. B) role that economic policymaking has on people's economic behavior. C) inability to measure economic performance accurately. D) moving away from fixed exchange rates to flexible exchange rates.

75)

Between 1970 and 2000, the Fed A) published their targets for money growth and often hit these targets. B) never published targets or actual amounts for money growth. C) published targets for money growth and rarely hit them. D) published actual money growth but not targets.

76)

Between 1970 and 2000, if the Fed had tried to hit its money growth targets, the

A) economy would have likely experienced very high inflation. B) federal funds rate would have changed often and by large amounts. C) interest rates would have likely been more stable. D) economy would have likely experienced very high inflation but interest rates would have likely been more stable.

77) Statistical analysis reveals that the long-run money velocity for euro-area M3 (which is equivalent to U.S. M2) A) is unstable in the euro area similar to the instability that exists in the United States. B) is much more stable in the United States than in the euro area. C) has increased in the euro area since 1980. D) is more stable in the euro area than in the United States.

78)

Which one of the following statements is true?

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A) While the Fed emphasizes money growth more than the ECB, both central banks have chosen interest rates as their operating target. B) While the Fed emphasizes money growth less than the ECB, both central banks have chosen interest rates as their operating target. C) Because the Fed emphasizes money growth less than the ECB, the Fed uses interest rates as their operating target while the ECB looks at growth in money aggregates. D) Both the Fed and the ECB use growth in money aggregates as their operating targets.

79)

One cost that potentially could result from central banks targeting money growth is A) high inflation. B) a slowdown in financial innovation. C) volatile interest rates. D) decreased independence.

80)

For a three-year period from October 1979 to October 1982, the FOMC A) primarily targeted reserves. B) primarily targeted the real federal funds interest rate. C) primarily targeted M2. D) gave up targeting reserves entirely.

81) During the period of October 1979 to October 1982, the FOMC's primary operating target resulted in A) the most stable period for the federal funds rate in history. B) reserves being highly volatile. C) the federal funds rate experiencing high volatility. D) the federal funds rate dropping to 2 percent (an all-time low to that date) and not rising above 3 percent.

82)

If the nominal interest rate decreases, the

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A) cost of holding money decreases. B) cost of holding money increases. C) velocity of money should increase. D) cost of holding money increases, and the velocity of money should decrease.

83) All other factors equal, if the costs of converting bonds and other financial securities to a means of payment decrease, A) the transactions demand for money should increase. B) the transactions demand for money should decrease. C) it shouldn't impact the transactions demand for money. D) nominal interest rates should decrease.

84) All other factors equal, as nominal interest rates increase, checking account balances should A) increase. B) decrease. C) remain constant. D) be converted to cash.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 85) Why does the Fed have to be concerned with money growth even though its main focus seems to be on interest rates?

86) If velocity of money is constant, real growth in the output of the economy is +2.5%, and inflation is 2.0%, what is the growth rate of money?

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87) The equation of exchange which is MV = PY is an identity, which means it is true by definition. If you think carefully, what variable in the equation by the way it is defined really makes the equation of exchange an identity?

88) If the Fed wanted to target price stability, meaning zero inflation, why should it set a target rate of inflation of around one percent?

89) The CPI is a commonly used and closely watched measure of inflation. However, it has limitations. What are they?

90) If the price of money is determined by supply and demand, what impact should a decrease in the supply of money (given steady money demand) have on the price of money and the rate of inflation?

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91) Assuming a constant nominal GDP, would the velocity of M1 equal the velocity of M2? Explain.

92) Irving Fisher derived the quantity theory of money from the equation of exchange. What two assumptions did he make to derive the theory and what is the basic assertion of the theory?

93) Professor Milton Friedman stated that "inflation is a monetary phenomenon." What did he mean by this statement and what is the basis for this assertion?

94) The empirical evidence on the velocity of money, specifically M2, shows it to be relatively stable over the long run. Does this imply that monetary policymakers really should focus on the growth rate of money for economic stability?

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95) Is keeping money growth low when the central bank can accurately forecast real growth a guarantee that short-run inflation will not occur? Explain.

96) If the Fed wanted to keep inflation in check given the growth rate of the economy, how should they have responded to the financial innovations of the mid to late 1970s and early 1980s in terms of money growth?

97) How does money velocity contribute to the observation that in countries with high rates of inflation, the inflation rate exceeds the rate of money growth?

98) Economists are fond of calculating measures of elasticity. If we calculate the income elasticity of money as the %ΔM/%ΔPY, where M is the quantity of money held and PY is nominal income, would you suspect the coefficient to be positive, negative or zero? Will the absolute value be greater or less than 1? Be sure to explain your choices.

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99)

Why do people hold money? Explain the reasons.

100)

In what ways have financial innovations affected the demand for money?

101) What would the portfolio demand for money look like if it were graphed on a set of axes? What would each axis represent?

102) How might fear created by an event such as the global pandemic of COVID-19 affect consumers’ demand for money?

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103) Identify determinants of money demand that might be affected during an event such as the global pandemic of COVID-19. Explain.

104) If we consider the relationship between the opportunity cost of holding money and velocity that existed in the 1980s, if the Fed followed the same policymaking in the 1990s and 2000s, would they have achieved the desired results? Explain.

105)

What factors can cause the portfolio demand for money to increase?

106)

Is variability in velocity more of a problem in high or low inflation countries? Explain.

107)

Why did a decline in mortgage rates in the 1990s cause the velocity of M2 to fluctuate?

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108) On what aspect of policymaking, according to Robert Lucas, have policymakers been shortsighted in the past?

109) If monetary policymakers cannot accurately forecast shifts in money demand, what shortterm policy instrument are they really only left with and why?

110) Given that the velocity of money can be unstable in the short run, is this reason enough to dismiss money growth as a policy target? Explain.

111) If the correlation between the rate of inflation and the rate of money growth were closer to −1 rather than +1 would the Fed care more or less about the growth rate of money? Explain your answer.

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112) Is it a necessary condition that velocity is constant, and that real output growth is assumed to be zero to have Milton Friedman's assertion that inflation is a monetary phenomenon be true?

113) If we consider the quantity theory of money and Professor Irving Fisher, who did a lot of his work in the early 20th century, why might Professor Fisher feel less confident about predicting constant velocity of money today than when he did his work?

114)

The equation for money demand that is derived from the equation of exchange is

We see that the equation does not explicitly address the interest rate. In fact, Professor Fisher assumed that velocity is constant which means 1/V is also a constant. Why do you think Professor Fisher left the interest rate out of the equation? Do you think he would if he were alive today? Explain.

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Answer Key Test name: Chap 20_6e 1) D 2) D 3) D 4) A 5) C 6) A 7) B 8) D 9) A 10) B 11) B 12) A 13) B 14) D 15) D 16) C 17) B 18) D 19) B 20) C 21) B 22) A 23) A 24) B 25) D 26) C Version 1

27) B 28) A 29) C 30) B 31) A 32) D 33) C 34) B 35) B 36) A 37) C 38) B 39) D 40) B 41) C 42) B 43) B 44) B 45) A 46) A 47) A 48) A 49) A 50) A 51) D 52) D 53) B 54) C 55) A 56) B Version 1

57) A 58) C 59) C 60) A 61) D 62) C 63) C 64) C 65) B 66) D 67) A 68) A 69) B 70) A 71) D 72) A 73) A 74) B 75) C 76) B 77) D 78) B 79) C 80) A 81) C 82) A 83) B 84) B

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85) The Fed needs to focus on money growth because economic research and the resulting evidence point to the fact that there is strong correlation between the rate of inflation and the rate of money growth. As a result, in order to avoid sustained episodes of high inflation, the Fed must also be concerned with money growth. 86) Here we can employ the percentage change form of the equation of exchange where: %Δ M + %Δ V = %Δ P + %Δ Y. Inserting the known values and solving for the %Δ M, we obtain: %Δ M + 0 = 2.0 + 2.5 or %Δ M = 4.5. 87) It is the velocity of money. It is defined as PY/ M. Since it is defined this way (nominal GDP divided by the money aggregate), any values of P, Y, or M will make the equation true. 88) Economists maintain that the CPI, which is a common measure of inflation, overstates the true rate of inflation by as high as one percentage point per year. This is primarily due to the fact that the CPI is measured using a fixed basket of goods and does not reflect the fact that consumers can substitute away from higher priced goods toward less expensive substitutes and that quality improvements are not always adjusted for, so what looks like a higher price may simply be an improvement in quality. In today’s world, distortions due to changes in health care likely contribute the most to the CPI’s overstating inflation.

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89) Economists maintain that the CPI, which is a common measure of inflation, overstates the true rate of inflation by as high as one percentage point per year. This is primarily due to the fact that the CPI is measured using a fixed basket of goods. The bias in the CPI arises from several sources. First, consumers' buying patterns change; and in particular, consumers can substitute away from higher priced goods toward less expensive substitutes. A second source of bias arises from the fact that quality improvements are not always adjusted for, so what looks like a higher price may simply be an improvement in quality. 90) A decrease in the supply of money would drive the price of money higher. That is, it would take less money to purchase the same quantity of goods. The result is a fall in the price of goods, which is deflation. 91) No, the velocity of M1 would be greater than the velocity of M2. The formula for velocity is nominal GDP/M. Given a constant numerator and the fact that M2 > M1, the velocity of M1 has to exceed the velocity of M2. 92) The basic assumptions Fisher made are that the %Δ in real output and the %Δ in velocity are both zero. With this, he forms the basic assertion that money growth translates directly into inflation since the %Δ M will have to equal the %Δ P and the %Δ P is the rate of inflation. 93) Professor Friedman meant that the source of inflation is money growth. His assertion is based on Fisher's quantity theory of money, which basically assumes that real GDP growth is zero, (determined by real economic resources and production technology) and that the velocity of money is constant (%Δ V = 0), since it is determined by institutional factors that are slow to change or can be viewed as constant over a short period of time. With these assumptions, then the %Δ M must equal the %Δ P, or the growth rate of the money supply will translate to the rate of inflation. Version 1

94) Not really. While it is true that over the long run the velocity of M2 appears stable, it does experience significant short run volatility and policymakers tend to have a relatively short-run focus. With the focus for policymakers being relatively short, changes in velocity can have enormous impacts on inflation in the short run as well as other economic variables. 95) No. The velocity of money can be volatile in the short run and increases in the velocity of money, even with low money growth, can cause the price level to increase well above the objectives set by policymakers. For policymakers to use money growth targets to stabilize inflation requires they understand how velocity changes. 96) The financial innovations of the late 1970s and early 1980s that impacted the Fed's strategies were the introduction of stock and money market mutual funds that provided investors with better returns than traditional demand deposit accounts and the opportunity to draft from these accounts. As a result, billions of dollars were moved from traditional demand deposit accounts into these mutual funds. This increased the velocity of money which has the same impact on the price level (given the growth of real output) as an increase in the money supply. If the Fed didn't want this increase in the price level, they should have reduced the percentage growth rate of money by the percentage increase in velocity.

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97) Inflation contributes to high velocity in the sense that inflation increases the opportunity cost of holding money. When inflation is extremely high, say 1,000 percent, the opportunity cost of holding money is equivalent to the rate of inflation, or in this case −1,000%. At this high of a rate money loses value quickly so people will want to exchange it for durable goods (which do not lose value with inflation) as quickly as possible. This will cause the velocity of money to rise rapidly. The quantity theory of money reveals that given a real income, the percentage change in the price level (inflation) will equal the percentage change in money growth plus the percentage change in velocity. So, the rate of inflation exceeds the growth rate of money. 98) First, we should see a positive elasticity (positive coefficient) since as nominal incomes increase, the demand for money also increases and vice versa. Also, the value of the coefficient should be less than one. As incomes increase it is unlikely that each additional dollar of income will be held as money. 99) First, people hold money in order to pay for the goods and services they consume. This is referred to as the transactions demand for money. Second, people hold money as a way of holding their wealth; this is called the portfolio demand for money. People also hold money to ensure against unexpected expenses. This form of money demand, sometimes called the precautionary demand for money is considered as part of transactions demand.

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100) People hold money in order to pay for the goods and services they consume. This is referred to as the transactions demand for money. Financial innovations such as ATMs and automatic funds transfers have allowed people to limit the amount of money they hold. Financial innovations that lower the cost of shifting money between bonds (or other investments) and checking accounts also result in lower money holdings at every level of income. 101) The portfolio demand for money arises because money is an asset which can be substituted with other assets in a portfolio. One could graph the portfolio demand for money on a set of axes where the interest rate would be on the vertical and the quantity of money held would be on the horizontal. The curve would be downward sloping, indicating that the quantity of money held would be lower when interest rates were higher and vice versa. This can be explained in terms of a simple choice between holding money or holding bonds in a portfolio. If interest rates are high, people may expect them to drop. Holding bonds would be a good strategy, because as interest rates drop their prices will rise. Therefore, people choose portfolios with low money holdings. The reverse would then be true if interest rates were low and expected to rise; people would choose to hold money instead of bonds.

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102) Consider why people hold money. First, people hold money in order to pay for the goods and services they consume. This is referred to as the transactions demand for money. Uncertainty about the state of the economy could increase the transactions demand for money. However, during the COVID-19 pandemic, people were afraid that the virus could be transmitted through the exchange of cash. So, for example, in a short period of time, it was reported that cash use in Britain was reduced by half. Stores were closed, and consumers were worried that the virus could be transmitted through the exchange of currency. Many stores around the world, including some supermarket and grocery store chains, opted to refuse cash and require payment by credit card or electronic means. Also, people also hold money to ensure against unexpected expenses. This form of money demand, sometimes called the precautionary demand for money, is considered as part of transactions demand and would likely increase amid the uncertainty and fear of a global pandemic. Second, people hold money as a way of holding their wealth; this is called the portfolio demand for money. Uncertainty and fear about the effects of the pandemic in asset markets could increase the portfolio demand for money. There is a lot of market volatility that accompanies this type of event.

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103) Nominal income might fall as businesses shut down during the pandemic to aid citizens in social distancing and keeping safe so that health care services are not overwhelmed. This would decrease the transactions demand for money. If the availability of alternative means of payment increases relative to cash as people are afraid to exchange money physically, this could also decrease the transactions demand for money. Wealth may decrease as financial markets increase in volatility, and this would decrease the portfolio demand for money. If the return on alternative assets falls, this would increase the portfolio demand for money. If there is more risk in using cash because of danger of passing the virus, this would decrease the portfolio demand for money as people would hold their money in other alternatives. 104) Likely not. In the 1990s and 2000s the sensitivity of velocity to interest rates (opportunity cost of holding money) was far greater than it was in the 1980s. In fact, the sensitivity of money demand to changes in the interest rate rose by a factor greater than six. If the Fed had followed the same policy in the 1990s and 2000s, it would not have the desired effect. This is a result of the variability in the velocity of money and how it can make monetary policymaking difficult. 105) The portfolio demand for money arises because money is an asset which can be substituted with other assets in a portfolio. There are five factors that affect the portfolio demand for money. An increase in demand would occur due to (1) an increase in wealth; (2) a lower return on alternative assets; (3) higher expected future interest rates; (4) rising risk of alternative assets; or (5) a decrease in the liquidity of alternative assets.

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106) In countries where inflation and money growth are both very high, say over 100 percent, variations in the growth of velocity are annoyances, and the solution to the inflation problem is to get control of money growth. In low inflation environments, the success of the use of money growth as a monetary policy tool very much is predicated upon the stability of velocity. In these environments an unstable velocity of money can make monetary policy very difficult. 107) When mortgage rates fall (as they did in the 1990s) people pay off their old high-rate mortgage by obtaining new mortgages at lower rates. When a mortgage is refinanced it can add to the demand for money in several ways. Many people remove part of the equity in their home when they refinance and deposit these funds into their liquid accounts which are part of M2 where they are held until they are spent. Also, when mortgages are refinanced, funds flow from the new investors to the holders of the old mortgages. These funds flow through accounts that are part of M2. So, when mortgage rates fall M2 can grow substantially, when they stabilize, M2 stabilizes or shrinks. In the meantime, though, velocity has fluctuated. 108) The Lucas critique focuses on the fact that people will anticipate policy as they make their decisions so policymakers need to consider the impact on peoples' economic decisions of the policy they will propose. People will not continue to make the same decisions once policies are changed and to think otherwise will likely result in outcomes far from what policymakers expected.

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109) If monetary policymakers cannot accurately forecast shifts in money demand, they cannot accurately forecast (predict) shifts in the velocity of money. As a result, if they try to target reserves or money growth, they potentially will create an environment of volatile interest rates, which would be very damaging to the real economy. Since this volatility and resulting damage is exactly what central bankers hope to avoid, they turn to the only viable short-term operating target left, which is smoothing fluctuations in the interest rate. 110) Not necessarily. Intermediate targets can be useful when stable links exist between it and policymakers' operating instruments on one hand and their policy objective on the other. For example, if there is a stable link between the monetary base and the quantity of money (perhaps through the deposit expansion multiplier) and a predictable relationship between the quantity of money and the rate of inflation, then targeting money growth can be useful. 111) The Fed would still pay attention to it since they are correlated. A positive correlation simply says the variables move together in the same direction. The negative correlation still implies the variables move together, just not in the same direction. So if positive changes in money growth occurred with negative changes in theprice level (lower rates of inflation or deflation), this would still be of interest to the Fed and they would still pay attention to the growth rate of money.

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112) Not really. Friedman's assertion would hold with the long-run trend rate of real growth and the assumption that over the long-run velocity is constant or even predictable. For example, if we assume that real output grows at a long-run rate of 3 percent and that velocity grows at 1 percent over the long run, then any growth rate of money that exceeds 2 percent will result in inflation in the long run. In this case, it is still an excessive growth rate of money that causes sustained inflation. So, Friedman's assertion that inflation is a monetary phenomenon remains true. 113) Professor Fisher might feel less confident today because financial innovation has both created a variety of assets that serve some of the uses of money and reduced transactions costs associated with converting assets into a means of payment. Together, these have made velocity both grow and become less predictable. 114) Professor Fisher made two assumptions. One was that velocity ( V) was determined by institutional structures that would not change quickly and that the real output of the economy ( Y) was determined by economic inputs and the production function. Basically, then, Professor Fisher must have assumed the only plausible role for money was for transactions, and he never recognized, or he dismissed, the speculative or wealth (portfolio) holding roles for money. This might make sense if he thought that since money holdings do not earn interest, people would never hold more money than what was needed for transactions since they would not want to give up any interest that they otherwise could have earned. If Professor Fisher were alive today, he certainly would be interested in the short term volatility of velocity, and he would likely view 1/ V as something other than a constant, realizing that velocity of money can be influenced by interest rates.

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CHAPTER 21 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) Short-run movements in inflation and output are ultimately attributed to changes in A) aggregate demand. B) aggregate supply. C) foreign policy. D) aggregate demand and aggregate supply.

2) Modern monetary policymakers work to reduce the volatility created by fluctuations in __________ by adjusting __________. A) aggregate demand; target interest rate B) aggregate supply; target monetary aggregate C) aggregate demand and aggregate supply; target interest rate D) aggregate demand and aggregate supply; target monetary aggregate

The Fed hopes to impact short-run inflation and output by altering A) the production function. B) aggregate supply. C) aggregate demand. D) fiscal policy.

The aggregate demand curve shows the quantity of A) nominal output demanded at each level of inflation. B) real output demanded at each level of inflation. C) output made available at each level of inflation. D) real output demanded at each level of real interest rate.

Aggregate supply is the quantity of

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A) real output supplied at each level of inflation. B) nominal output supplied at each level of inflation. C) real output supplied at each level of real interest rate. D) output the country wants at each level of inflation.

Business cycles are viewed as A) movements in the short-run equilibrium. B) situations where aggregate demand does not equal short-run aggregate supply. C) inevitable; every economy must experience them. D) movements in the long-run equilibrium.

7) A characteristic of long-run equilibrium is that the economy is producing its potential output, which is A) the maximum level of output the economy could produce at any time. B) the level of output the economy produces when its resources are used at normal rates. C) defined as using 80 percent of the economy's resources at any time. D) the level of output consistent with an unemployment rate of 7.5 percent.

A slowdown in the pace of inflation is A) deflation. B) disinflation. C) temporary inflation. D) temporary deflation.

In the long run, with %ΔV = 0, we can conclude that the inflation rate equals the

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A) rate of money growth. B) rate of money growth plus growth in potential output. C) rate of money growth minus growth in potential output. D) rate of money growth plus change in velocity of money.

10)

Potential output of the country when viewed over long periods of time A) rises in spurts and then starts a downward trend that can last years. B) is surprisingly constant. C) always decreases. D) tends to rise over time.

11)

Which one of the following would cause an increase in the potential output of a country? A) an increase in the capital stock B) a temporary decrease in exports C) an increase in the money supply D) a decrease in the labor force

12) The potential output of a country would increase as a result of each of the following, except which one? A) an increase in population B) an increase in capital per worker C) technological innovation that increases labor productivity D) depreciation of the capital stock

13)

Current output

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A) determines potential output. B) is below potential output when an expansionary gap exists. C) cannot exceed potential output. D) is below potential output during a recessionary gap.

14)

In the long run, current output will A) equal potential output. B) be less than potential output. C) be above potential output. D) only equal potential output if unemployment is zero.

15)

In the long run, if we ignore changes in velocity, inflation will A) be zero. B) equal the rate of money growth. C) equal money growth less the growth in potential output. D) equal money growth plus the growth in potential output.

16) Given the equation of exchange, MV = PY, when central bankers control short-term nominal interest rates by adjusting the level of reserves in the banking system, their actions are expected to primarily affect A) the rate of growth of V. B) the value of V. C) potential Y as opposed to current Y. D) the rate of growth of M.

17)

To an economist, the term "inflation" refers to

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A) any price increases. B) a continually rising price level. C) a one-time change in the average price level. D) increases in prices of critical goods like food and energy.

18) If inflation is very high, say 50 or 100 percent a year, monetary policymakers wishing to lower it will shift their focus to controlling A) the long-term interest rate. B) the short-term interest rate. C) the exchange rate. D) money growth.

19)

Recent policy statements by the FOMC announce and explain its

A) decisions for long-term interest rates. B) targets for money growth with no mention of interest-rate targets. C) decisions for money-growth targets but also mentioning short-term interest-rate decisions. D) short-term interest-rate and balance-sheet adjustments with no mention of money growth targets.

20) The FOMC targets the federal funds rate, and if they are going to alter the course of the economy this must influence the A) real interest rate. B) long-term nominal interest rate. C) real exchange rate. D) nominal exchange rate.

21)

For central bankers to alter the real interest rate by changing the nominal interest rate,

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A) the rate of inflation has to remain constant. B) inflation expectations should be quite stable. C) the expected rate of inflation has to change. D) the change in the expected rate of inflation must equal the change in the nominal interest rate.

22)

Empirical evidence suggests that over the last several decades,

A) the nominal and real federal funds rates are related inversely. B) the nominal and real federal funds rates are highly positively correlated. C) while the FOMC has had a lot of influence over the nominal federal funds rate, they have been less successful at changing the real federal funds rate. D) there is no correlation between the nominal and real federal funds.

23)

Which one of the following is not a part of aggregate expenditure? A) consumption B) nominal interest rate C) government purchases D) net exports

24)

Which one of the following would not be included in aggregate expenditures? A) new military equipment purchased by the federal government B) new computers purchased by a law firm C) social Security payments made by the government to retirees D) tuition payments made by college students

25)

Which one of the following would not be included in aggregate expenditures?

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A) your purchase of a new car B) your purchase of new textbooks for the semester C) the value of 100 shares of Microsoft stock you purchased D) the value of blue jeans produced in the United States and exported to Japan

26)

Of all of the components of aggregate demand, the most interest sensitive is A) investment. B) government purchases. C) consumption. D) net exports.

27) Which component of aggregate expenditures is the least sensitive to changes in the real interest rate? A) investment B) consumption C) net exports D) government purchases

28)

Consumption can be sensitive to changes in the real interest rate because

A) higher interest rates can increase the cost of durable goods like automobiles. B) higher interest rates will result in less saving. C) lower real interest rates will decrease spending on durable goods and increase spending on non-durable goods. D) lower interest rates increase savings.

29)

When the real interest rate

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A) increases, the reward for saving decreases. B) decreases, current consumption becomes less expensive and the reward for saving decreases. C) decreases, the cost of current consumption increases. D) increases, the level of saving always decreases.

30)

Increases in the real interest rate in the United States will cause net exports to A) decrease because the dollar depreciates. B) increase because the dollar depreciates. C) decrease because the dollar appreciates. D) increase because the dollar appreciates.

31)

A decrease in the real interest rate in the United States will cause net exports to A) increase, because exports will remain constant but imports will decrease. B) decrease, because exports will decrease and imports will increase. C) decrease, because exports will increase but imports will increase. D) increase, because exports will increase and imports will decrease.

32)

An increase in the real interest rate should cause aggregate expenditures to A) increase. B) decrease. C) remain constant. D) change in an indeterminate direction.

33)

Which one of the following would not shift the aggregate expenditures curve?

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A) a change in the real interest rate B) changes in consumer or business confidence C) fiscal policy changes D) changes in net exports that result from exchange rate changes

34) If the level of current output suddenly falls below the potential level of output, central bankers would typically A) lower the real interest rate. B) raise the real interest rate. C) keep the real interest rate constant and focus on only changing the nominal interest rate. D) attempt to shift the aggregate expenditures curve.

35) If government purchases increase and as a result push current output above potential output, monetary policymakers are likely to A) lower the real interest rate. B) raise the real interest rate. C) keep the real interest rate constant and focus on only changing the nominal interest rate. D) purchase Treasury securities.

36)

The relationship between the long-run real interest rate and potential output A) is direct. B) is inverse. C) is constant since the long-run real interest rate is primarily determined by risk. D) depends on the actions of central bankers.

37) With the economy at its potential level of output, the federal government undertakes a large military buildup. All other things equal, the long-run real interest rate will

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A) increase. B) decrease. C) remain constant since output is at its potential level. D) change at the same rate as inflation.

38) It has been argued that the information technology age has greatly increased productivity and potential output. If this is true, then the A) the long-run real interest rate is also higher as a result. B) nominal long-run interest rates should have increased. C) we should have seen lower short-run interest rates than we have seen. D) the long-run real interest rate is lower as a result.

39)

The long-run real interest rate varies

A) directly with changes in non-interest-sensitive components of aggregate demand and inversely with potential output. B) inversely with changes in non-interest-sensitive components of aggregate demand and inversely with potential output. C) directly with changes in non-interest-sensitive components of aggregate demand and directly with potential output. D) directly with changes in non-interest-sensitive components of aggregate demand and does not vary with potential output.

40)

In the United States, most of the recessions are associated with A) ill-timed fiscal policy. B) decreasing net exports. C) decreases in investment. D) large decreases in consumption.

41) In the United States, most of the recessions are associated with fluctuations in investment, which are caused by changes in Version 1

A) inflation. B) ill-timed fiscal policy. C) net exports and changes in consumption. D) the real interest rate and changes in expectations about future business conditions.

42)

The monetary policy reaction curve A) is the guideline the Fed publishes in setting their interest rate target. B) approximates the behavior of central bankers. C) has remained fairly constant over the years. D) is set by Congress and given to the Fed as a guideline to follow.

43)

A monetary policy reaction curve requires the central bank to have a(n) A) money growth target. B) inflation target. C) unemployment target. D) economic growth target.

44) If the axes in the model for the monetary policy reaction curve are the real interest rate (vertical axis) and the rate of inflation (horizontal axis), then the monetary policy reaction curve would A) have a positive slope. B) have a negative slope. C) have a zero slope. D) be vertical.

45) The point where the central bank's target inflation rate is consistent with the long-run real interest rate lies

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A) above the monetary policy reaction curve. B) below the monetary policy reaction curve. C) on the monetary policy reaction curve. D) on the horizontal (inflation) axis.

46) If policymakers are aggressive in keeping current inflation near the target inflation rate, then the monetary policy reaction curve will A) be steep. B) be flat. C) have an undefined slope. D) be vertical.

47) If a point lies on the monetary policy reaction curve, and at this point the inflation rate equals the target rate of inflation, we know that the real interest rate corresponding to this point is A) above the long-run real interest rate. B) equal to the long-run real interest rate. C) below the long-run real interest rate. D) equal to current output and above potential output.

48)

The slope of the monetary policy reaction curve is determined by

A) how strongly the economy reacts to changes in the nominal interest rate. B) how strongly the inflation rate impacts peoples' decisions. C) how aggressively policymakers change interest rates in response to deviations between current and target inflation rates. D) people's expectations for inflation.

49) If policymakers are not aggressive about keeping inflation close to the target rate, the slope of the monetary policy reaction curve would be

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A) steep. B) relatively flat. C) vertical. D) negative.

50) If the slope of the monetary policy reaction curve is relatively flat, it means that central bankers are A) very concerned about keeping inflation close to the target rate. B) not concerned at all about inflation. C) less concerned about keeping inflation close to its short-run target. D) not going to let inflation deviate from its target at all.

51) The effect on the monetary policy reaction curve resulting from policymakers decreasing their inflation target would be A) the monetary policy reaction curve shifting to the left. B) a movement up the existing monetary policy reaction curve. C) a movement down the existing monetary policy reaction curve. D) the monetary policy reaction curve shifting to the right.

52)

When the monetary policymakers raise the target inflation rate, they A) raise the current real inflation rate at every level of current inflation. B) lower the current real interest rate at every level of current inflation. C) in effect, shift the monetary policy reaction curve to the left. D) in effect, move up along the current monetary policy reaction curve.

53) What would be the impact on the monetary policy reaction curve if the Fed were to raise the target inflation rate?

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A) The monetary policy reaction curve shifts to the left. B) There is a movement up the existing monetary policy reaction curve. C) There is a movement down the existing monetary policy reaction curve. D) The monetary policy reaction curve shifts to the right.

54) The dynamic aggregate demand curve illustrates that the relationship between inflation and real output is A) direct. B) inverse. C) independent. D) undefined.

55)

An inflation rate above the target rate will result in a movement

A) up along the monetary policy reaction curve and a movement up the dynamic aggregate demand curve. B) down along the monetary policy reaction curve and a movement down the dynamic aggregate demand curve. C) up along the monetary policy reaction curve and a leftward shift of the dynamic aggregate demand curve. D) up along the monetary policy reaction curve and a rightward shift of the dynamic aggregate demand curve.

56)

An inflation rate below the target rate will result in a movement

A) up along the monetary policy reaction curve and a movement down the dynamic aggregate demand curve. B) down along the monetary policy reaction curve and a movement down the dynamic aggregate demand curve. C) up along the monetary policy reaction curve and a rightward shift of the dynamic aggregate demand curve. D) up along the monetary policy reaction curve and a leftward shift of the dynamic aggregate demand curve.

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57) Each of the following factors contribute to the slope of the dynamic aggregate demand curve, except the A) strength of the effect of inflation on real balances. B) current level of technology. C) extent to which monetary policymakers react to a change in current inflation. D) size of the response of aggregate expenditures to changes in the interest rate.

58) The fact that central bankers tend to respond to higher rates of inflation by increasing the real interest rate is one reason why the A) dynamic aggregate demand curve shifts left. B) dynamic aggregate demand curve slopes downward. C) dynamic aggregate demand curve shifts right. D) monetary policy reaction curve has a negative slope.

59)

One of the ways inflation reduces aggregate demand is by A) increasing nominal GDP. B) increasing velocity. C) reducing real balances. D) increasing wealth.

60) The dynamic aggregate demand curve has a negative slope for all the following reasons except which one? A) reduction in real wealth caused by inflation B) the fact that high rates of inflation are good for the stock market C) redistribution that occurs as inflation has a greater impact on the poor than on the wealthy D) higher current inflation leading policymakers to increase the real interest rate, which depresses various components of aggregate expenditures.

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61)

A rightward shift in the dynamic aggregate demand curve could result from A) a decrease in government purchases. B) an increase in imports. C) a rightward shift of the monetary policy reaction curve. D) an increase in business pessimism about future prospects.

62)

A decrease in taxes would cause A) the dynamic aggregate demand curve to shift to the left. B) a movement down and along the existing dynamic aggregate demand curve. C) a movement up and along the existing dynamic aggregate demand curve. D) the dynamic aggregate demand curve to shift to the right.

63)

A decrease in the inflation target by the central bank would A) have no impact on the positioning of the dynamic aggregate demand curve. B) cause the dynamic aggregate demand curve to shift to the left. C) cause a movement down the dynamic aggregate demand curve to. D) be reflected by a movement down and along the existing dynamic aggregate demand

curve.

64) If monetary policymakers fear a recession resulting from increased pessimism on the part of businesspeople and they want to avoid the recession, they would A) shift the monetary policy reaction curve to the right. B) shift the monetary policy reaction curve to the left. C) likely lower their target rate for inflation. D) encourage fiscal policymakers to act.

65) In the short run, the point on the aggregate demand curve where an economy will end up in equilibrium depends on

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A) the money supply. B) the long-run rate of inflation. C) potential output. D) the short-run aggregate supply curve.

66)

In the short run, the aggregate supply curve is A) vertical. B) horizontal. C) upward-sloping. D) downward-sloping.

67)

If most people expect the inflation rate will increase, the A) long-run aggregate supply curve would shift right. B) aggregate demand curve would shift right. C) short-run aggregate supply curve would shift to the right. D) short-run aggregate supply curve would shift to the left.

68) If output and inflation are unrelated in the long run, the long-run aggregate supply curve must be A) horizontal. B) vertical. C) upward-sloping. D) the same as short-run aggregate supply.

69)

The long-run aggregate supply curve intersects the horizontal axis at the

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A) potential level of output. B) current level of output. C) expected rate of inflation. D) actual rate of inflation.

70)

At any point along the long-run aggregate supply curve, A) expected inflation equals current inflation and current output is below potential

output. B) the economy is moving toward its potential output level. C) current output equals potential output and expected inflation equals current inflation. D) expected inflation is moving toward current inflation.

71)

Which one of the following statements is not correct?

A) The point where the short-run and long-run supply curves intersect corresponds to the potential level of output. B) Any point on the short-run aggregate supply curve reflects current inflation equaling target inflation. C) Inflation and output are unrelated in the long run. D) In the long run, inflation is determined by monetary policy.

72) The intersection of the aggregate demand curve and the short-run aggregate supply curve determines A) current inflation, but not current output. B) potential output. C) current output, but not current inflation. D) current output and current inflation.

73)

The economy is in both a short- and long-run equilibrium if

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A) current inflation equals expected inflation and current output equals potential output. B) the aggregate demand curve intersects the short-run aggregate supply curve. C) the long-run aggregate supply curve is at potential output. D) the short-run aggregate supply curve intersects the long-run aggregate supply curve at potential output.

74)

If the economy is in long-run equilibrium, then A) inflation should be accelerating. B) current output should be greater than potential output. C) current inflation should equal expected inflation. D) current inflation should be less than expected inflation.

75) The self-correcting mechanism to return the economy to potential output from output gaps is the change in A) potential output. B) aggregate demand. C) short-run aggregate supply. D) the real interest rate by the central bank.

76) The conditions that hold in long-run equilibrium include each of the following, except which one? A) Imports equal exports. B) Current inflation is steady and equals target inflation. C) Current output equals potential output. D) Current inflation equals expected inflation.

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77) Suppose an economy is currently operating at point 0 in the following graph. This economy is experiencing a(n)

A) recessionary gap. B) expansionary gap. C) long-run equilibrium. D) inflation rate below expected inflation.

78) The debate over the causes of recessions in the United States in recent years has included arguments about A) monetary policy, but not higher oil prices. B) decreases in exports. C) higher oil prices, but not monetary policy. D) both monetary policy and higher oil prices.

79)

If a recession were the result of monetary policy, we should observe

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A) inflation increasing as output decreases. B) potential output decreasing. C) inflation slowing as output falls. D) a high rate of money growth.

80)

Evidence points out that since the mid-1950s just about every recession was preceded by A) low interest rates. B) rising interest rates. C) falling interest rates. D) negative real interest rates.

81) Evidence points out that since the mid-1950s just about every recession was preceded by rising interest rates. This suggests that the recessions were A) caused in part by the actions of the Federal Reserve. B) the result of changes in consumer confidence. C) due to increases in oil prices and other production costs. D) caused by simultaneous shifts in aggregate demand and aggregate supply.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 82) What are the determinants of the potential output for an economy?

83) Use the equation of exchange to show that in the long run, inflation must equal money growth less the growth of potential output.

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84) Temporary changes in inflation lead to adjustments in the price level. What causes permanent increases in inflation and why?

85) If changes in the nominal federal funds rate result in equal changes to the expected rate of inflation, how effective would it be for the FOMC to target the nominal federal funds rate?

86) Suppose that, ceteris paribus, the government passes a $2 trillion stimulus package to assist with a slowdown that accompanies a global pandemic. Ignore any monetary policy actions for now. How would this change Aggregate Expenditure in the economy? What impact would this have on potential output and the real interest rate? Include a graph as part of your explanation.

87) Draw a graph of the monetary policy reaction curve (MPRC) and describe what determines its location.

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88) When policymakers adjust the real interest rate, they are either moving along a fixed monetary policy reaction curve or shifting the curve. What is the difference? Provide an example of each.

89) Rank the components of aggregate demand by their sensitivity to changes in the real interest rate. Start with the most sensitive to the least sensitive.

90) Why would central bankers have to pay attention to forecasts regarding consumer sentiment and expectations of business owners and managers?

91)

What distinguishes the short-run real interest rate from the long-run real interest rate?

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92) Why is it necessary to understand fluctuations in investment if we want to understand the fluctuations in the business cycle?

93) If the economy is producing a level of output that is consistent with the potential output level, and government purchases increase, describe what happens in terms of the long-run real interest rate, and why, to keep the economy at its potential output level.

94) Given a central bank's monetary policy reaction curve, if inflation increases by 1% why would policymakers likely have to increase the nominal interest rate by more than the increase in the expected rate of inflation?

95) Discuss what happens to the monetary policy reaction curve if the Fed were to lower their inflation target and why?

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96) Is the monetary policy reaction curve applicable only to central banks that have an explicit inflation target? Explain.

97) Can central bankers set short-term interest rate targets and still control inflation in the long run or are these goals mutually impossible? Explain.

98) Explain the impact on the monetary policy reaction curve and the nominal interest rate if the level of government purchases were to decrease and the central bank does not change its inflation target.

99) Assuming the free flow of capital across borders, explain why a country that has a fixed exchange rate cannot have an independent monetary policy reaction curve.

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100) Use the monetary policy reaction curve to link a higher inflation rate to lower aggregate demand.

101)

Explain the changes that would cause the dynamic aggregate demand curve to shift.

102)

Explain why the short-run aggregate supply curve has a positive slope.

103) Explain why changes in expectations of future inflation shift the short-run aggregate supply curve. Provide an example and a graph showing a decrease in SRAS.

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104) How would the discovery of a previously unknown large reserve of oil affect the shortrun aggregate supply curve and why? What other change could have the same effect?

105) Is the actual amount of output that corresponds to the long-run aggregate supply curve fixed? Explain.

106) Explain the difference between SRAS and LRAS. What happens at the point where they intersect?

107)

What are the conditions for long-run equilibrium?

108) Output and inflation movements can arise from either demand or supply shifts. How can we tell them apart?

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109) Evidence seems to point out that just before past recessions occurred in the U.S., interest rates rose. Why would monetary policymakers choose to cause recessions?

110) Discuss why many economists maintain that continued deficit spending by government is likely to "crowd out" (decrease) investment spending in the long run.

111) Former Bank of England Governor Mervyn King, commenting on a speech given by then Fed Chairman Greenspan, said "any (coherent) monetary policy can be written as an inflation target plus a response to supply shocks." What do these comments mean and what insight do they provide us to the focus of central banks?

112) Economists usually maintain that policy designed to increase aggregate demand cannot have any long-run real effects. What lies behind this argument?

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113) At the conclusion of its meeting on January 27, 2016, the Federal Open Market Committee released a statement that included the following sentence: “Given the economic outlook, the Committee decided to maintain the target range for the federal funds rate at ¼ to ½ percent. The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and return to 2 percent inflation.” What is the significance of this statement?

114) Use the model of dynamic AD, SRAS, and LRAS to explain the difference between short-run equilibrium and long-run equilibrium. Draw a graph illustrating each situation.

115) Consider the scenario illustrated in the following graph. What situation is occurring in this economy at equilibrium 0? Explain the adjustment process that will move the economy to long-run equilibrium at equilibrium 1.

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Answer Key Test name: Chap 21_6e 1) D 2) C 3) C 4) B 5) A 6) A 7) B 8) B 9) C 10) D 11) A 12) D 13) D 14) A 15) C 16) D 17) B 18) D 19) D 20) A 21) B 22) B 23) B 24) C 25) C 26) A Version 1

27) D 28) A 29) B 30) C 31) D 32) B 33) A 34) A 35) B 36) B 37) A 38) D 39) A 40) C 41) D 42) B 43) B 44) A 45) C 46) A 47) B 48) C 49) B 50) C 51) A 52) B 53) D 54) B 55) A 56) B Version 1

57) B 58) B 59) C 60) B 61) C 62) D 63) B 64) A 65) D 66) C 67) D 68) B 69) A 70) C 71) B 72) D 73) A 74) C 75) C 76) A 77) B 78) D 79) C 80) B 81) A

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82) The key determinants are the levels and quality of economic inputs; these include the size and quality of the labor force (human capital), the size and quality of the capital stock, and the amount and quality of natural resources. In addition, the level of technology that exists can contribute to how well these inputs are used to produce output. This is the basic production function that is the foundation of any study of the relationship between output and inputs. 83) The equation of exchange is MV = PY; if we write this equation in potential change form we have %Δ M + %Δ V = %Δ P + %Δ Y; If we ignore velocity which is unimportant in the long run, we realize the %Δ P, which is inflation, has to equal the %Δ M− %Δ Y, or inflation equals money growth less the growth of potential output. 84) Permanent increases in inflation can only result from monetary policy. In the long run, inflation is the difference between the growth rate of money and the growth rate of potential output, assuming velocity is constant or predictable over the long run. As a result, any sustained inflation must be fueled by money growth, which would have to be directed by monetary policymakers. 85) It wouldn't be effective if changes to the real economy require changes to the real interest rate. If changes in the nominal federal funds rate would also result in equal changes to the expected rate of inflation, then the real federal funds rate would not change. If the real interest rate does not change, the real economy isn't going to change.

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86) This fiscal policy increases government expenditure which will increase AE, shifting it to the right as shown in the following graph. At the level of potential output in the economy, YP, the real interest rate is now higher (r*1 instead of r*0). Remember that the real interest rate, r*, is that level at which aggregate expenditure equals potential output.

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87) In order to ensure that deviations of inflation from the target rate are only temporary, policymakers respond to changes in inflation by changing the real interest rate in the same direction. Higher current inflation requires a policy response that raises the real interest rate, and lower current inflation requires a policy response that lowers the real interest rate. Graphing the MPRC with inflation on the horizontal axis and the real interest rate on the vertical axis, we have an upward-sloping MPRC as shown in the following graph. The location depends on where policymakers would like the economy to end up in the long run, which is the equilibrium toward which the economy tends over time. The MPRC is set so that when current inflation equals target inflation, the real interest rate equals the long-run real interest rate so that r = r* whenπ = π*.

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88) A movement along the MPRC is a reaction to a change in current inflation. So, if there is a deviation of inflation from the target rate, in order to ensure that it is temporary, policymakers respond to the change in inflation by changing the real interest rate in the same direction. If current inflation is higher than the target, for example, the policy response will raise the real interest rate. If there is an increase in the long-run real interest rate that equates aggregate expenditure with potential output, then the central bank’s target inflation rate is higher such that when current inflation equals target inflation, the real interest rate equals the long-run real interest rate. This is a movement up along the MPRC. A shift in the MPRC represents a change in the level of the real interest rate at every level of inflation. To see what can shift the monetary policy reaction curve, look at the variables that are held constant when drawing the curve. We hold both target inflation and the long-run real interest rate fixed. If either of these variables change, the entire curve shifts. For example, an increase in the inflation target shifts the MPRC to the right. 89) The most sensitive is investment demand, followed by consumption and net exports. Consumption is affected because higher interest rates mean higher inflation-adjusted payments for goods such as cars, making them cost more. In addition, higher interest rates increase the return to saving and more saving means less consumption. Net exports are affected since the value of the dollar on foreign exchange markets is impacted by the demand for dollars which is affected by the real interest rate. Changes in the value of the dollar will impact both the price of exports as well as imports. Finally, government purchases are the least sensitive to changes in the real interest rate.

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90) Central bankers realize that they can impact the level of aggregate demand through changing the real interest rate. But they also realize that aggregate demand can change due to other causes like changes in consumer and/or business optimism and policymakers need to consider how aggregate demand may be changed due to these other factors so that they do not over or under correct. 91) The short-run real interest rate is the interest rate that equilibrates aggregate demand and current output. The long-run real interest rate equilibrates aggregate demand with potential output. In the long run, the level of aggregate demand is consistent with the economy's ability to produce its normal level of output. 92) Investment is not the largest component of aggregate demand but over the short run it can be volatile. Consumption and government purchases are fairly stable over the short run and net exports are too small to make much of an impact, so the short run changes in aggregate demand are often driven by changes in investment. In addition, investment is the most interest-sensitive component of aggregate demand, making it relatively responsive to monetary policy. 93) If the economy is producing its potential output and government purchases increase the short-run result may be an expansionary gap. In the long run the real interest rate will rise. This is so that one of the interest sensitive components of aggregate demand (investment, consumption, and/or net exports) decreases to keep the level of output at potential and corrects for the expansionary gap. 94) The higher rate of inflation will have the policymakers wanting to raise the real interest rate. Since the real interest rate is the nominal interest rate less the rate of inflation, raising the nominal interest rate by the same amount that the rate of inflation has increased may not raise the expected real interest rate.

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95) If the Fed were to lower their inflation target the monetary policy reaction curve would shift left. One point on the curve is the point where the inflation target is consistent with the long-run real interest rate. Since the long-run real interest rate has not changed, but the inflation target is lower, the entire curve would have to shift left or upwards so that the point reflecting the new inflation target and long-term real interest rate is on the curve. 96) No. The monetary policy reaction curve really summarizes the central bank's response to inflation and output gaps. The response to inflation is shown explicitly. The response to output gaps is implicit assuming that output gaps impact the inflation rate. The monetary policy reaction curve can also illustrate policymakers' responses to inflation when the inflation target is implicit. This can be tested and verified using historical data. 97) They can attain both goals. The monetary policy reaction curve shows that the central bankers can influence aggregate demand and, ultimately inflation by adjusting the real interest rate. In the long run, inflation is determined by money growth. The central bankers can alter their balance sheets and the monetary base in the short run to change the short-term real interest rate. Money growth on the other hand depends on the willingness of central bankers to expand their balance sheets for the long run. 98) The monetary policy reaction curve would shift right. A decrease in government purchases lowers the level of aggregate demand. Without a change in the target inflation rate, this means the central bank has set a lower real interest rate at every level of current inflation. This will also decrease the nominal interest rate since the real interest rate is lower and the target inflation rate has not changed.

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99) We saw that a country that adopts a fixed exchange rate, for example fixing their currency to the U.S. dollar, then must adopt the monetary policy set by the FOMC. To ensure the stability of the exchange rate, the country will need to alter its real interest rate in line with FOMC changes. Over the long run, as inflation rates in the two countries converge, the monetary policy reaction function of the country should converge to that of the FOMC. 100) When the inflation rate is above the target, the central bank will respond by raising the real interest rate. This is the monetary policy reaction curve. The higher interest rates will reduce the interest sensitive components of aggregate demand such as investment and interest sensitive consumption and net exports. So the higher rate of inflation leads to the lower quantity aggregate demand; this is illustrated by the aggregate demand curve. 101) The dynamic aggregate demand curve would shift as a result of (1) changes in aggregate expenditures. Changes in any of the components of aggregate expenditures that are not caused by movements in the real interest rate shift the dynamic aggregate demand curve. The curve would also shift due to (2) shifts in the monetary policy reaction curve that could be due to changes in the inflation target or changes in the long-run real interest rate. 102) The short-run aggregate supply curve shows an upward-sloping relationship between current inflation and the quantity of output. Producers increase the quantity of output supplied as inflation rises because the prices of the factors used as inputs in production tend to be fixed in the short run (in nominal terms) and so inflation reduces the real cost. Put another way, in the short term, production costs don't change much, so when retail prices rise firms increase the quantity supplied in order to take advantage and make higher profits.

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103) The short-run aggregate supply curve is the upward-sloping relationship between current inflation and the quantity of output. Workers and firms care about real wages and prices—that is, the level of compensation and profits measured in goods and services that they can purchase. As we have noted, it costly to adjust wages and prices, and these changes occur infrequently. During months or years during which they are fixed, inflation erodes the real wages paid to workers and real prices charged by firms. Thus, everyone is concerned about expected inflation, and the higher expected inflation is, the faster nominal wages and prices will rise. This provides the link between inflation expectations and the SRAS. Higher expectations are analogous to changes in production costs. For example, an increase in expected inflation increases production costs, lowering production at every level of current inflation and shifting the short-run aggregate supply curve to the left as shown in the following graph.

104) This discovery should mean a lower price of oil, which is a factor that drives production costs down. The result would be a rightward shift in the short-run aggregate supply curve. Such a shift would also occur as a result of a change in expectations of future inflation (specifically expectations of lower inflation).

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105) No. The long-run supply curve is vertical at the economy's potential level of output, which indicates that there isn't a long-run relationship between the rate of inflation and output. The potential level of output, though, is dependent on many factors, including the amount and quality of resources (inputs), the rate of improvements in technology, the rate of innovation and invention, the amount of investment, the rate of depreciation, the level of education, etc. As a result, the level of potential output in many countries is usually increasing. So, while we draw the long-run aggregate supply curve as vertical at the potential level of output, the curve is usually shifting to the right over time. 106) SRAS is the upward-sloping relationship between inflation and the quantity of aggregate output supplied by the firms that produce it, while LRAS is the vertical relationship between inflation and the quantity of aggregate output supplied. SRAS is upward-sloping because production costs adjust slowly such that increases in produce prices make it profitable to increase quantity supplied. LRAS is vertical at the level of potential output because in the long run all prices and wages adjust and the economy moves to the point where current output equals potential output. SRAS and LRAS intersect at the point where current inflation equals expected inflation. 107) The conditions include that current output equals potential output. This puts the economy on its long-run supply curve. Also, current inflation equals target inflation. This means that monetary policymakers will not have any incentive to alter the current rate. And finally, current inflation equals expected inflation. This will tend to keep the short-run aggregate supply curve stable.

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108) While shifts in either the dynamic aggregate demand curve or the short-run aggregate supply curve can have the same effect on inflation, they have opposite effects on output. If the dynamic aggregate demand curve shifts to the right, increasing inflation, it will result in higher output. If the short-run aggregate supply curve shifts to the left, increasing inflation, output falls. Therefore, changes in output associated with inflation give an indication as to whether the cause is a shift in demand or a shift in supply. 109) The primary answer is that they were concerned about inflation and that they sought to slow the economy down by raising real interest rates. This reflects the tough choices that monetary policymakers face when presented with the challenge to reduce high rates of inflation. 110) The long-run real interest rate is the rate that equates aggregate demand with potential output. If government purchases increase or deficit spending continues to increase, this causes aggregate demand to increase. This increase in non-interest-sensitive spending in the short run is likely to lead to an expansionary gap which will put upward pressure on the long-run real interest rate. The increased real interest rates will cause interest-sensitive spending to decrease. The most interest-sensitive spending is investment, so often it is argued that large government borrowings lead to reduced private investment. A more general argument could be that government deficits will crowd out private interest-sensitive spending in the long run.

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111) Governor King is pointing to the fact that central banks focus particularly on the rate of inflation, that's why he made the comment regarding the inflation target. But central banks also consider general economic conditions. As a result, supply shocks will have central banks responding to the shocks by changing interest rates to levels they otherwise would not absent the shock. In summary, the statement that central banks focus generally on economic conditions and particularly on the rate of inflation holds true and is revealed by the comments. 112) The basis for the argument lies in the fact that the real output of the country is determined by potential output, which itself is determined by the availability and quality of inputs (resources) and the long-run production function. As a result, an increase in aggregate demand, in the long run, can lead to higher rates of inflation, but not a permanent increase in output. The permanent increase in output can only come from having more or better-quality resources or a change in technology. 113) FOMC members had concluded that economic conditions justified keeping nominal interest rates low in order to keep the real interest rate down to raise aggregate expenditures, so as to close the recessionary output gap and raise inflation. But, having raised their interest-rate target at their meeting six weeks earlier, and with inflation forecast to rise to 2 percent within two years, observers were largely in agreement that the next move in the target rate would be up.

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114) Short-run equilibrium is determined by the intersection of the dynamic aggregate demand curve (AD) with the short-run aggregate supply curve (SRAS) as shown in the following graph on the left. In equilibrium, we see the levels of current output and inflation. For long-run equilibrium, we must include the vertical long-run aggregate supply (LRAS) curve on the graph, as shown in the following graph on the right. When SRAS and AD intersect each other and LRAS at the same point, we have long-run equilibrium. At this point, we have π0 = πe, Y0 = YP, and π0 = πT. This means that current inflation equals expected inflation, current output equals potential output, and current inflation is steady and equal to target inflation.

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115) At equilibrium 0, current inflation is less than expected inflation (π 0<π e 0) and current output is lower than potential output ( Y 0< YP). Because people form their expectations based on recent experience, inflation expectations begin to fall, shifting the SRAS curve to the right. The process continues until current inflation equals expected inflation at which point current output will be equal to potential output. This occurs when SRAS shifts so that it intersects AD and LRAS at equilibrium 1.

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CHAPTER 22 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) The period 1974–1975 is somewhat unique in U.S. economic history, because A) the output was growing rapidly and the inflation rate was falling. B) both the output and the inflation rate were falling. C) output was falling yet the inflation rate rose dramatically. D) output and the inflation rate were both rising.

2) Historical evidence shows that, in the United States, the lower the economic growth, the more likely A) inflation is to fall. B) output gaps are to fall. C) unemployment is to fall. D) government spending is to fall.

A "shock" is something that creates a shift in A) the demand curve only. B) the supply curve only. C) either the demand curve or the supply curve. D) both the demand curve and the supply curve at the same time.

4) Permanent declines in inflation such as those seen in Chile and Sweden must have been a result of A) an increase in the central bank's monetary target. B) a decrease in the central bank's inflation target. C) less independence for their central banks. D) a change to targeting interest rates instead of inflation rates.

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Which one of the following statements is not correct?

A) A fall in the central bank's target inflation rate shifts the monetary policy reaction curve to the left. B) A decrease in the central bank's inflation target raises the real interest rate policymakers set at each level of inflation. C) Shifts in the monetary policy reaction curve shift the dynamic aggregate demand curve in the same direction. D) A fall in the central bank's target inflation rate causes the monetary policy reaction curve to flatten.

6) A reduction in the central bank's inflation target shifts the dynamic aggregate demand curve to the left, resulting in A) lower current output and higher inflation. B) higher current output and higher inflation. C) lower current output and lower inflation. D) higher current output and lower inflation.

A reduction in the central bank's inflation target will result in A) an increase in potential output. B) no change in potential output. C) a decrease in potential output. D) the long-run aggregate supply curve having an upward slope.

If there is an increase in aggregate demand, ceteris paribus, potential output will A) increase. B) decrease. C) increase at first and then decrease. D) not change.

An increase in aggregate demand with no adjustment in monetary policy will result in

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A) an increase in potential output and higher inflation. B) a decrease in potential output and higher inflation. C) no change in potential output but higher inflation. D) no change in inflation.

10) If monetary policymakers do not want an increase in government purchases, which increases aggregate demand, to cause an increase in inflation, they would A) shift the monetary policy reaction curve to the right, raising inflation at every real interest rate. B) do nothing and let the economy's self-correcting mechanism work. C) shift the monetary policy reaction function left, increasing the real interest rate at every rate of inflation. D) increase the growth rate of money.

11) Without a change in target inflation, anything that shifts the aggregate demand curve to the right will cause A) a temporary increase in output. B) a permanent reduction in inflation. C) a temporary decrease in inflation. D) an increase in output in the long run.

12) If monetary policymakers do not change their inflation target and aggregate demand shifts left, A) there will be a temporary decrease in output. B) potential output will decrease. C) there will be an increase in inflation in the long run. D) it will result in a permanent reduction in inflation.

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13) In response to the deep recession that began in December 2007, U.S. President George W. Bush signed legislation in February 2008 to cut income taxes temporarily. One year later, U.S. President Barack Obama approved a much larger package of temporary tax cuts and increases in government spending to counter the economic slump. Assume that the economy had adjusted back to long-run equilibrium prior to the government interventions taking effect. So, starting from long-run equilibrium, where on the graph below would the economy be after this initial increase in government spending, ceteris paribus, but before any self-adjustment?

A) (Y p; π T) B) (Y P; π 3) C) (Y 0; π 2) D) (Y 1; π 1)

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14) Assume that an economy starts from long-run equilibrium, and then there is an increase a sharp increase in oil prices, ceteris paribus. Where on the following graph would the economy be after this initial shock but before any self-adjustment?

A) (Y p; π T) B) (Y P; π 3) C) (Y 0; π 2) D) (Y 1; π 1)

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15) Assume that an economy starts from long-run equilibrium, and then monetary policymakers increase their inflation target, ceteris paribus. Where on the following graph would the economy end up after long-run adjustment to this policy change?

A) (Y p; π T) B) (Y P; π 3) C) (Y 0; π 2) D) (Y 1; π 1)

16) During the Vietnam War, monetary policy officials reacted to the increases in aggregate demand resulting from military expenditures by A) not shifting the monetary policy reaction function. B) dramatically slowing money growth. C) shifting the monetary policy reaction curve to the left. D) keeping the same inflation target and raising the real interest rates.

17) The 2008 and 2009 tax cuts and the increase in government spending that occurred at the same time did not have the same inflationary impact as the similar policy in the 1960s because, in the 2000s,

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A) the fiscal stimulus came at a time when the economy was already overheated. B) monetary policymakers, having perceived the inflation risk, responded appropriately. C) aggregate demand was already above potential output. D) consumer and business confidence in the economy was already high.

18)

If inflation increases, ceteris paribus, this could be illustrated as a A) rightward shift of the long-run aggregate supply curve. B) leftward shift of the short-run aggregate supply curve. C) rightward shift of the short-run aggregate supply curve. D) movement down along the short-run aggregate supply curve.

19)

Which one of the following would be classified as a negative supply shock? A) an increase in the legal minimum wage B) a decrease in the price of oil C) an increase in government purchases D) an increase in demand for exports

20)

Which one of the following would be classified as a negative supply shock? A) an increase in the price of oil B) an increase in government purchases C) an increase in export demand D) a decline of investor optimism

21)

An increase in the price of oil should cause the short-run aggregate supply curve to A) shift to the right. B) become vertical. C) become horizontal. D) shift to the left.

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22)

Negative supply shocks cause shifts in

A) only the short-run aggregate supply curve. B) the dynamic aggregate demand curve. C) the monetary policy reaction curve but only if policymakers do not change their inflation target. D) the short-run aggregate supply curve and, possibly, the long-run aggregate supply curve.

23)

Stagflation is a term that usually describes an economy experiencing A) low inflation. B) low inflation coupled with low growth. C) high inflation coupled with low growth. D) low unemployment rates and low inflation rates.

24)

Which one of the following would shift the short-run aggregate supply curve to the right? A) an increase in oil prices B) a reduction in the minimum wage C) a change in the law requiring overtime pay for anyone working more than 30 hours a

week D) an increase in payroll taxes

25)

Stagflation occurs when the inflation rate A) decreases and current output decreases. B) increases and current output decreases. C) decreases and current output increases. D) increases and current output increases.

26)

An increase in the rate of inflation

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A) can only result from increases in aggregate demand. B) can only result from leftward shifts in the short-run aggregate supply curve. C) will result only if the long-run aggregate supply curve is vertical. D) can result from shifts in either the dynamic aggregate demand curve or the short-run aggregate supply curve.

27) An inflation shock that shifts the short-run aggregate supply curve leftward and leaves the long-run supply curve unchanged means the economy's potential level of output will A) increase. B) not change. C) decrease. D) decrease only if monetary policymakers do not respond.

28)

Which one of the following statements is most correct?

A) A recession is officially defined as two consecutive quarters where the real growth rate is negative. B) A recession officially begins when unemployment exceeds 5.0 percent. C) There is no hard and fast definition of a recession. D) The official date of a recession is determined by the Federal Reserve Board, but usually with at least a three-month delay.

29)

"Official" recessions in the United States are declared by A) the Federal Reserve. B) the U.S. Department of the Treasury. C) the National Bureau of Economic Research. D) Congress.

30)

Almost all recessions identified by the NBER are characterized by

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A) declining real GDP. B) higher interest rates. C) durations exceeding two years. D) higher rates of inflation.

31) Which one of the following is not correct, with regard to the definition of a recession as used by the NBER? A) A recession occurs whenever there is a dip in the growth rate. B) The exact length of time needed for a downturn to be declared a recession is not specified. C) Many key economic indicators are used, some of which may move in opposite directions. D) A recession is characterized by lower levels of economic activity.

32) According to the NBER, a severe decline in economic activity that lasted fewer than two quarters A) could not be considered a recession. B) could still be considered a recession. C) would not be called a recession until more than two years had passed. D) would immediately be called a recession.

33)

Business cycles

A) vary in the length of recessions but not the time in between recessions. B) vary in the time between recessions but not in the length of recessions. C) vary in both the length of recessions and the time between recessions. D) are by definition recurring waves that rise and fall in a periodic and predictable pattern.

34)

A review of economic data suggests that

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A) expansions are shorter than recessions. B) business cycles are recurrent and periodic. C) over the last 50 years, recessions are becoming more common. D) recessions are shorter in duration than expansions.

35)

As of the beginning of 2020, the longest recession since the 1940s began in A) 1952. B) 1973. C) 1981. D) 2007.

36)

Stabilization policy refers to the use of A) only fiscal policy. B) only monetary policy. C) either fiscal or monetary policy. D) policy to shift the long-run aggregate supply curve.

37)

Policymakers can stabilize the economy by shifting A) the short-run aggregate supply curve. B) the dynamic aggregate demand curve. C) the long-run aggregate supply curve. D) neither the short-run aggregate supply curve nor the dynamic aggregate demand

curve.

38)

Policymakers can

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A) eliminate the effects of negative supply shock. B) neutralize movements in aggregate demand. C) shift the short-run aggregate supply curve. D) shift the monetary policy reaction function to stabilize the economy.

39) What tool is available to monetary policymakers to shift the short-run aggregate supply curve to the left following a positive inflation shock? A) A rightward shift of the monetary policy reaction curve B) A leftward shift of the monetary policy reaction curve C) Open market purchases of government securities D) None since the actions of monetary policymakers affect the dynamic aggregate demand curve

40) Suppose that consumer and business confidence fall. Also, monetary policymakers respond to keep inflation on an unchanged target. If monetary policymakers respond, output would A) remain close to potential output. B) fall below potential output. C) rise above potential output. D) remain close to potential output but inflation would still rise despite their actions.

41) In practice, it is difficult to keep inflation and output from fluctuating when aggregate expenditures change because A) policymakers respond too quickly to the shifts that have occurred. B) changes in interest rates have an immediate impact on the economy. C) changes in consumer or business confidence can be very difficult to recognize as they are occurring. D) monetary and fiscal policymakers work too closely together.

42)

Unemployment insurance and the proportional nature of the tax system are examples of

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A) discretionary fiscal policy. B) automatic fiscal policy. C) both discretionary and automatic fiscal policy. D) expansionary fiscal policy.

43)

The dynamic aggregate demand curve shifts as a result of A) discretionary fiscal policy. B) automatic fiscal policy. C) either discretionary or automatic fiscal policy. D) fiscal policy but only when it's used in conjunction with monetary policy.

44) as

Tax cuts would have the same directional effect on the dynamic aggregate demand curve

A) decreases in government purchases. B) the Federal Reserve selling U.S. treasury securities. C) the Federal Reserve buying U.S. treasury securities. D) temporary tax increases.

45)

Comparing monetary and fiscal policy, A) fiscal policy has an advantage because it is faster to implement than monetary policy. B) fiscal policy is easier to implement. C) monetary policy is easier to implement. D) history has shown fiscal policy to be more effective at stabilization.

46)

Fiscal policy suffers from the problem of being

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A) formulated and implemented by politicians subject to short-run incentives. B) implemented too quickly. C) influenced only by nonpolitical interests. D) global instead of domestic in the effects.

47)

When compared to fiscal policy, monetary policy A) is influenced more by politics. B) can be implemented faster. C) cannot usually be fine-tuned. D) is global instead of domestic in the effects.

48) Monetary policymakers can respond to the impact that positive inflation shocks have on output by shifting the A) monetary policy reaction curve left. B) monetary policy reaction curve right. C) short-run aggregate supply curve to the left. D) short-run aggregate supply curve to the right.

49) If a positive inflation shock occurs and monetary policymakers do not change the inflation target, output will eventually A) return to potential output and inflation will equal the inflation target. B) rise above potential output while inflation will equal the inflation target. C) fall below potential output while inflation will equal the inflation target. D) return to potential output but inflation will exceed the inflation target.

50) During the Great Moderation experienced in the United States during the 1990s, the volatility of inflation and growth

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A) moved in opposite directions. B) both dropped significantly. C) both increased but only slightly. D) disappeared.

51) Most economists attribute the Great Moderation experienced in the United States during the 1990s mainly to A) good fortune. B) slowing productivity growth. C) aggressive fiscal policy. D) better understanding and use of monetary policy.

52) Possible explanations that have been offered for the Great Moderation experienced in the United States include all of the following except which one? A) good fortune B) economies that have become more flexible in absorbing shocks C) calm financial markets D) better understanding and use of monetary policy

53)

Higher potential output levels without any monetary policy intervention will lead to A) higher real interest rates. B) lower real interest rates and higher inflation rates. C) higher real interest rates and lower inflation rates. D) lower real interest rates and lower inflation rates.

54)

Increases in potential output shift

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A) the long-run aggregate supply curve. B) the short-run aggregate supply curve. C) both the long-run aggregate supply curve and the short-run aggregate supply curve. D) the long-run aggregate supply curve, the short-run aggregate supply curve, and the dynamic aggregate demand curve.

55)

Disinflation occurs when A) the inflation rate is negative. B) the inflation rate is 2 percent or less. C) the inflation rate goes above 10 percent. D) the rate of inflation declines.

56)

Opportunistic disinflation occurs when policymakers A) leave the target inflation rate unchanged. B) take advantage of negative supply shocks. C) are able to permanently lower inflation. D) are able to shift LRAS to the left.

57)

Since 1950, the U.S. economy has likely experienced A) more periods of deflation than disinflation. B) more periods of disinflation than deflation. C) an equal number of periods of deflation and disinflation since they are synonymous. D) no periods of either deflation or disinflation.

58)

During the period from 1995 to 1999, the U.S. economy

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A) experienced the great productivity slowdown. B) experienced increases in productivity that allowed the Fed the opportunity to raise the inflation rate. C) experienced increases in productivity that allowed the Fed the opportunity to let the inflation rate fall. D) saw its potential level of output decrease.

59) Which one of the following statements best describes the level of potential output in the United States? A) It never changes year to year. B) It is very erratic year to year. C) It usually increases year to year. D) It has been decreasing since 1999.

60)

Real business cycle theory seeks to explain business cycle fluctuations by focusing on A) shifts in potential output. B) the inflexibility of prices and wages. C) aggregate demand. D) changes in monetary policy.

61)

The key part of the real business cycle theory model is A) the importance of monetary policy. B) the short-run aggregate supply curve. C) changes in aggregate demand. D) changes in potential output.

62)

Real business cycle theory explains fluctuations in output through

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A) changes in aggregate demand. B) changes in productivity. C) shifts of the short-run aggregate supply curve. D) changes in monetary policy.

63)

Increases in productivity result in

A) higher inflation as output increases. B) lower inflation as output decreases. C) opportunities for policymakers to reduce their inflation target without inducing a recession. D) increases in production possibilities.

64)

The assumption that prices and wages are flexible implies that the

A) short-run aggregate supply curve is irrelevant. B) short-run aggregate supply curve shifts slowly in response to deviations of current output from potential output. C) long-run aggregate supply curve is irrelevant. D) long-run aggregate supply curve could not shift.

65)

Globalization and trade A) increase inflation in the short run. B) shift both the short-run and long-run aggregate supply curves to the right. C) reduce policymakers’ opportunities to reduce inflation permanently. D) break the link between domestic inflation and domestic monetary policy.

66)

Globalization and trade reduce inflation in the

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A) short run but not in the long run. B) short run and in the long run. C) long run but not in the short run. D) short run but increase inflation in the long run.

67) In an economy like the United States, the impact of a decrease in import prices on overall inflation can be best described as A) nonexistent. B) a modest increase. C) a modest decrease. D) a significant decrease, particularly as globalization and trade increase.

68)

Policymakers can neutralize A) supply shocks, but only in the short run. B) supply shocks, but only in the long run. C) supply shocks in both the short run and the long run. D) only demand shocks.

69) In which situation would policymakers be unable to neutralize the effect on the economy? A) federal government deficit B) increase in the price of oil C) imports exceeding exports D) decline in consumer confidence

70)

Policymakers could neutralize all of the following except which one?

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A) an increase in federal government spending on defense B) an increase in the price of oil C) a trade deficit D) a decrease in business confidence

71)

Estimates of gross domestic product (GDP) are revised A) quickly and often. B) for many years after the fact. C) only in the following quarter. D) each month.

72) If the economy's output response to changes in current inflation is small, the slope of the dynamic aggregate demand curve will be A) flat. B) steep. C) positive. D) zero.

73) If the monetary policy reaction curve has a relatively flat slope, the dynamic aggregate demand curve is likely to have a A) relatively steep slope. B) relatively flat slope. C) positive slope. D) zero slope.

74) If the monetary policy reaction curve has a relatively steep slope, the dynamic aggregate demand curve is likely to have a

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A) relatively steep slope. B) relatively flat slope. C) positive slope. D) zero slope.

75) If monetary policymakers respond aggressively to current inflation above the target inflation rate, the A) monetary policy reaction curve would be flat. B) dynamic aggregate demand curve would have a steep slope. C) monetary policy reaction curve would have a positive and steep slope. D) dynamic aggregate demand curve would shift rightward.

76) rates

Central bankers with a relatively steep monetary policy reaction curve will move interest

A) more aggressively when inflation rises, leading to more volatility in output. B) more aggressively when inflation rises, leading to less volatility in output. C) less aggressively when inflation rises, leading to more volatility in output. D) less aggressively when inflation rises, leading to less volatility in output.

77) rates

Central bankers with a relatively flat monetary policy reaction curve will move interest

78)

A flat dynamic aggregate demand curve corresponds to a

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A) steep monetary policy reaction curve and means that supply shocks will create large changes in current output. B) flat monetary policy reaction curve and means that supply shocks will create large changes in current output. C) steep monetary policy reaction curve and means that supply shocks will create small changes in current output. D) flat monetary policy reaction curve and means that supply shocks will create small changes in current output.

79)

In which situation will inflation fall the fastest?

A) A negative supply shock occurs, the dynamic aggregate demand curve is steep, and so is the monetary policy reaction curve. B) A negative supply shock occurs, the dynamic aggregate demand curve is flat, and so is the monetary policy reaction curve. C) A negative supply shock occurs, the dynamic aggregate demand curve is flat, and the monetary policy reaction curve is steep. D) A negative supply shock occurs, the dynamic aggregate demand curve is steep, and the monetary policy reaction curve is flat.

80) If monetary policymakers are more concerned about output fluctuations than inflation fluctuations, A) they will choose a relatively steep monetary policy reaction curve in which movements in the real interest rates are small. B) they will choose a relatively flat monetary policy reaction curve in which movements in the real interest rates are small. C) they will choose a relatively steep monetary policy reaction curve in which movements in the real interest rates are large. D) they will choose a relatively flat monetary policy reaction curve in which movements in the real interest rates are large.

81)

Monetary policymakers face a tradeoff between

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A) the level of output and the rate of inflation. B) the volatility in output and the volatility in inflation. C) low unemployment and high inflation. D) high unemployment and low inflation.

82)

When faced with negative supply shocks, policymakers

A) will stabilize both inflation and output. B) will always focus on stabilizing output. C) cannot stabilize output, so they tend to focus on inflation. D) face a trade-off because they cannot simultaneously stabilize both output and inflation.

83) In the decade after 2007, the U.S. economy grew at a modest pace. Former Treasury Secretary Lawrence Summers has offered a hypothesis for this that differs from the conventional explanation that potential output slowed sharply. Summers’ secular stagnation shifts the focus on to ______ and argues that the real interest rate that prevails in long-run equilibrium is ______. A) supply; positive B) supply; negative C) demand; positive D) demand; negative

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 84) Explain why understanding short-run fluctuations in output and inflation requires that we study shifts in dynamic aggregate demand and short-run aggregate supply.

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85) Explain why changes in the central bank's inflation target will shift the dynamic aggregate demand curve.

86) Describe the immediate short-run effect to the economy from an increase in government purchases, as well as the self-correcting mechanism that will restore long-run equilibrium.

87) If monetary policymakers do not want the current inflation rate to increase, yet they observe increasing aggregate demand from higher government purchases, will they have to accept a higher inflation target? Explain.

88) Discuss the short- and long-run output responses resulting from an increase in money growth when the economy is producing a current level of output that equals potential output, all other factors constant.

89) Why could it be effectively argued that the temporary increase in inflation from the spending for the Vietnam War was made permanent by the Fed?

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90) In 2001, a combination of tax cuts and increased defense spending in the United States did not have the same inflationary effect as the similar policy in the 1960s. Explain the difference.

91) Use the long-run model presented in Chapter 22 to answer this question. If there is a decrease in aggregate demand, and monetary policymakers counter the decrease in aggregate demand, what will be the impact on output and inflation? Explain.

92) Why does it take so long for the declaration of the beginning and end of recessions in the U.S. and why is there a lack of clarity as to what is and is not a recession?

93)

Why can monetary policymakers neutralize demand shocks but not supply shocks?

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94)

Neutralizing demand shocks is easier in theory than in practice. Why?

95)

What is meant by saying that automatic fiscal policy is countercyclical?

96) Fiscal policy can act just like monetary policy to offset shifts in the dynamic aggregate demand curve and stabilize inflation and output. Explain how the two policies could have the same effect.

97) Why would most economists usually default first to monetary policy for stabilization before using fiscal policy?

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98) What is opportunistic disinflation and what provides the opportunity? Explain how the process works.

99)

What explanations have been offered to account for the Great Moderation?

100) Use the long-run AD/SRAS/LRAS model to describe the adjustment process the economy would go through from an increase in potential output.

101) Why do increases in potential output allow monetary policymakers to think "opportunistically" about disinflation?

102)

Explain the view called real business cycle theory.

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103) Explain why real business cycle theory renders the short-run aggregate supply curve irrelevant.

104)

Explain how globalization impacts inflation in both the short run and the long run.

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105) Assume the economy is in long-run equilibrium. Use the AD/SRAS/LRAS model to illustrate shifts that occur in the short run and in the long run as the economy opens up to trade with other countries. There is no fiscal or monetary policy implemented as the economy selfadjusts. Explain the results.

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106) Assume the economy is in long-run equilibrium. Use the AD/SRAS/LRAS model to illustrate shifts that occur in the short run and in the long run as the economy opens up to trade with other countries. Assume that monetary policymakers do intervene as initial globalization moves the economy away from long-run equilibrium. Explain the results.

107) Does an increase in the rate of inflation always imply that aggregate demand is increasing? Explain.

108) In recent years, discussions of the causes of recessions have focused on monetary policy and higher oil prices as the likely causes. Discuss how we can get insight into the likely cause by focusing on macroeconomic variables.

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109) While monetary policymakers cannot shift the short-run aggregate supply curve following inflation shocks, they can minimize the impact that the changes in inflation have on output. Describe how they can do this through the monetary policy reaction curve.

110) Consider the two Monetary Policy Reaction Curves shown below. What does the shape of each MPRC tell us about the views of the central bankers in that country?

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111) Suppose monetary policymakers in a small economy are most concerned with keeping output close it its potential level and use interest rates as their primary policy tool. Draw the AD/SRAS/LRAS model illustrating this stance. Explain how aggressively these central bankers are likely to move interest rates in response to an increase in inflation. Why is this the case?

112) Describe two possible contributors to the growth slowdown that occurred in the United States in the decade after 2007 according to conventional supply-oriented theory and two possible contributors according to Lawrence Summers’ secular stagnation, demand-oriented theory.

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113) More than once in our history government officials tried to slow rapidly rising inflation by instituting wage and price controls; in essence, making it illegal to raise prices. In terms of the model, which includes aggregate demand, short-run aggregate supply and long-run aggregate supply, describe what the intended result of the officials would be and what the likely result may be.

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Answer Key Test name: Chap 22_6e 1) C 2) A 3) C 4) B 5) D 6) C 7) B 8) D 9) C 10) C 11) A 12) A 13) D 14) C 15) B 16) A 17) D 18) B 19) A 20) A 21) D 22) D 23) C 24) B 25) B 26) D Version 1

27) B 28) C 29) C 30) A 31) A 32) B 33) C 34) D 35) D 36) C 37) B 38) B 39) D 40) A 41) C 42) B 43) A 44) C 45) C 46) A 47) B 48) A 49) A 50) B 51) D 52) C 53) D 54) C 55) D 56) C Version 1

57) B 58) C 59) C 60) A 61) D 62) B 63) C 64) A 65) B 66) A 67) C 68) D 69) B 70) B 71) B 72) B 73) A 74) B 75) C 76) A 77) D 78) A 79) C 80) B 81) B 82) D 83) D

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84) The economy naturally moves to long-run equilibrium, where output equals potential output and inflation equals the central bank's target. The economy will move away from its long-run equilibrium immediately after either the short-run aggregate supply curve or the dynamic aggregate demand curve shift. This means that understanding short-run fluctuations in output and inflation (meaning departures from the long-run equilibrium) requires that we study shifts in dynamic aggregate demand and short-run aggregate supply. 85) To explain this, let us illustrate with an analysis of the effect of a decrease in the policymakers' inflation target. The process begins with the monetary policy reaction curve. A fall in the inflation target shifts the monetary policy reaction curve to the left, raising the real interest rate policymakers set at each level of inflation. This reduces aggregate expenditure at every level of inflation, thus shifting the dynamic aggregate demand curve to the left as well. The analysis would be parallel for an increase in the central bank's inflation target. 86) The increase in government purchases will cause the dynamic aggregate demand curve to shift right. The immediate impact of this increase is to raise both current output and inflation. But, because current inflation exceeds expected inflation, expected inflation rises, shifting the short-run aggregate supply curve to the left. Eventually, current inflation rises and current output falls until the economy reaches the point at which the dynamic aggregate demand curve crosses the long-run aggregate supply curve. At that point, current inflation equals expected inflation and target inflation, while current output equals potential output.

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87) Not necessarily. If the increase in aggregate demand puts upward pressure on inflation, the monetary policymakers could compensate by shifting their monetary policy reaction function to the left, increasing the real interest rate at every rate of inflation. In this case the higher real interest rate should cause the dynamic aggregate demand curve to shift left restoring long-run equilibrium at the target rate of inflation. 88) In the short run, an increase in money growth will shift the dynamic aggregate demand curve to the right. The level of current output will increase. In this case, output takes up the increase in aggregate demand. Over time this will put upward pressure on prices (inflation) and as prices adjust upwards the short-run aggregate supply curve will shift left, and the economy will move up its vertical long-run aggregate supply curve. Once prices (inflation) have fully adjusted the economy will return to its potential level of output, and the increased aggregate demand resulting from increased money growth will result in inflation and not a permanently higher level of potential output. 89) The increase in aggregate demand that resulting from expenditures for the war along with other social programs fueled an expansionary output. The Fed could have dampened this output gap if they would have shifted the monetary policy reaction curve to the left, raising the real interest rate at every rate of inflation. They failed to do this, which resulted in a temporary increase in inflation becoming a permanent increase. 90) The cut in taxes and increased defense spending represented a fiscal stimulus, but it came at a time when the economy was weakening due to other factors. The Federal Reserve also had a better understanding of the policy response needed to keep inflation low. 91) If monetary policymakers counter demand increase, the output gap may be avoided, and the policymakers can preserve their inflation target.

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92) There is no official definition of a recession. The unofficial arbiter of the timing of recessions is the NBER's business cycle dating committee. The committee includes many measures in determining whether the economy has entered or is leaving a recessionary period. Output is not the only measure looked at, so while many people may still focus on dips in actual output to identify a recession, the NBER's committee is looking at the overall level of economic activity. And as we saw in an earlier chapter, there are delays in measuring the level of economic activity and the measurements are often subjected to numerous revisions. 93) Monetary policy is enacted through shifts in the dynamic aggregate demand curve. Therefore, if aggregate demand were to increase, monetary policymakers can offset that by raising the real interest rate (shifting the monetary policy reaction curve) and thus bring about an opposite effect on the dynamic aggregate demand curve. However, central bankers cannot shift the short-run aggregate supply curve. 94) To neutralize demand shocks, monetary policymakers shift the monetary policy reaction curve and thus effect changes in real interest rates to create offsetting changes in aggregate demand. However, in practice it is extremely difficult to keep inflation and output from fluctuating when aggregate expenditure changes. There are two reasons for this. First, it takes time to recognize what has happened. For example, changes in consumer or business confidence can be difficult to recognize as they are occurring. Second, the changes in interest rates that policymakers cause do not have an immediate effect on the economy. Thus, in theory, central bankers can neutralize aggregate demand shocks but those shocks cause fluctuations in output and inflation.

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95) Automatic fiscal policy includes unemployment insurance and the proportional nature of the tax system. These adjust mechanically to stimulate an economy that is slowing down and put the brakes on an economy that is speeding up. The reason for that is that when the economy slows down tax payments decrease and payments for things like unemployment insurance increase, providing stimulus automatically. Similar, when the economy speeds up tax payments increase and payments of things like unemployment insurance decrease, thus applying the brakes automatically. Thus, automatic fiscal policy, by stimulating a slowing economy and cooling off a hot economy, acts countercyclically to resist fluctuations in aggregate expenditure and keep the economy stable. 96) Fiscal policy consists of changes in taxes and/or government spending. An increase in taxes or a decrease in government spending results in a decrease in aggregate expenditure, similar to a monetary policy that resulted in higher interest rates. A decrease in taxes or an increase in government spending results in an increase in aggregate expenditure, similar to a monetary policy that lowered interest rates. Put simply, both policies can be used to effect changes in aggregate demand to provide stimulus or cool off the economy in the context of other changes that are occurring. 97) Monetary policy offers a lot of advantages over fiscal policy. Monetary policy can be implemented faster and central bankers do have independence from political pressure. Fiscal policy is formulated and implemented by politicians who are subject to political pressure and must please constituents. Also, economists prefer stimulus packages that influence a few key people to do something they were not doing versus policies that pay people to do something they were going to do anyway. Monetary policy is likely to fall in the former category while fiscal the latter. Version 1

98) Opportunistic disinflation means that central bankers can exploit the opportunity created by a positive supply shock to achieve a lower inflation rate. A positive supply shock shifts the short-run aggregate supply curve to the right, resulting in higher output and lower inflation. Central bankers then shift the monetary policy reaction curve to the left (raising the real interest rate), which then shifts the dynamic aggregate demand curve to the left as well. This drives output below potential output, which puts downward pressure on inflation. As a result, inflation falls to the new lower target level. A positive supply shock creates an opportunity for policymakers to guide the economy to a new lower inflation target without inducing a recession. 99) Three possible explanations have been offered for this period of unprecedented economic stability. One is that everyone was extremely lucky and that the period from 1985 to 2007 was simply an exceptionally calm period. The second is that economies have become more flexible in absorbing external economic disturbances. And the third is that monetary policymakers have figured out how to do their job effectively. 100) The increase in potential output would shift the long run aggregate supply curve to the right. The aggregate demand curve, as well as the short-run aggregate supply curve would not have changed. Without a response from monetary policymakers, the short run aggregate supply curve would shift downward eventually restoring potential output at a lower rate of inflation. Alternatively, if the central bank responds by shifting the monetary policy reaction curve to the right, it could speed the adjustment of the economy to the new, higher potential output while maintaining its former inflation target.

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101) Increases in potential output put downward pressure on inflation rates. As a result, monetary policymakers have the opportunity to lower the target rate of inflation at every real interest rate without creating a recession. 102) Real business cycle theory seeks to explain fluctuations in the business cycle through changes in potential output. Prices and wages are viewed as flexible, so inflation adjusts rapidly in response to demand and supply shocks. To explain recessions and booms, real business cycle theorists look to fluctuations in potential output, focusing on changes in productivity and their impact on gross domestic product. According to real business cycle theory, the only sources of fluctuations in output are shifts in productivity. 103) Real business cycle theory seeks to explain fluctuations in the business cycle through changes in potential output. Prices and wages are viewed as flexible so inflation adjusts rapidly in response to demand and supply shocks. This assumption renders the short-run aggregate supply curve irrelevant. Equilibrium output and inflation are determined by the point of intersection of the dynamic aggregate demand curve and the long-run aggregate supply curve, where current output equals potential output. 104) The impact of globalization on economic activity and inflation is similar to that of productivity enhancing technological progress. Just as advances in technology increase potential output, globalization shifts both the short-run and long-run aggregate supply curves to the right along the dynamic aggregate demand curve to a point where output is higher and inflation is lower. In the long run, output will return to potential output, but like any other positive supply shock, globalization offers monetary policymakers the opportunity to reduce inflation permanently.

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105) The impact of globalization on economic activity and inflation is similar to that of productivity enhancing technological progress. Just as advances in technology increase potential output, globalization shifts both the short-run and long-run aggregate supply curves to the right along the dynamic aggregate demand curve to a point where output is higher and inflation is lower. In the graph above in the panel on the left, the economy starts out in long-run equilibrium 0. MPRC does not shift so the AD is unchanged. Output and inflation are determined by the intersection of the SRAS and dynamic AD at equilibrium 1 where output is now higher and inflation is lower. Since we are assuming no monetary policy intervention, in the long run, adjustment will occur. At equilibrium 1 in the graph above, expected inflation exceeds current inflation, so it starts to fall, shifting the SRAS curve to the right, driving inflation down even further. This continues until expected inflation equals current inflation and current output equals potential output. The new long-run equilibrium occurs at equilibrium 3 in the panel on the right where output equals the new higher level of potential output and inflation is below the original target level. 106) The impact of globalization on economic activity and inflation is similar to that of productivity enhancing technological progress. Just as advances in technology increase potential output, globalization shifts both the short-run and long-run aggregate supply curves to the right along the dynamic aggregate demand curve to a point where output is higher, and inflation is lower. In the graph above in the panel on the left, the economy starts out in long-run equilibrium 0. MPRC does not shift so the AD is unchanged. Output and inflation are determined by the intersection of the SRAS and dynamic AD at equilibrium 1 where output is now higher, and inflation is lower. After a lag, the central bank realizes potential output has risen. Assuming policymakers are happy with their current inflation target, they will work to move the economy to the point on the new long-run aggregate supply curve consistent with that initial target. This means shifting the monetary policy reaction curve to the right. This change in monetary policy shifts the dynamic aggregate demand curve to the right. The policy adjustment will drive output and inflation up until they reach their new long-run equilibrium levels at equilibrium 2 in the preceding panel on the right.

107) No, not always. While rightward shifts in the dynamic aggregate demand curve can cause increases in the rate of inflation, higher inflation rates can also occur even if the dynamic aggregate demand curve is stable. Negative inflation shocks that shift the short-run aggregate supply curve to the left will also cause higher rates of inflation.

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108) If a recession was caused by monetary policy, the dynamic aggregate demand curve should shift to the left and inflation should decrease. On the other hand, if the recession was caused by a negative supply shock, the inflation rate should rise as the output decreases. 109) The steepness of the monetary policy reaction curve determines the slope of the aggregate demand curve. A relatively flat monetary policy reaction curve which says policymakers will not raise real interest rates a lot in response to higher inflation will cause the aggregate demand curve to be steep. A steep aggregate demand curve will minimize the effect on output from any shift in the short-run aggregate supply curve. 110) In the panel on the left, the MPRC is steeper. The central bankers are intent on keeping inflation close to the target and will move interest rates aggressively when inflation rises. The MPRC in the panel on the right is flatter. These central bankers are more concerned about keeping output close to potential and will move interest rates by less in reaction to an inflation increase. 111) The graph shown illustrates what happens when policymakers are less concerned about keeping inflation close to target in the short run, and more concerned about keeping current output near potential output. When policymakers worry more about short-run fluctuations in output than about temporary movements in inflation, they will choose a relatively flat MPRC in which movements in the real interest rate are small, even when inflation strays far from its target level. The result is a steep dynamic aggregate demand curve like the one drawn above. Notice what happens in this case following a negative supply shock. Inflation rises and output falls—but the output gap is small while the deviation of inflation from expected inflation is large. The consequence is that expected inflation rises significantly and adjusts only slowly back to the target. Stable output means volatile inflation.

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112) Is the slowdown primarily a supply story of slowing productivity or a demand story of insufficiently low real interest rates? Slower labor force growth, slower productivity growth, reduced gains in labor quality, reduced gains in labor quality, slower firm creation due to regulation, and trend decline in rates of job-finding all lend credence to the supplyoriented explanation. Reduced propensity to consume due to high private debt, reduced public investment due to high public debt, falling price of investment goods, preference for safe assets, and increased inequality all lend credence to the demand-oriented explanation. Accurately measuring the contributions of these factors is not easy and evidence to date is not clear cut. 113) The inflation the economy was experiencing had to be the result of either rightward shifts in aggregate demand or leftward shifts in the short-run aggregate supply curve. The wage and price controls were likely intended to stop the leftward shift in the short-run aggregate supply curve since higher input costs lead to these leftward shifts. The controls could also slow the rightward shifts in aggregate demand if they were accompanied by slower money growth or if they caused people to hold more money (decreasing the velocity of money). The actual results, though, are many and often not what was intended. If inflation couldn't adjust, eventually current output would decrease, workers would not continue to work longer hours without raises or the likelihood of receiving one soon. The result could be a decrease in potential output, which would make shortages even more likely. Experience also points to the fact that when the controls are removed, input costs increase dramatically and inflation increases, (moving the short-run aggregate supply curve upward). In the long run the economy will return to its potential level of output where current inflation equals expected and target inflation. Since wage and price controls cannot increase potential output, in the long run they cannot be beneficial. Version 1

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CHAPTER 23 MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question. 1) During the financial crisis of 2007–2009, which one of the following countries experienced a decline in real GDP roughly twice that of the United States? A) Canada B) the United Kingdom C) Japan D) Turkey

2) one?

All of the following could represent the transmission of monetary policy, except which

A) households altering their spending on durable goods B) income tax rates changing C) firms altering their growth plans D) net exports changing

The monetary policy transmission mechanism refers to the concept that monetary policy A) always seems to work the way central bankers think it will. B) works quickly. C) only works through changes consumption and investment. D) affects the economy in potentially many ways.

Traditional channels of the monetary policy transmission mechanism include A) income tax rates. B) interest rates. C) fiscal policy transmission. D) regulatory channels.

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An easing of monetary policy should A) increase spending by households and businesses and increase net exports. B) raise net exports but lower spending by households and businesses. C) decrease spending by households and businesses as well as net exports. D) increase investment and household spending but lower net exports.

An easing of monetary policy means A) decreasing the target interest rate. B) decreasing the central bank’s balance sheet. C) increasing reserve requirements. D) increasing the federal funds rate.

Decreases in the real interest rate will result in a(n) A) increase in net exports because it will lead to a depreciation of the dollar. B) decrease in net exports because it will lead to a depreciation of the dollar. C) increase in net exports because it will lead to an appreciation of the dollar. D) decrease in net exports because it will lead to an appreciation of the dollar.

8) Which one of the following traditional channels of monetary policy transmission can be described as powerful? A) the interest-rate channel B) the exchange-rate channel C) both the interest-rate channel and the exchange-rate channel D) neither the interest-rate channel nor the exchange-rate channel

The interest-rate channel of monetary policy transmission appears to be

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A) weak because the investment component of total spending isn't very sensitive to interest rates. B) weak because the investment component of total spending is very sensitive to interest rates. C) strong because the investment component of total spending isn't very sensitive to interest rates. D) strong because the investment component of total spending is very sensitive to interest rates.

10)

Changing short-term interest rates have a(n) A) strong and immediate impact on household purchase decisions. B) no impact on household purchasing decisions. C) somewhat modest impact on household purchasing decisions. D) a modest impact on current decisions and no impact on future purchasing decisions.

11) With respect to consumer behavior, the interest-rate channel of monetary policy transmission appears to be A) weak because people's decisions to purchase cars or houses depend more on shortterm rates rather than long-term rates. B) weak because people's decisions to purchase cars or houses depend more on longterm rates rather than short-term rates. C) strong because people's decisions to purchase cars or houses depend on the shortterm rates that policymakers can change. D) strong because it affects both spending and saving decisions.

12)

The impact of monetary policy on the exchange rate and net exports is best described as A) the strongest of all the parts of the transmission mechanism. B) powerful, but lagging. C) difficult to forecast. D) nonexistent.

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13)

The direct impact of short-term interest rate changes by central banks on spending is A) definitely the strongest of all transmission mechanisms. B) not that powerful. C) only effective for consumption but not investment. D) only effective for net exports but not for investment and consumption.

14)

Evidence suggests that A) high real interest rates cause recessions. B) central bankers raise real interest rates to cause recessions. C) high real interest rates have no effect on levels of growth. D) high real interest rates are followed by lower levels of growth.

15) The Federal Reserve's surveys of bank loan officers contain questions about all of the following except which one? A) interest rates being charged B) supply of and demand for loans C) quantity and quality of loans D) tax rates being charged

16)

The Federal Reserve's surveys of bank loan officers contain questions about A) the interest rates being charged. B) the supply of and demand for loans. C) the quantity and quality of loans. D) All of the answers given are correct.

17)

The Federal Reserve conducts an opinion survey on bank-lending practices because

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A) if banks stop making loans and businesses can’t borrow to finance investment projects, economic growth could slow. B) an increase in the quantity of loans granted is a signal of tighter credit standards. C) climbing interest-rate spreads indicate that banks are engaging in riskier behavior. D) an increase in the quantity of new loans is a leading indicator of slower economic growth.

18) one?

Banks provide all of the following essential services for a modern economy except which

A) direct resources from savers to investors B) monitor loan recipients’ use of borrowed funds C) improve social welfare through taxes and transfers D) solve problems caused by information asymmetries

19)

The bank-lending channel of monetary policy focuses on A) the interest rate banks charge their largest customer. B) the willingness and ability of banks to lend. C) how central bank policy influences the solvency of banks. D) the deposit insurance premiums banks will end up paying.

20)

An open market purchase of securities by the central bank from banks usually will

A) increase the banks' revenue even if the bank does nothing with the reserves. B) induce the banks to make more loans since their revenue will decrease if they do nothing. C) decrease the amount of deposits in the banking system. D) decrease the banks' willingness and ability to make loans.

21)

An open market sale of securities by the central bank to banks usually will

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A) diminish the inclination of banks to make loans. B) induce the banks to make more loans since their revenue will decrease if they do nothing. C) increase the amount of deposits in the banking system. D) increase the banks' willingness and ability to make loans.

22) The additional capital requirements put in place following the banking crisis of the 1980s led to a A) quick rebound in the willingness and ability of banks to make loans. B) further slowdown in bank lending. C) period of rapid economic growth in the early 1990s. D) prolonged economic slowdown lasting much of the 1990s.

23)

The balance-sheet channel of monetary policy works because it can

A) increase a borrower's asset value but not the burden of their liabilities. B) change the value of a borrower's assets and liabilities, but not a borrower's net worth. C) increase a borrower's assets and reduce the cost of their liabilities. D) change a borrower's net worth without affecting the value of their assets and liabilities.

24)

For a firm, a decrease in the interest rate resulting from monetary policy can decrease A) the value of its assets. B) the cost of its liabilities. C) its net worth. D) the firm’s value.

25) Firm A has assets that are mainly in financial securities and liabilities that carry variable interest rates. Firm B has the same assets as Firm A and the same amount of liabilities, but its liabilities are all at fixed interest rates. If the central bank lowers interest rates, everything else constant, then Version 1

A) Firm B's net worth will increase more than Firm A's. B) Firm A's net worth will increase more than Firm B's. C) Neither firm's net worth will change. D) The net worth of both firms will increase and by the same amount.

26)

If a borrower's net worth increases, the A) likelihood of moral hazard also increases. B) borrower is likely to want to take less risk. C) moral hazard risk for the potential lenders decreases. D) supply of loans decreases.

27)

Increases in a borrower's net worth reduce the A) information symmetries. B) profit potential for banks. C) ease of obtaining financing. D) information costs of lending.

28) What is the driving force in the bank-lending and balance sheet channels of monetary policy transmission? A) profit B) information C) homogeneity D) competition

29) A change in each of the following can contribute to the change in the supply of loans resulting from an interest rate change, except which one?

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A) borrowers' net worth B) demand for loans C) potential of moral hazard D) percentage of loan payment to income

30)

A fall in interest rates tends to push stock prices A) and real estate prices up. B) and real estate prices down. C) up and real estate prices down. D) down and real estate prices up.

31)

Bankers might be less willing to make loans even as interest rates rise when A) the net worth of borrowers also increases. B) the demand for loans falls. C) there are accounting scandals. D) there is stability in financial markets.

32)

The importance of the bank-lending channel of monetary policy transmission increases A) with the growth of loan brokers and asset-backed securities. B) when banks contribute less to an economy’s growth over time. C) when banks are a more important source of funds for firms and individuals. D) because technology has solved the problems of information and moral hazard.

33)

The relationship between interest rates and stock prices is referred to as the A) interest-rate mechanism of monetary policy. B) investment-spending mechanism of monetary policy. C) wealth-creating mechanism of monetary policy. D) asset-price channel of monetary policy.

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34) If central bankers raise the interest rate, the asset-price channel of monetary policy implies that A) stock prices will decrease. B) stock prices will remain the same but bond prices will increase. C) bond prices will remain flat. D) stock prices will increase and bond prices will remain flat.

35)

Stock prices may rise from a reduction in interest rates because A) the present value of future earnings will increase. B) stockholders will expect lower future earnings. C) financial market participants are less optimistic about future earnings. D) the present value of future earnings will decrease.

36)

Stock prices rise A) usually 6 to 12 months after interest rates are reduced. B) immediately after interest rates are increased. C) in anticipation of an interest rate reduction. D) only after people are convinced the central bank interest rate cut is permanent.

37)

The relationship between real estate markets and interest rates is

A) nonexistent. B) inverse; higher interest rates drive down real estate prices and vice versa. C) complex; cuts in the short-term interest rate lead to increases in long-term rates and higher real estate prices. D) direct; high interest rates lead to high real estate values as people abandon other financial assets.

38)

Higher home values can increase output in the economy if homeowners

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A) sell their existing home and build a new one. B) continue to build equity in their current homes. C) plan for retirement by holding onto homes as a long-term asset. D) use college savings plans to finance college education instead of refinancing their mortgage.

39)

Higher stock prices can lead to greater investment spending by firms because the

A) cost of external financing is lower. B) market value of a firm is now less than the replacement cost of the firm. C) firm gets 100 percent of the increase in the stock value. D) cost of internal financing is lower and the firm also gets 100 percent of the increase in the stock value.

40)

Each of the following is a transmission channel of monetary policy, except which one? A) balance-sheet channel B) tax-impact channel C) asset-price channel D) exchange-rate channel

41)

Which one of the following statements best reflects monetary policy?

A) It is a hard and fast science. B) Its impact is impossible to predict. C) It is a lot like gambling because the outcomes are uncertain most of the time. D) There is certainly some science involved, a lot of understanding that is needed, but a lot of uncertainty remains.

42) one?

The challenges facing policymakers today include each of the following, except which

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A) The economy's sustainable growth rate is highly stable. B) Nominal interest rates cannot fall below the effective lower bound (somewhat below zero). C) Stock and property values are subject to booms and busts. D) The structure of the economy and financial system continues to evolve.

43) To compensate for the collapse of intermediation and the fragility of financial markets during the 2007–2009 financial crisis, central banks deployed all but which one of the following unconventional tools? A) forward guidance B) lowering interbank lending interest rate targets C) quantitative easing D) targeted asset purchases

44) All but which one of the following is a reason that policymakers are concerned about the strength of the rebound from the 2007–2009 financial crisis? A) Banks would make credit expensive and difficult to obtain. B) Investors would be cautious about buying securitized assets. C) Households would prefer to save more and borrow less. D) The pace of technological change would slow.

45) The information problems that intensified the financial crisis of 2007–2009 are similar to those that exist in the market for A) oil. B) eggs. C) wheat. D) used cars.

46) All but which one of the following could be adjusted as a means of deflating asset price bubbles? Version 1

A) tariffs B) capital requirements C) capital surcharges D) fees for insuring the capital of banks

47)

If a zero-coupon bond sells for par, the nominal interest rate on that bond is A) 100 percent. B) negative. C) zero. D) infinity.

48)

Bonds must have yields above the effective lower bound because A) people can always hold cash. B) central banks cannot act boldly when facing deflation. C) the U.S. Treasury guarantees all bonds to have a positive yield. D) the banking technology does not exist to deal with negative yields.

49)

The fact that investors can always hold cash creates A) a problem for monetary policymakers when the short-term interest rates approach

zero. B) an opportunity for the U.S. Treasury to issue bonds that have negative nominal interest rates. C) an upward bound on nominal interest rates. D) negative nominal interest rates.

50)

One of the limiting factors for using monetary policy is that

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A) the central banks are limited in their ability to print money. B) central banks are limited in their ability to make loans. C) there is a lower nominal-interest-rate bound of zero. D) the real interest rate cannot fall below zero.

51)

Firms have a harder time getting loans during periods of deflation because

A) deflation increases the net worth of firms. B) deflation aggravates information problems in ways dissimilar to inflation. C) the economy’s self-adjustment process works more quickly during deflation. D) for a firm seeking a loan, deflation increases the real amount of their assets but doesn’t change the value of their liabilities.

52) A way for policymakers to avoid the problems that deflation can present and still meet their objective of price stability is to A) set a target of zero inflation. B) keep the monetary base fixed. C) set a higher inflation target. D) target a nominal interest rate of zero.

53)

Most central bankers do not set an inflation target of zero because A) it is almost impossible to achieve. B) they believe it would cause price volatility. C) the central bank could hit the lower bound. D) it is difficult to act preemptively.

54)

When central bankers are acting preemptively, they are

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A) letting markets work and taking a wait and see approach. B) aggressively trying to hit a zero-inflation target. C) usually focused on reducing expansionary gaps. D) taking bold steps to stabilize the economy.

55) Between September 2007 and December 2008, the FOMC reduced the target federal funds rate 5.25 percentage points toward zero. A reason for this was that the FOMC A) was acting preemptively. B) feared over stimulating the economy. C) was taking a wait-and-see approach to previous cuts. D) was feeling political pressure to act.

56)

If the target federal funds rate reaches the lower bound A) the FOMC would run out of policy options. B) monetary policy would no longer be of use. C) the FOMC would turn to unconventional measures, such as forward guidance. D) the FOMC would simply reset the target.

57)

If the target federal funds rate reaches the lower bound, the FOMC

A) must stop purchasing securities since they cannot lower nominal rates below the lower bound. B) would likely shift their focus to purchasing longer-term securities. C) would likely raise the required reserve rate. D) would likely raise the discount rate.

58) Policymakers are often reluctant to turn to unconventional monetary policy measures because

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A) they are uncertain of the quantitative impact of using them. B) such policies are potentially too powerful. C) such policies require Congressional approval and Congress is often slow to act. D) such policies require coordination with the central bankers of foreign countries.

59) Think about the consequences of a shock that depresses aggregate expenditure and leads to a recessionary gap. Under normal circumstances, the central bank could use conventional monetary policy tools and A) seek to reduce expectations of future policy rates. B) cut the nominal interest rate enough to lower the real interest rate. C) use its balance sheet to expand the monetary base. D) purchase securities of different maturities to affect their market prices and rates.

60) Think about the consequences of a shock that depresses aggregate expenditure and leads to a recessionary gap. Suppose that inflation is zero, and the overnight interest rate falls to the effective lower bound. Which one of the following unconventional monetary policy tools would likely not work in this scenario? A) Seek to reduce expectations of future policy rates. B) Use its balance sheet to expand the monetary base. C) Purchase securities of different maturities to affect their market prices and rates. D) Set an inflation objective low enough to combat price instability.

61) Price bubbles, such as those that occurred in markets for equity and property in 2007–09, are identified A) by earnings reports that are overstated. B) while they are happening by a sharp rise in prices. C) after the fact by a sharp rise and then a sharp decline in prices. D) when financial asset prices reflect the book value of companies.

62)

Monetary policymakers could keep equity and property price bubbles from developing by

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A) raising their interest rate target when they suspect a bubble. B) lowering their interest rate target when they suspect a bubble. C) expanding the money supply in the economy. D) purchasing U.S. Treasury securities to drive up their prices.

63) When equity and property prices collapse (bust), bank balance sheets are impaired because A) banks hold a lot of corporate stocks. B) banks own a lot of property outright. C) the collateral that is backing many of the loans banks have made is now worth less. D) banks hold a lot of corporate stocks and they also own a lot of property outright.

64) Some people who believe monetary policymakers should not address equity and property price bubbles argue their position based on A) their belief that government should stay out of private matters. B) their belief that staying out of the economy promotes stability. C) the lack of experience policymakers have with financial markets. D) the observation that price bubbles are virtually impossible to identify when they are developing.

65)

Over the past 30 years, bank loans as a percentage of total credit A) increased from less than 60 percent to over 90 percent. B) stayed fairly constant at around 80 percent. C) decreased from accounting for virtually all the credit to less than 60 percent. D) dropped from 75 percent to less than 30 percent.

66)

The importance of the bank lending transmission mechanism of monetary policy

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A) has increased over the past 30 years. B) decreased during the three decades leading up to the financial crisis of 2007–2009. C) should continue to grow in importance. D) has always been the weakest of all the mechanisms.

67) Changes such as the movement away from bank lending toward asset-backed securities leading up to the financial crisis of 2007–2009 A) increase the importance of the bank-lending channel of monetary policy. B) eliminated the bank-lending channel as a mechanism for monetary policy. C) do not affect the importance of the bank-lending channel. D) require central bankers to rethink quantitative impacts of changing policy tools.

68) The movement away from bank lending toward asset-backed securities leading up to the financial crisis of 2007–2009 A) increased the importance of the bank-lending channel of monetary policy. B) eliminated the bank-lending channel as a mechanism for monetary policy. C) decreased the importance of the bank-lending channel. D) led the FOMC to abandon interest-rate targets.

69)

Instruments that have been securitized are created when

A) the central expands its balance sheet. B) consumers carry debt on more than five credit cards at the same time. C) mortgages are bundled, but no other instruments can become securitized. D) a broker bundles together a large number of financial instruments such as home mortgages and then sells shares in the pool.

70)

Which one of the following statements is most correct?

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A) The use of monetary policy in the United States has not changed much since the creation of the Fed. B) The quantitative impact on output of altering the target federal funds rate has been quite stable. C) Monetary policymakers operate in an environment with very little uncertainty. D) Monetary policymakers operate in an environment where change is quite common.

71)

Increases in the real interest rate will result in a(n) A) increase in net exports because it will lead to a depreciation of the dollar. B) decrease in net exports because it will lead to a depreciation of the dollar. C) increase in net exports because it will lead to an appreciation of the dollar. D) decrease in net exports because it will lead to an appreciation of the dollar.

72)

Stock prices may rise from a reduction in interest rates because A) consumer and business confidence about future growth improves. B) stockholders will expect lower future earnings. C) financial market participants are less optimistic about future earnings. D) the present value of future earnings will decrease.

73)

Each of the following is a transmission channel of monetary policy, except which one? A) household net worth channel B) treasury securities channel C) asset-price channel D) exchange-rate channel

74)

Bonds cannot have yields below the effective lower bound because

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A) the U.S. Treasury guarantees all bonds to have a positive yield. B) the banking technology does not exist to deal with negative yields. C) people can always hold cash. D) monetary policymakers have no restrictions.

75) In theory, lower real interest rates will tend to cause all but which one of the following to increase? A) consumption spending B) investment spending C) net exports D) government spending

76)

The driving force in the balance-sheet channel of monetary policy mechanism is A) information. B) timing. C) asset diversity. D) bank net worth.

77) One impact of the 2007–2009 financial crisis was to heighten the challenges faced by monetary policymakers. All but which one of the following outcomes grew more prominent as a result of the crisis? A) Stock and property values tend to go through boom and bust cycles. B) The nation’s current account deficit keeps widening. C) Policymakers options are limited since the nominal interest rate cannot fall below the effective lower bound. D) The structures of the economy and financial system are constantly evolving.

ESSAY. Write your answer in the space provided or on a separate sheet of paper. 78) Identify at least three effects that can impact the economy when the central bank changes its balance sheet. Version 1

79) Explain how an easing of monetary policy works through the exchange rate and what potential impact on the economy this would have.

80) Discuss why the interest-rate transmission mechanism of monetary policy isn't as strong as most people may think it might be.

81) Lower interest rates can lead to higher home prices, and this can lead to increased household spending since homeowners can spend this additional equity. If you were a lender, is there any danger in making loans to homeowners for this new equity or are these truly risk-free loans since they are secured by the equity in the house?

82) Will an open market sale by the Federal Reserve increase banks' willingness to make loans? Explain.

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83) Inflation can reduce the true cost of debt, and policymakers lower interest rates to encourage borrowing. Is it a good idea then to always take advantage of lower interest rates to borrow and rely on inflation to reduce the cost of debt and to increase your ability to repay the loan?

84)

How did financial regulation affect bank lending in the 1980s?

85) The name “balance-sheet channel of monetary policy” implies that monetary policy has to impact categories on a firm's balance sheet. Explain how the balance sheet of a firm will be impacted by an increase in interest rates.

86)

Why might the supply of loans increase as interest rates fall?

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87) How does adverse selection factor into explaining the reduced supply of loans when interest rates increase?

88)

Explain why a lowering of interest rates should raise stock prices.

89) What role, if any, did the accounting scandals involving some U.S. companies in 2001 and 2002 play in the supply of loans?

90)

Explain how the asset-price channel of monetary policy works in real estate markets.

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91) Explain why a corporation may find it advantageous to undertake greater investment when the value of its stock shares increase.

92) During the 2007–2009 financial crisis, what prevented policy easing from being transmitted as usual to the real economy?

93)

Why can't the nominal interest rate be negative?

94) Why is deflation, combined with a recessionary gap and a nominal interest rate that cannot be reduced, a monetary policymaker's nightmare?

95) Why did the FOMC cut the target federal funds rate so aggressively between September 2007 and December 2008 in a series of 10 cuts?

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96) What are the unconventional policy options that central bankers can use if the traditional target interest rate hits the lower bound?

97)

What are the pros and cons of a policy of "leaning against bubbles?"

98) When faced with inflation above desirable levels, is there anything that policymakers can do about concern that a deep recession will lower inflationary expectations sharply and thereby raise real interest rates in a destabilizing manner?

99) Why are policymakers reluctant to make unconventional tools part of their regular arsenal of policy tools?

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100) The chapter seems to imply that the direct influence of short-term interest rate changes by central bankers is not that powerful in terms of their direct impact on spending. Why then do so many people pay attention to monetary policy?

101) Why is it more correct to say that there may be correlation between high interest rates and the growth rate of output but there is no clear causation?

102) Explain why high levels of household debt and securitization of many mortgages made things worse than they would have been during the financial crisis of 2007–2009. Describe the new “mortgages” some economists have proposed to keep this from happening again.

103) If greater stock prices can lead to greater investment spending, should central bankers ever worry about stock prices becoming too high?

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104) What are the arguments for and against monetary policymakers intervening to address equity and property price bubbles?

105) Discuss the impact of the evolving financial system on the bank-lending channel of monetary policy transmission? Evaluate what that is likely to mean for future changes in the target federal funds rate.

106) Describe how, as of early 2020, the financial crisis that ended in 2009 has had a greater impact on the shape of the financial system than any event since the Great Depression.

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Answer Key Test name: Chap 23_6e 1) C 2) B 3) D 4) B 5) A 6) A 7) A 8) D 9) A 10) C 11) B 12) C 13) B 14) D 15) D 16) D 17) A 18) C 19) B 20) B 21) A 22) B 23) C 24) B 25) B 26) C Version 1

27) D 28) B 29) B 30) A 31) C 32) C 33) D 34) A 35) A 36) C 37) B 38) A 39) A 40) B 41) D 42) A 43) B 44) D 45) D 46) A 47) C 48) A 49) A 50) C 51) B 52) C 53) C 54) D 55) A 56) C Version 1

57) B 58) A 59) B 60) A 61) C 62) A 63) C 64) D 65) C 66) B 67) D 68) C 69) D 70) D 71) D 72) A 73) B 74) C 75) D 76) A 77) B 78) Changes in the real interest rate that will occur as the central bank adjusts their balance sheet will find households adjusting their spending on durable goods, businesses altering their investment plans, exchange rates changing and impacting the level of exports and imports, stock and bond prices changing and banks adjusting their balance sheets.

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79) An easing of monetary policy lowers the target nominal interest rate, which lowers the real interest rate. The lower real interest rate will cause the demand for dollars to weaken, lowering its value. The lower value of the dollar will cause an increase in net exports, since exports will increase and imports decrease. 80) Investment spending does not seem to be that sensitive to interest rates. Information problems often make external financing difficult and costly for firms to undertake so the majority of investments are financed by the businesses themselves using their own funds. So, while a change in interest rates does change the cost of external financing, it does not have that great of an impact on investment itself. 81) There is some risk. If lower interest rates can increase the value of homes, then certainly higher rates can lead to decreases in the value of a home. If a lender were to make a loan for the entire equity in the house, there is no cushion to fall back on if the value of the home were to decrease. It would seem that prudent lending should leave a cushion between the value of the home and the amount of the loan(s) against this value. 82) No, it will do just the opposite. If the Fed sells securities to banks, they are replacing reserves, which did not earn revenue for the banks, with securities, which do earn revenue. As a result, bank revenue will increase even if the banks do nothing. Also, the reserves of the banking system are now lower so collectively, banks have less willingness and ability to make loans. 83) While this seems like a good strategy it is not likely to work. First off, long term increases in real wages are tied to productivity and not inflation. Also, if central bankers are doing their jobs, they will keep inflation at a modest level, so hoping that inflation will pay off loans is a strategy that is not likely to work, and if an individual takes on a lot of debt, they may find themselves in a very difficult position. Version 1

84) In 1980, then-President Jimmy Carter authorized the Federal Reserve to impose credit controls to reduce bank lending. The banking crisis of the 1980s resulted in many banks having relatively weak balance sheets, mainly from loan losses that were suffered. When new capital requirements were placed on banks in such already weakened financial positions it had the effect of further decreasing banks' willingness and ability to make loans. 85) An increase in interest rates will lower the value of the firm's assets. If nothing else were to change, the firm's net worth would decrease, since net worth is assets less liabilities. But there are likely to be other changes. If the firm has any interest-sensitive liabilities, the increase in interest rates will increase the interest expense for the firm, which will reduce profits. The reduction in profits will reduce net worth since profits increase the owner's net worth. 86) There are a number of reasons for this. First, at lower interest rates the borrower's loan payments will be lower, and the percentage that loan payments make up of a borrower's income will be reduced, making the borrower a better risk. Also, the lower interest rate should increase the borrower's net worth by increasing asset values and reducing interest expense, thereby increasing profits. Finally, with a higher net worth, the moral hazard problem is reduced. The borrower is less likely to take on greater risk if they have a higher net worth in the firm since they have more to lose. 87) When interest rates increase it becomes more expensive for borrowers to service their debt. Lenders are aware of this and so are suspicious of those borrowers who still want to borrow at the higher rates. To the extent that information asymmetries exist, the rational move on the part of lenders may be to simply not lend.

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88) The price of a stock reflects the net present value of the future flow of earnings. Immediately we see then from the present value formula that a lower discount (interest) rate will increase the present value. Also, if lower interest rates boost consumer and business confidence, raising expectations, the anticipation of higher future earnings will also increase the present value of share prices. 89) The accounting scandals potentially played a very large role. As we have learned, information in lending is critical and when bankers are worried about the accuracy of accounting information, they will be less willing to make loans to anyone, including companies that have solid financial accounting. Accurate financial statements and strong enforcement are critical factors in the supply of loans. 90) When policymakers lower the short-term interest rates this usually leads to a reduction in mortgage rates. A decrease in mortgage rates usually leads to greater demand for residential housing driving up the price of existing homes. This can also lead to greater consumption if it causes homeowners to free up some of the equity in their homes for other spending. 91) If the share price of a firm's stock increases, other factors constant, the firm may find the ratio of their market value to replacement cost is higher. As a result, the actual cost of financing investment is now lower since the market values investment higher than the actual cost. This will encourage greater investment on the part of the firm. 92) Essentially it was the fundamental problem of asymmetric information. The double-pronged issue of moral hazard and adverse selection came into play as the quality of information made it difficult for lenders and borrowers to judge the soundness of their business partners. This made borrowing and lending quite difficult.

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93) Investors can always hold cash. Since cash carries a zero nominal interest rate, no investor would willingly hold a bond (which carries some risk) that pays a negative interest rate when they could carry cash, which pays a zero-interest rate. 94) If we consider this piece-by-piece the answer becomes clear. Recall that when current output is below potential output so that there is a recessionary output gap, current inflation is below expected inflation, and expected inflation falls. In this case, that drives deflation down further. In this case however, if nominal interest rates are already at the ELB, they cannot be reduced. Now compound the problem with deflation. If nominal interest rates hit their effective lower bound and deflation occurs, the real interest rate is rising. The increasing real interest rates could further decrease aggregate demand making the recessionary gap worse and potentially leading to a deflationary spiral. As this happens monetary policymakers are left watching without the ability to lower nominal interest rates. 95) This was an example of the Fed acting preemptively. The economy was slow, and the rate of inflation was low enough that the Fed probably had deflation fears in mind when they were aggressively cutting the rate. By cutting the rate aggressively the Fed had hopes that the economy would recover well before deflation would be a problem. 96) The central bank can use forward guidance to diminish expectations for future policy rates; quantitative easing to expand its balance sheet; and targeted asset purchases to influence relative asset prices (especially in dysfunctional markets) and stimulate expenditures.

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97) Leaning against bubbles is a policy of purposefully bursting asset price bubbles before they burst on their own. Proponents say that stabilizing inflation and real growth would imply the use of interest rates to discourage bubbles from developing in the first place. If successful, this policy would reduce the consumption and investment booms that accompany bubbles, along with the bursts that inevitably follow. Opponents counter that bubbles are simply too difficult to identify when they are developing. They would add that past efforts to puncture asset bubbles (in 1929 in the United States and in 1990 in Japan) led to profound economic depressions. 98) Yes, three things. First, they can set their inflation objective with the perils of deflation in mind. Second, they can act boldly when there is even a hint of deflation. Third, they can utilize unconventional policy tools like forward guidance, quantitative easing, and targeted asset purchases. 99) They are reluctant primarily because of continued uncertainty about how and why they work and how to apply them effectively. Effective monetary policymaking rests on well-established quantitative relationships of the impact of a change in the target interest rate on the central bank objective. Such relationships with unconventional tools are unknown. A second reason is that an exit from an unconventional strategy is uncertain and may be difficult. A third reason is that some unconventional policy tools have a fiscal character that could invite greater political scrutiny of the central bank, diminishing its independence.

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100) While it is true that the direct impact of short term interest rate changes on investment spending and consumer spending seem to be relatively weak transmission mechanisms, what is true is these shortterm interest rate changes can have significant impacts on stock and real estate markets by altering the value of financial assets as well as on the behavior of banks concerning their willingness to lend. These transmission mechanisms seem to be quite strong and, as a result, the impact of interest rate changes can have significant impacts on the decision making of many individuals. Monetary policy can be highly effective as a result. 101) Correlation implies that two variables move together (either directly in the same direction or inversely, in opposite directions). Interest rates and output growth seem to be inversely correlated. To imply causality from correlation however is a common mistake. Central bankers may be raising interest rates to combat inflation and their decisions may be independent from what is happening to output. An example used in the chapter shows that high oil prices may cause both a slowdown in output growth as well as higher inflation. If central bankers focus on the higher inflation and raise interest rates as a result, the correlation between interest rates and economic growth is present, but the causality is not.

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102) The burden of high mortgage debt among those with lower incomes drove down consumption as house prices sank, contributing to the loss of jobs. An extraordinary credit expansion stoked the housing boom, especially among families with lower incomes. And, the cooling of the boom drove down consumption more sharply than in a normal recession, exacerbating the bust that was the Great Recession. Securitization of many of the mortgages made it nearly impossible for lenders and borrowers to agree on what might have been mutually beneficial write-downs. Some economists have proposed new “mortgages” that shift part of the risk of house price declines to lenders and away from borrowers. Instead of merely being lenders, the suppliers of funds would become part owners of the collateral. In exchange, they would receive a portion of the increase value of the house when it is sold. 103) Yes, they should. If stock prices become irrationally high, as many feel they did in the technology sector in the United States in the late 1990s and early 2000s, the existing firms in that sector have a very strong incentive to invest and entrepreneurs have strong incentives to build businesses. The problem can be if the increases in stock are not based on well-reasoned projections of future earnings, the economy may actually be allocating resources inefficiently, and this inefficient allocation of resources can be extremely costly both in the short run as share prices eventually fall (or worse crash) leading to closings and layoffs. But the long-run costs can also be significant since many financial intermediaries will be reluctant to fund future investment and savers may be reluctant to put funds into stocks.

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104) The arguments for intervention include that price bubbles can lower the cost of financing to firms experiencing the bubbles. This can, however, lead to an inefficient allocation of resources, away from companies where the true value of the company is reflected in its share price toward these companies where the prices are likely to burst (fall) in the near future. Once these share prices collapse, the transition period can be quite long, and the costs of transition can be high. Another argument for intervention involves what these bubbles and their subsequent bursts do to the balance sheets of banks. Loans are often granted where the stock and property are collateral for the loans. The high prices of the collateral allow firms to receive larger loans. However, when the prices collapse the banks are left with inadequate and sometimes worthless collateral, which will reduce their lending activity. The main argument against intervention is that bubbles are difficult to identify as they are developing. This argument seems reasonable but just because something is difficult to measure is no excuse for not trying. In fact, the Fed relies on the asset-price channel, which uses estimates of future wealth and stock prices and as a result they need to be able to estimate how changes in the target interest rate will impact equity and property prices.

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105) The shift away from bank financing and toward financing in the capital markets means that the bank-lending channel of monetary policy transmission has become less important. This poses a challenge to central bankers, who need to know the quantitative impact their policies are likely to have. But as the structure of the financial system evolves, the effect of a 25- or 50-basis-point change in the federal funds rate will change as well. If the investment component of total spending becomes even less interest-sensitive than it is at present, then it may mean that the changes in the target federal funds rate will have to be larger in order to affect desired changes. This would likely mean more interest rate volatility. However, as the financial system evolves central bank policymaking is likely to evolve with it.

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106) There have been a number of changes in the financial system since the Great Recession. The financial crisis interrupted the trend toward capital market finance. Specifically, securitization has declined or slowed since 2006. In the aftermath of the financial crisis, U.S. government agencies became the dominant source of new housing finance and, more than a decade after the crisis began, the GSEs and federal agencies still backed nearly two-thirds of U.S. mortgage originations. Although the U.S. Treasury proposed winding them down gradually, by early 2019, they remained under federal control with uncertain prospects. The impact of the Dodd-Frank Act of 2010 also remains unclear at this time. Many of the key elements remain untried, and new political leaders are dismantling some of the Dodd-Frank regulations. The 2018 Economic Growth, Regulatory Relief, and Consumer Protection Act reduced costs imposed on small banks and eased capital requirement on medium-sized institutions. The Treasury proposed a number of changes that would ease supervision of the largest institutions, and the Financial Stability Oversight Council reversed its own prior decisions, removing the last two large nonbanks from the category of “systemically important financial intermediaries” that are subject to the strict supervision of the Federal Reserve. The nature of the financial system is ever changing, and the future is difficult to predict.

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