7.a. If the production function is of the form Y = K1/2(AN)1/2, and A is normalized to 1, we have Y = K1/2N1/2 .

In this case, capital's and labor's shares of income are both 50%. 7.b. This is a Cobb-Douglas production function. 7.c. A steady-state equilibrium is reached when sy = (n + d)k. From Y = K1/2N1/2 ==> Y/N = K1/2N-1/2 ==> y = k1/2 ==> sk1/2 = (n + d)k

327

==> k-1/2 = (n + d)/s = (0.07 + 0.03)/(.2) = 1/2 ==> k1/2 = 2 = y ==> k = 4 . 7.d. At the steady-state equilibrium, output per capita remains constant, since total output grows at the same rate as the population (7%), as long as there is no technological progress, that is, A/A = 0. But if total factor productivity grows at A/A = 2%, then total output will grow faster than population, that is, at 7% + 2% = 9%, so output per capita will grow at 2%.

10.a. The production function is of the form Y = K1/2N1/2 ==> Y/N = (K/N)1/2 ==> y = k1/2. From k = sy/(n + d) = sk1/2/(n +d) ==> k1/2 = s/(n + d) ==> y* = s/(n + d) = (0.1)/(0.02 + 0.03) = 2 ==> k* = sy*/(n + d) = (0.1)(2)/(0.02 + 0.03) = 4. 10.b. Steady-state consumption equals steady-state income minus steady-state saving (or investment), that is, c* = y sy = f(k*) - (n + d)k*. The golden-rule capital stock corresponds to the highest permanently sustainable level of consumption. Steady-state consumption is maximized when the marginal increase in capital produces just enough extra output to cover the increased investment requirement. From c = k1/2 - (n + d)k ==> (c/k) = (1/2)k-1/2 - (n + d) = 0 ==> k-1/2 = 2(n + d) = 2(.02 + .03) = .1==> k1/2 = 10 ==> k = 100. Since k* = 4 < 100, we have less capital at the steady state than the golden rule suggests. 10.c. From k = sy/(n + d) = sk1/2/(n + d) ==> s = k1/2(n + d) = 10(0.05) = .5. 10.d. If we have more capital than the golden rule suggests, we are saving too much and do not have the optimal amount of consumption.

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CHAPTER 16 TECHNICAL PROBLEMS Technical Problems 1. Assume the Fed sells Treasury bills valued at $10 (million) to a bank. Fed Balance Sheet: Assets Govt. securities Other assets Liabilities Currency 0 Bank deposits - $10 Liabilities Deposits

- $10 0

Bank Balance Sheet: Assets Deposits at the Fed - $10 Govt. securities + $10 Other assets 0

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The bank has lost $10 million in reserves (deposits at the Fed). If reserve requirements are no longer met, the bank will have to acquire new reserves. If a bank depositor buys the Treasury bills, then the balance sheet will be: Bank Balance Sheet: Assets Reserves Other assets Liabilities Deposits

- $10 0

- $10

Again, the bank may have to make up for the loss of reserves.

2. Assume the Fed buys $10 million worth of gold and then decides to sterilize the effect of this purchase on the monetary base through open market operations. Fed Balance Sheet: Assets Gold Other assets Liabilities Currency 0 Member bank deposits + $10

+ $10 0

The purchase of gold increased the monetary base (bank reserves) by $10 million. Fed Balance Sheet After Sterilization: Assets Gold Govt. securities

+ $10 - $10

Liabilities Bank deposits (+10 -10) = $0

The sale of government securities to banks decreased the monetary base (bank reserves) by $10 million, so there is no overall change in the monetary base.

3.a. If the required reserve ratio were 100%, then banks could not create any loans. In this case, the money multiplier would be equal to 1, and the Fed would have total control over the money supply. However, this would significantly change the banking industry, since banks no longer would be able to extend loans. 3.b. Since banks would not be able to issue any loans, the assets side would contain only reserves. 3.c. Banking could still remain profitable as long as banks were able to generate service charges to cover their operating costs.

4.

To decide whether it is better for the Fed to target the monetary base or interest, we need to know whether most economic disturbances arise from the expenditure sector or the money sector. If most disturbances occur in the expenditure sector (assume the IS-curve shifts to the
428

right), then monetary base targeting is better, since interest rate targets would force the Fed to aggravate the disturbance. Under interest rate targeting, the Fed would be forced to change money supply (shifting the LM-curve to the right) and aggregate demand would be changed even more. But if most disturbances occur in the money sector (assume the LM-curve shifts to the left), then interest rate targeting is better, since the Fed can easily offset the disturbance. Under interest rate targeting the Fed could change money supply (shifting the LM-curve to the right again) without affecting aggregate demand. interest rate targeting i IS LM2 LM1 = LM3 i2 i2 i1 i1 i IS1 monetary base targeting IS1 LM

0 Y2 Y1 Y

0 Y1 Y2 Y

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CHAPTER 18 TECHNICAL PROBLEMS Technical Problems 1.a. According to the expectations theory of the term structure, the yield of a ten-year bond is simply the average of all one-year bond yields covering these ten years. In other words, i10 = (1/10) it.
t =1 10

1.b. If there is no uncertainty, then the yield of the ten-year bond should be exactly the average of all one-year bond yields covering these ten years, in this case, 10%. The fact that the yield is 12%, reflects the fact that uncertainty exists and that the ten-year bond offers a risk premium of 2%.

2.a. The present value of the bond can be determined by the present discounted value formula, that is, PV = ct /(1 + i) + FV/(1 + i)
t t =1 10 10

==> 100 = ct /(1 + 0.1)t + 100/(1 + 0.1)10.

t =1

10

Since the price (PV) is equal to the face value (FV), the coupon rate has to be equal to the market interest rate, that is, 10%. In other words, the coupon value is 10% of the face value of $100 or ct = $10. 2.b. A drop in the interest rate will increase the present discounted value (price) of the bond. You bought the bond at a price PV = 100, but could now sell it for more. This can also be seen another way. The bond pays a coupon value of $10 each year, that is, 10% of the face value of $100. But the market pays you only 5% or $5 out of $100. Therefore people would be willing to buy this bond for a price higher than $100. The exact price can be calculated by the formula above with i = 5% (or, more easily, looked up in a bond table).

3.

If interest rates increase in Mexico but remain the same in the U.S., we will have an outflow of funds from the U.S. to Mexico. The Mexican peso will appreciate against the value of the U.S. dollar. In other words, the $/peso exchange rate (e) will rise as it will take more U.S. currency to buy Mexican pesos. This can also be seen from the following equation: (e/e) = iUS - iM. In other words, if Mexican interest rates (iM) increase, then the $/peso exchange rate (e) has to increase.

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4.

The price of a stock is the present discounted value of the expected dividends from holding that stock. If expected dividends go up, so will the price of the stock. If financial investors expect high future profits for U.S. firms, they are more likely to buy stocks in those firms since they expect higher dividend payments. Thus the high average rate of return on U.S. stock holdings was an indication that financial investors expected high future profits for U.S. firms during that period, indicating a strong performance for the U.S. economy as a whole.

CHAPTER 20 TECHNICAL PROBLEMS Technical Problems 1. The imposition of a tariff raises the relative price of imports and increases the demand for domestic goods. This increases the level of domestic output, causing interest rates to rise. Higher domestic interest rates will lead to an inflow of funds and the domestic currency will begin to appreciate. But the higher value of the domestic currency will lower the relative price of imports again. With perfect capital mobility, the currency appreciation will progress to the point where the overall change in net exports is zero. In the end, output and the interest rate will be back at their original levels.

2.

Assume a $10 billion balance of payments deficit occurs: The central banks balance sheet before sterilization: Assets foreign exchange - 10 other reserves 0 monetary base The central banks balance sheet after sterilization: - 10 Liabilities member bank deposits - 10 currency 0 monetary base Liabilities member bank deposits currency monetary base - 10

Assets foreign exchange - 10 govt. securities + 10 monetary base 0

0 0 0

3.a. If a country is initially in an internal and external balance, the IS-, LM- and BB-curves all intersect at the full-employment level of output Y* (see the graph below). If the foreign interest rate increases, funds will flow out, leading to a balance of payments deficit. To restore external balance, the domestic interest rate must increase, that is, the BB-curve must shift up.

431

ISo

LMo BB' = 0 BB = 0

i1 io 0 Y* 3.b. i ISo i1 io 0 Y* Y IS' LM' LMo Y

BB' = 0 BB = 0

A reduction in money supply combined with an increase in government purchases will increase the interest rate and help to restore an external and internal balance. This policy mix will shift the LM-curve to the left and the IS-curve to the right. A new equilibrium can be reached at the full-employment level of income but at a higher interest rate. In other words, the IS'-, LM'- and BB'-curves will all intersect again at Y*. 3.c. If the government takes no action, an automatic adjustment process will take place through changes in money supply and prices. The balance of payments deficit will lead to a reduction in money supply (a shift in the LM-curve to the left). Assuming that prices are flexible, the price level will decrease due to the reduction in aggregate demand as a result of the decrease in money supply. The lower domestic price level will increase competitiveness in global markets, and net exports will increase (a shift of the IS-curve to the right). The decrease in the price level will also increase real money balances so the shift of the LM-curve to the left will be partially reversed. A new long-run equilibrium will eventually be established at the full-employment level of output Y*.

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4.

A country experiencing a permanent increase in its exports will develop a trade surplus. Under the assumption that the central bank does not undertake sterilization operations, the increase in net exports combined with the increase in money supply will lead to an increase in aggregate demand. This will result in an increase in domestic prices, making import goods relatively less expensive and export goods relatively more expensive. Eventually, this will lead to a decrease in net exports. As long as the surplus exists, domestic prices will continue to rise until an internal and external balance is reestablished.

5.

After a currency depreciation exports should rise and imports should decline, both in the short run and in the long run. However, empirical evidence suggests that in the short run the volume effect is too small to overcome the price effect. In other words, in the short run, the volume of imports does not change much, even though relative import prices have risen, thus increasing the value of imports. Only in the long run, when consumers and producers have had time to adjust to the change in relative prices, will the volume effect become large enough to overcome the price effect. In other words, eventually, the volume of imports will decline while the volume of exports will increase sufficiently to bring about an improvement in the trade balance.

6.

An increase in money supply will shift the LM-curve to the right, driving the domestic interest rate below the foreign interest rate. A capital outflow will occur and the domestic currency will start to depreciate. As a result, exports will rise, imports will decline, and the IS-curve will shift to the right due to the increase in net exports (NX). The level of output demanded and the domestic interest rate will rise until they reach the level of the foreign interest rate. Since the new level of output demanded will be above the full-employment level, there will be upward pressure on prices. The rising price level will reduce real money balances and the LM-curve will start moving back to the left. Since the domestic interest rate will be above the foreign interest rate, funds will flow into the country and the domestic currency will appreciate. As a result, imports will rise and exports will decline. The IS-curve will shift back to the left, due to the decrease in net exports. The level of output demanded will decline

433

again and the domestic interest rate will decrease until it reaches the level of the foreign interest rate. In the end, the level of output demanded will again be at the fullemployment level.

i ISo

IS1 4

LMo(po) = LM1(p1) LM1(po)

i1 io i2

1=5

0 Yo Y2Y4 Y3 Y

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Chapter 3: Growth and Accumulation

Difficulty: Medium 1. Growth accounting explains A) how economic decisions control the accumulation of capital B) how the current savings rate affects the stock of capital in the future C) what part of growth in total output is due to growth in different factors of production D) all of the above E) only A) and B) Ans: C

Difficulty: Easy 2. The relationship between the output produced in an economy, the input of factors of production, and the state of technological knowledge is called the A) the aggregate supply function B) aggregate production function C) aggregate investment function D) marginal product of labor E) marginal product of capital Ans: B

Difficulty: Medium 3. Given the production function Y = AF(K,N) and assuming constant returns to scale, the contribution of capital to output growth can be estimated by A) adding the growth rate of capital to the term A B) multiplying the growth rate of capital by capital's share in production C) subtracting the growth rate of labor from the rate of technological advancement D) multiplying the capital-labor ratio by the level of output E) multiplying total factor productivity with capitals share in production Ans: B

Difficulty: Easy 4. For the U.S. economy, we can assume that A) output grows at the same rate as both capital and labor
435

B) capital is a larger source of growth than labor C) labor is a larger source of growth than capital D) capital and labor both contribute equally to output growth E) both A) and D) Ans: C

Difficulty: Easy 5. Which of the following is NOT a source of long-term output growth? A) growth in consumption expenditures B) growth in labor inputs C) growth in capital inputs D) improved technological efficiency E) growth in the stock of knowledge Ans: A

Difficulty: Medium 6. Which of the following is NOT a source of increased factor productivity? A) advances in knowledge B) growth in the size of the labor force C) more efficient resource allocation D) improved methods of production E) technological progress Ans: B

Difficulty: Easy 7. Which of the following economists contributed greatly to neoclassical growth theory in the 1950s and 1960s? A) Robert Barro B) Robert Lucas C) Gregory Mankiw D) Paul Romer E) Robert Solow Ans: E

Difficulty: Easy 8. Changes in total factor productivity are also called A) the marginal product of labor B) the marginal product of capital

436

C) changes in input costs D) the Cobb-Douglas residual E) the Solow residual Ans: E

Difficulty: Easy 9. Which of the following is NOT a source of increased factor productivity? A) an increase in average years of schooling B) an increase in on-the-job training C) increased investment in health D) an increase in the size of the capital stock E) an increase in the rate of innovation Ans: D

Difficulty: Easy 10. According to Solow's estimate, out of the average annual economic growth rate of 2.9% for the U.S. from 1909 to 1949, how much was attributable to the accumulation of capital? A) 0.12% B) 0.32% C) 0.75% D) 1.22% E) 1.55% Ans: B

Difficulty: Easy 11. The Cobb-Douglas aggregate production function provides a fairly good approximation of the U.S. economy if we assume that A) the shares of capital and labor are equal B) the share of capital is 0.65 and the share of labor is 0.35 C) the share of capital is 0.45 and the share of labor is 0.55 D) the share of capital is 0.25 and the share of labor is 0.75 E) the share of capital is 0.15 and the share of labor is 0.85 Ans: D

437

Difficulty: Medium 12. If we assume a Cobb-Douglas production function, where the share of capital is 0.25 and the share of labor is 0.75, then the marginal product of labor is equal to A) Y/N B) 3Y/4N C) (3/4)N D) 3K/4N E) 3N/4Y Ans: B

Difficulty: Medium 13. If we assume a Cobb-Douglas production function where the share of capital is equal to 0.2 and the share of labor is equal to 0.8, then the marginal product of capital is equal to A) 5N/K B) 5Y/K C) Y/4K D) Y/5K E) Y/K Ans: D

Difficulty: Difficult 14. Assume a Cobb-Douglas production function where the share of capital and labor is each 1/2. If the growth in total factor productivity is zero and labor and capital each grow by 2%, then A) output growth is 4% and the marginal product of capital is Y/K B) output growth is 2% and the marginal product of capital is Y/(2K) C) output growth is 2% and the marginal product of labor is (2Y)/N D) output growth is 1% and the marginal product of labor is Y/(2N) E) output growth is 1% and the marginal product of capital is (2Y)/K Ans: B

Difficulty: Difficult 15. Assume a Cobb-Douglas production function where the share of capital is 0.3 and the share of labor is 0.7. If capital grows by 1.5%, labor grows by 2%, and growth of total factor productivity is 1.2%, by how much does total output grow? A) 4.70%

438

B) 3.50% C) 3.05% D) 2.85% E) 1.20% Ans: C

Difficulty: Difficult 16. Assume a Cobb-Douglas production function where the share of labor is 0.7 and the share of capital is 0.3. If there is no technological progress, capital grows at 1.5%, and labor doesn't grow at all, what is the growth rate of output? A) 0.45% B) 0.60% C) 1.05% D) 1.50% E) 2.00% Ans: A

Difficulty: Difficult 17. Assume a Cobb-Douglas production function where the share of labor is 0.7 and the share of capital is 0.3. If there is no technological progress, labor grows at 2%, and capital grows at 1.5%, then real output will grow by A) 0.45% B) 1.50% C) 1.85% D) 2.85% E) 3.05% Ans: C

Difficulty: Medium 18. Assume that the rate of technological advance is 1.5% and both labor and capital grow at a rate of 2%. What is the rate of output growth if labor's share of income is three times as high as capitals share and there are constant returns to scale?
439

A) 1.5% B) 2.0% C) 3.0% D) 3.5% E) 5.5% Ans: D

Difficulty: Medium 19. Assume labor's share of income is 80% and capital's share of income is 20%. If we assume constant returns to scale, there are no technological advances, and both labor and capital grow at an annual rate of 3%, then the growth rate of output will be A) 0.6% B) between 0.6% and 2.4% C) between 2.4% and 3% D) 3% E) greater than 3% Ans: D

Difficulty: Medium 20. Assume a production function with constant returns to scale. The share of capital in production is 1/4 and the share of labor is 3/4. If both labor and capital grow at 1.6% and the rate of technological progress is 1.2%, what is the rate of growth of real output? A) 1.2% B) 1.6% C) 2.8% D) 3.2% E) 4.8% Ans: C

Difficulty: Difficult 21. Assume a production function with constant returns to scale. Labor's share of income is 4/5 and capital's share is 1/5. If labor grows at 3%, capital at 2%, and the rate

440

of technological advance is 1.2%, roughly how many years would it take to double the current level of output? A) 12 B) 18 C) 23 D) 35 E) 48 Ans: B

Difficulty: Difficult 22. Assume a production function with constant returns to scale. Labor's share of income is 0.7 and capital's share is 0.3. If labor grows at 4% and capital grows at 3%, how many years would it take to double the current level of output if no technological advances are made? A) 7 B) 10 C) 19 D) 23 E) 33 Ans: C

Difficulty: Difficult 23. Assume a Cobb-Douglas production function, where the share of labor (N) and capital (K) is each 1/2 and A = 1. If the growth rate of labor is n = 0.06, the rate of depreciation is d = 0.04, and the savings rate is s = 0.2, what is the value of the steady-state capital-labor ratio? A) 0.5 B) 1 C) 2 D) 4 E) 5 Ans: D

Difficulty: Easy
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24. From 1973 to 1992, by how much more did GDP grow in Japan than in the United States? A) 10% B) 22% C) 36% D) 54% E) 66% Ans: C

Difficulty: Easy 25. Which of the following countries had the lowest ratio of investment to GDP in 1992? A) Japan B) Norway C) Singapore D) Taiwan E) United States Ans: E

Difficulty: Easy 26. If we compare the annual growth rates in the U.S. and Japan, we see that from 1950 to 1992, the difference in average annual growth in GDP per capita between Japan and the U.S. was about A) 1.2% B) 2.2% C) 2.8% D) 3.8% E) 5.2% Ans: D

Difficulty: Easy 27. Which of the following is FALSE? A) a high level of investment generally does not lead to a higher living standard B) in industrial countries the amount of labor is less important than the skills and talent of the work force C) a country that possesses rich natural resources should have a high standard of living D) countries with fewer average years of schooling often have lower living standards E) if a poor country invests in health it can significantly increase the quality of human

442

capital and thus raise overall living standards Ans: A

Difficulty: Medium 28. If two countries have the same aggregate production function, rate of technological growth, and savings rate, then A) they will always have the same per-capita income B) the country with the higher rate of population growth will have a higher per-capita income C) the country with the lower rate of population growth will have a higher per-capita income D) the country with the highest depreciation rate will have the highest per-capita income E) both C) and D) Ans: C

Difficulty: Medium 29. In the neoclassical growth model, an increase in the savings rate A) raises the steady-state level of output B) lowers the steady-state level of output C) raises the long-term economic growth rate D) lowers total factor productivity E) both A) and C) Ans: A

Difficulty: Medium 30. In the neoclassical growth model, if a nation's savings rate decreases, we should expect that A) the long-run income per capita will increase B) the long-run capital-labor ratio will increase C) the growth rate of output will temporarily decrease but eventually return to its longrun trend D) all of the above E) none of the above Ans: C

Difficulty: Medium

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31. In the neoclassical growth model, an increase in the rate of population growth will A) raise the growth rate of output B) increase the level of output per capita C) increase the steady-state capital-labor ratio D) all of the above E) only B) and C) Ans: A

Difficulty: Medium 32. In a neoclassical growth model, a decline in population growth will A) shift the production function down B) shift the savings function down C) decrease the slope of the investment requirement line D) all of the above E) only A) and C) Ans: C

Difficulty: Medium 33. In the neoclassical growth model, if the capital-labor ratio is below the (optimal) steady-state level, we should expect that A) economic growth will continue to decline unless technological advances are made B) income per capita will decrease since gross investment is not sufficient to supply new workers with adequate capital C) the savings rate will decline due to the lack of economic growth D) all of the above E) none of the above Ans: E

Difficulty: Medium 34. In a neoclassical growth model, if the capital-labor ratio is lower than the (optimal) steady-state level, we should expect that A) B) C) D) saving is smaller than the investment requirement output per capita will temporarily grow at a rate lower than population growth income per capita will decrease there will be a temporary increase in the capital stock that is greater than the increase in population
444

E) all of the above Ans: D

Difficulty: Medium 35. The convergence to a steady-state capital-labor ratio k* is ensured by the fact that if k is at a level A) lower than k*, saving will exceed the investment required to maintain a constant k, causing k to rise B) lower than k*, investment will exceed saving, leading to an increase in the capital stock C) lower than k*, saving will exceed the investment required to maintain a constant k, causing output per capita to decline D) higher than k*, the rate of depreciation will be higher than the savings rate, causing k to decrease E) higher than k*, output per capita will continue to increase until a new steady-state equilibrium is reached Ans: A

Difficulty: Difficult 36. An economy with a capital-labor ratio that is lower than the steady-state level can achieve a steady-state equilibrium at this lower capital-labor ratio only if A) the savings rate decreases B) the rate of depreciation decreases C) the rate of population growth decreases D) technological advances are made E) all of the above Ans: A

Difficulty: Medium 37. In a neoclassical growth model, a nation with a declining population growth rate will experience A) a decrease in living standards B) an increase in living standards C) a lower savings rate D) an increase in long-term growth E) a decrease in the steady-state capital-labor ratio Ans: B

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Difficulty: Medium 38. A neoclassical growth model would predict that if the rates of both population growth and saving increase, then the steady-state capital-labor ratio will A) increase B) decrease C) stay the same D) temporarily increase, but then go back to its original level E) most likely change but we cannot say for sure how Ans: E

Difficulty: Medium 39. Assume a neoclassical growth model with constant returns to scale. Which of the following statements is TRUE? A) a declining population growth rate will increase per-capita income B) an increase in the savings rate will permanently increase the growth rate of output C) an increase in the depreciation rate will increase the capital-labor ratio D) technological advances will have no effect on the long-run growth rate of output E) none of the above Ans: A

Difficulty: Medium 40. The idea of a steady state is that A) the capital-labor ratio grows at a constant rate B) output per capita grows at a constant rate C) output, capital, and labor all grow at the same rate D) an increase in the savings rate will not affect the capital-labor ratio E) real output cannot grow Ans: C

Difficulty: Easy 41. According to the neoclassical growth model, a one-time technological advance will A) shift the investment requirement line up B) increase the long-term growth rate of output C) have no effect on the steady-state capital-labor ratio
446

D) lead to a decrease in the rate of depreciation E) none of the above Ans: E

Difficulty: Medium 42. The steady state is defined as a long-run equilibrium at which capital, labor, and output all grow at the same rate. To be in a steady state in a neoclassical model, which of the following equations has to be satisfied? A) y = (n - d)k B) sy = (n + d)k C) sf(k) = (n - d)k D) sy = nk + d E) y = f(k) = sk + nd Ans: B

Difficulty: Medium 43. In the neoclassical growth model, the steady-state capital-labor ratio is determined by the equation A) k = (n + d)y B) k = s(n + d) C) k = sy/(n + d) D) k = y/(n - d) E) k = (n + d)/sy Ans: C

Difficulty: Easy 44. In a neoclassical growth model in which a one-time advance in technology occurs we could expect A) the level of saving and investment to increase until a new and higher steady-state capital-labor ratio is reached B) the level of income per capita to increase but the steady-state growth rate of output to remain unaffected C) the level of output for any given capital-labor ratio to increase D) all of the above E) none of the above
447

Ans: D

Difficulty: Easy 45. When current saving and investment are just enough to equip new entrants into the labor force with the same amount of capital that the average person already in the work force uses, then A) the economy is in a steady state B) output per head is constant C) capital per head is constant D) capital is growing at the same rate as the population E) all of the above Ans: E

Difficulty: Medium 46. For a neoclassical growth model, which of the following statements is FALSE? A) an increase in the savings rate will increase the steady-state growth rate of aggregate output B) an increase in population growth will increase the steady-state growth rate of aggregate output C) an increase in population growth will reduce the steady-state level of income per capita D) if poor countries save at the same rate as rich countries and have access to the same technology, they will eventually catch up E) long-run growth results from improvements in technology Ans: A

Difficulty: Medium 47. According to neoclassical growth theory which of the following does NOT affect a nation's long-term growth rate? A) the savings rate B) technological progress C) the rate of depreciation D) population growth E) both A) and C) Ans: E
448

Difficulty: Medium 48. In a neoclassical growth model, steady-state consumption is maximized when the marginal increase in the capital-labor ratio (k) produces just enough extra output per capita (y) that the marginal product of k is equal to A) n + d B) sy/(n d) C) sy/(n + d) D) sa - (n + d) E) s - (n + d) Ans: A

Difficulty: Medium 49. The golden-rule capital stock (k**) ensuring that steady-state consumption is maximized is at the point on the production function f(k) where the marginal product of capital (k) is equal to A) n + d B) n - d C) s(n + d) D) sa/(n + d) E) sa/(n - d) Ans: A

Difficulty: Medium 50. The golden-rule capital stock (k**) corresponds to A) the highest permanently sustainable level of steady-state consumption B) the point at which a marginal increase in capital produces just enough extra output to cover the increased investment requirement C) the point on the production function y = f(k), where the slope of f(k) is equal to (n + d) D) all of the above E) none of the above Ans: D

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Chapter 16: The Fed, Money, and Credit

Difficulty: Easy 1. While the Fed can influence the money stock, the ratio of currency to deposits in the country at any given time is determined A) by banks B) jointly by the Treasury and the Fed C) only by lending institutions which provide banking services D) only by the actions of the Treasury Department E) by the public, as households and businesses hold money in the form they prefer Ans: E

Difficulty: Medium 2. Assume many more stores agree to accept credit and debit cards. Which of the following will be a likely outcome? A) the money multiplier will decrease B) the money multiplier will increase C) money supply will decrease, given a fixed monetary base D) the currency-deposit ratio will increase E) the reserve-deposit ratio will decrease Ans: B

Difficulty: Medium 3. The assumption that banks hold less excess reserves and consumers hold less currency when market interest rates increase implies that A) the size of the money multiplier decreases as interest rates rise B) the Fed has total control over the supply of money C) changes in money supply occur as economic conditions change D) monetary policy is totally ineffective E) none of the above Ans: C

Difficulty: Easy 4. The relationship between the stock of money and the monetary base is A) determined solely by the reserve-deposit ratio B) determined solely by the currency-deposit ratio C) between zero and one D) the money multiplier

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E) the income velocity of money Ans: D

Difficulty: Easy 5. High-powered money A) earns more interest than other forms of money B) consists of currency held by the public and bank reserves C) consists of currency held by the public and demand deposits at banks D) includes time and demand deposits held at banks E) is created whenever the Fed sells government bonds Ans: B

Difficulty: Medium 6. The size of the money multiplier A) cannot be influenced by actions of the Fed B) declines with a decrease in high-powered money C) declines as the currency-deposit ratio decreases D) increases as the reserve-deposit ratio decreases E) increases as the reserve requirement is increased Ans: D

Difficulty: Medium 7. The money multiplier will increase if A) the Fed decides to buy government securities B) the Fed decides to sell government securities C) consumers decide to hold less currency relative to deposits D) consumers decide to hold more currency relative to deposits E) the Fed increases the reserve requirement Ans: C

Difficulty: Medium 8. Other things remaining the same, the smaller the currency-deposit ratio, A) the larger the reserve-deposit ratio B) the smaller the reserve-deposit ratio C) the larger the money multiplier D) the smaller the money multiplier E) the larger the monetary base Ans: C

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Difficulty: Medium 9. The reserve ratio-deposit is likely to increase whenever A) uncertainty about the net flow of bank deposits increases B) the market interest rate increases C) the Fed lowers reserve requirements D) the Fed increases the discount rate E) the Fed undertakes open market sales Ans: A

Difficulty: Medium 10. The size of the money multiplier is likely to increase A) as market interest rates increase B) as market interest rates decrease C) as the Fed undertakes open market purchases D) as the Fed undertakes open market sales E) as the currency-deposit ratio increases Ans: A

Difficulty: Easy 11. The formula for the money multiplier (mm) is A) mm = (1 + re)/(cu + re) B) mm = (1 + cu)/(cu + re) C) mm = (1 - cu)/(cu + re) D) mm = (cu + re)/(1 - cu) E) mm =1/(cu + re ) Ans: B

Difficulty: Medium 12. An increase in the market interest rate will increase the size of the money multiplier since A) the reserve-deposit ratio will decrease B) the currency-deposit ratio will increase C) the demand for money will decrease D) banks will earn more interest on their existing assets E) banks will get more interest on the deposits they hold at the Fed Ans: A

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Difficulty: Easy 13. Banks have an incentive to minimize their excess reserves since A) they earn only a very low interest rate on the reserves they hold at the Fed B) larger reserves mean less liquidity C) deposits are bank assets while reserves are not D) the higher the reserve-deposit ratio, the weaker the bank's financial position E) it makes banks less vulnerable in case there is a run on banks Ans: A

Difficulty: Easy 14. Banks tend to hold some excess reserves A) for precautionary purposes to reduce the probability of illiquidity B) to avoid the costs of borrowing from other banks at the federal funds rate C) to avoid the costs of borrowing from the Fed at the discount rate D) all of the above E) none of the above Ans: D

Difficulty: Easy 15. The introduction of federal deposit insurance after the Great Depression caused A) an increase in the excess reserve ratio B) an increase in the currency-deposit ratio C) a decrease in the size of the money multiplier D) the money multiplier to become more stable E) all of the above Ans: D

Difficulty: Medium 16. In which of the following years was the discount rate (also known as the primary credit rate) at its lowest level? A) 1985 B) 1991 C) 1995 D) 2000 E) 2008 Ans: E

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Difficulty: Easy 17. Which of the following is NOT an instrument of the Fed for controlling money supply? A) the excess reserve ratio B) the required reserve ratio C) changes in the discount rate (the primary credit rate) D) open market operations E) both A) and D) Ans: A

Difficulty: Medium 18. If the currency-deposit ratio is 23% and the reserve-deposit ratio is 7%, the size of the money multiplier is A) 0.3 B) 2.0 C) 3.0 D) 3.3 E) 4.1 Ans: E

Difficulty: Medium 19. If the currency-deposit ratio is 20%, the reserve-deposit ratio is 10% and the stock of high-powered money is H = 400, money supply is A) 1,000 B) 1,200 C) 1,600 D) 2,000 E) 4,000 Ans: C

Difficulty: Medium 20. The stock of high-powered money is increased when the Fed A) sells securities in the open market B) increases the reserve requirement C) sells foreign exchange (francs, yen, etc.) D) makes loans to banks E) none of the above Ans: D

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Difficulty: Medium 21. The stock of high-powered money is reduced when A) the Fed buys foreign currency in the foreign exchange market B) the Fed lends to member banks C) the Treasury deposits funds in its account at the Fed D) the Fed buys government securities from the public E) all of the above Ans: C

Difficulty: Difficult 22. If money supply is M = 1,200, currency outstanding is Cu = 380, and the monetary base (high-powered money) is H = 480, A) the money multiplier is 2.5 and bank deposits are D = 820 B) the money multiplier is 2.5 and bank deposits are D = 720 C) the money multiplier is 1.4 and bank deposits are D = 860 D) the money multiplier is 1.4 and bank deposits are D = 820 E) the money multiplier is 1.7 and bank deposits are D = 720 Ans: A

Difficulty: Difficult 23. Assume that the currency-deposit ratio is 32%, the required reserve ratio is 7%, the excess reserve ratio is 1%, and total money supply is $1,320 billion. What is the amount of high-powered money? A) $132 billion B) $165 billion C) $330 billion D) $400 billion E) $800 billion Ans: D

Difficulty: Difficult 24. Assume money supply is $1,200 billion, bank deposits are $800 billion, and the reserve-deposit ratio is 10%. By how much is money supply likely to change if the Fed conducts an open market sale valued at $40 million? A) -$100 billion B) -$60 billion C) +$40 billion D) +$60 billion

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E) +$100 billion Ans: A

Difficulty: Medium 25. If money supply is M = 1,200, bank deposits are D = 800, and the monetary base (high-powered money) is H = 480, A) the reserve-deposit ratio is 40% and the money multiplier is 4 B) the reserve-deposit ratio is 40% and the money multiplier is 2.5 C) the reserve-deposit ratio is 10% and the money multiplier is 4 D) the reserve-deposit ratio is 10% and the money-multiplier is 2.5 E) the reserve-deposit ratio is 10% and the money multiplier is 1.5 Ans: D

Difficulty: Easy 26. The Federal Reserve can decrease bank reserves by A) selling bonds to the public B) lowering the reserve requirements C) lowering the discount rate (the primary credit rate) D) buying foreign exchange E) making open market purchases Ans: A

Difficulty: Medium 27. The federal funds rate A) is not affected by open market operations B) is also known as the primary credit rate C) is the rate that banks have to pay if they borrow from the Fed D) is the rate a bank has to pay if it borrows funds temporarily from another bank E) none of the above Ans: D

Difficulty: Medium 28. If the Fed were to abolish reserve requirements, A) it could no longer exert any influence over money supply B) the size of the money multiplier would become infinite C) the size of the money multiplier would become 1 D) both A) and B) E) none of the above

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Ans: E

Difficulty: Medium 29. If the Fed decreases the reserve requirement, A) market interest rates will go up B) national income is likely to decrease at least in the short run C) the Fed is probably trying to fight inflation D) bank profits are likely to increase E) all of the above Ans: D

Difficulty: Easy 30. If the Fed imposed a 100% reserve requirement, it would imply that A) the Fed had no control over money supply B) the Fed would no longer be able to conduct any open market operations C) the money multiplier would be equal to one D) the money multiplier would be equal to zero E) banks would become completely obsolete Ans: C

Difficulty: Easy 31. The federal funds rate is the rate that A) banks are charged if they borrow funds from the Fed B) the Fed pays on reserves held as deposits in its account C) banks charge each other, usually for large overnight loans D) banks charge their best customers E) the FDIC charges to insure deposits Ans: C

Difficulty: Medium 32. When the central bank intervenes in the foreign exchange market by purchasing foreign currency, it also routinely engages in open market sales of government securities. Why? A) it has to sell securities to acquire the necessary funds B) to avoid a recession that may be caused by the reduction in money supply resulting from the purchase of foreign currency C) it wants to isolate the domestic economy from foreign competition D) to increase the profitability of its portfolio

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E) to prevent its intervention in the foreign exchange market from having a direct effect upon the domestic money supply Ans: E

Difficulty: Medium 33. Which are the three channels by which the Federal Reserve can reduce money supply? A) buy government securities, lower reserve requirements, and lower the discount rate B) buy government securities, raise reserve requirements, and raise the discount rate C) buy government securities, lower reserve requirements, and raise the discount rate D) sell government securities, raise reserve requirements, and raise the discount rate E) sell government securities, lower reserve requirements, and raise the discount rate Ans: D

Difficulty: Easy 34. If the Federal Reserve wanted to reduce inflation, the most effective policies would be to A) sell government securities and raise reserve requirements B) sell government securities and lower reserve requirements C) buy government securities and lower reserve requirements D) buy government securities and raise reserve requirements E) buy government securities and keep reserve requirements the same Ans: A

Difficulty: Medium 35. Difficulties for the Fed in conducting successful monetary policy arise from the fact that A) the Fed has no good control over the primary credit rate (the discount rate) B) the Fed often has to follow orders from the Treasury department C) changes in some of the variables that are important to monetary policy (e.g., velocity) cannot always be accurately anticipated D) FOMC has to vote on policy changes before they are implemented E) both C) and D) Ans: C

Difficulty: Easy 36. Over which of the following does the Fed have the most control? A) the stock of money

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B) the stock of bank reserves C) the amount of excess reserves held by banks D) the size of the money multiplier E) the currency-deposit ratio Ans: B

Difficulty: Medium 37. The effect of an increase in government spending on aggregate demand is greatest if the government finances it by A) increasing taxes B) borrowing from the domestic public C) borrowing indirectly from the Fed D) selling Treasury bills to banks E) issuing long-term government bonds Ans: C

Difficulty: Medium 38. If the Fed wanted to maintain a constant interest rate after an increase in government spending, it would need to A) buy government securities in open market operations B) sell government securities in open market operations C) raise reserve requirements D) increase the primary credit rate (the discount rate) E) increase the currency-deposit ratio Ans: A

Difficulty: Medium 39. If the Fed wanted to keep income at the original level after a tax increase, it would need to A) buy government securities in open market operations B) sell government securities in open market operations C) raise reserve requirements D) raise the primary credit rate (the discount rate) E) raise the currency-deposit ratio Ans: A

Difficulty: Difficult 40. If most economic disturbances are the result of shifts in money demand, the Fed

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should A) target money supply to regain economic stability B) sell government securities whenever interest rates increase C) conduct open market purchases whenever interest rates increase D) target the total amount of reserves available to the banking system E) none of the above Ans: C

Difficulty: Medium 41. If most disturbances in our economy are coming from the expenditure sector, the Fed should A) buy government securities whenever interest rates go up to keep income stable B) sell government securities whenever interest rates go up to keep interest rates stable C) follow money supply targets rather than interest rate targets D) follow interest rate targets rather than money supply targets E) change reserve requirements more frequently Ans: C

Difficulty: Medium 42. If a central bank were to set an interest rate target and stick to it, A) much of the economy's instability would be eliminated B) the central bank would no longer be able to control money supply C) the central bank would never be able to provide sufficient money for economic growth to get the economy out of a recession D) inflation would no longer be a problem since the central bank would have credibility E) velocity would become very stable even in the short run Ans: B

Difficulty: Medium 43. During the financial crisis that started in 2008, the Fed A) lowered short-term interest rates until they reached almost zero percent B) bought some non-traditional assets to intervene in long-term markets and drive longterm interest rates down C) started to pay interest to banks on the reserves they held with the Fed D) all of the above E) none of the above Ans: D

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Difficulty: Medium 44. If the monetary growth rate is far above the target range previously announced by the Fed, financial investors are likely to assume that future interest rates will increase since A) the Fed is likely to reduce money supply soon B) inflation will start to increase C) borrowing will increase in anticipation of higher inflation D) all of these are possible E) none of these are possible Ans: D

Difficulty: Easy 45. When conducting monetary policy, the Fed should not just look at the total amount of money but also at the total amount of credit, since A) the link between money and nominal GDP is insignificant B) if not enough credit is available investment will be reduced, affecting GDP negatively C) banks can ration credit, affecting the impact of monetary policy D) all of the above E) only B) and C) Ans: E

Difficulty: Medium 46. If the Fed is trying to peg the interest rate, it A) needs to sell government securities whenever interest rates go up B) needs to tie the discount rate to the three-month Treasury-bill rate C) loses control over money supply D) needs to restrict money supply whenever interest rates increase E) none of the above Ans: C

Difficulty: Medium 47. Which of the following is an intermediate target of the Fed? A) high-powered money B) bank reserves C) the federal funds rate D) money supply E) price stability Ans: D

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Difficulty: Difficult 48. Assume that the Fed's goal is to stabilize national income. Under what conditions would a money supply target be more desirable than an interest rate target? A) when money demand is very interest inelastic and investment is very interest elastic B) when money demand is very interest elastic and investment is very interest inelastic C) when consumer spending is very predictable D) when uncertainties and fluctuations are coming mainly from the expenditure sector E) when uncertainties and fluctuations are coming mainly from changes in money demand Ans: D

Difficulty: Medium 49. Between 1990 and 1992, the Fed conducted monetary policy almost entirely with reference to interest rates since A) banks rationed credit B) the economy grew at a very fast pace C) the growth rates of different monetary aggregates diverged widely D) the objective was to increase the profitability of banks E) the objective was to keep money supply stable Ans: C

Difficulty: Medium 50. One of the problems that the Fed has when conducting monetary policy is that A) it can control the supply of high-powered money but cannot always accurately predict the size of the money multiplier B) it can control the size of the money multiplier but cannot always control the amount of high-powered money C) it cannot influence the federal funds rate by its open market operations D) it can set the discount rate but cannot influence the federal funds rate, which is determined by banks E) velocity is stable in the short run but not in the long run Ans: A

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Chapter 18: Financial Markets and Asset Prices

Difficulty: Easy 1. If we plot the interest rates on government securities with different terms to maturity over the last three decades, we can see that A) there is no clear pattern B) they are all volatile but follow a similar pattern C) 10-year bonds have always had a lower yield than three-month Treasury bills D) interest rates on average were lower in the 1980s than in the 1990s E) interest rates were at their highest around 1991 Ans: B

Difficulty: Easy 2. If your bank pays you a nominal interest rate of 2.5% on funds in your savings account and the rate of inflation is 4%, what is the real rate of return on your savings? A) +6.5% B) +2.5% C) +1.5% D) -1.5% E) -4.0% Ans: D

Difficulty: Easy 3. The concept of arbitrage is very important to the understanding of financial markets since A) it can explain why U.S. government securities are much more desirable than securities from some foreign governments B) it explains why we are unable to predict future stock market swings C) it explains why the stock market reacts slowly to new information D) it says that, in equilibrium, asset prices will make financial investors equally willing to buy or sell an asset E) it says that future behavior of stock prices can be extrapolated from past behavior Ans: D

Difficulty: Easy 4. The concept of arbitrage A) applies to the stock, bond, and foreign currency markets B) only applies to the stock market

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C) only applies to the stock and bond markets D) only applies to the foreign currency market E) doesnt apply to any of these markets Ans: A

Difficulty: Easy 5. The concept of arbitrage implies that A) stock market prices cannot be accurately predicted B) financial markets are inefficient C) international interest rate differentials persist over the long run D) long-term bonds and short-term bonds have the same yield E) none of the above Ans: E

Difficulty: Easy 6. Generally one can expect the yield of a corporate bond to be higher A) if the maturity of a bond is shorter B) if the bond is more liquid C) if the bond is less liquid D) if the corporation has a better rating E) if the earnings of the corporation are higher Ans: C

Difficulty: Easy 7. Payments made on government bonds in periodic instances (once a year, for example) are called A) face values B) par values C) dividends D) coupon payments E) none of the above Ans: D

Difficulty: Easy 8. If the current market interest rate rises from 4% to 5%, the price of a ten-year maturity bond will A) fall more than the price of a two-year maturity bond B) fall less than the price of a two-year maturity bond

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C) rise more than the price of a two-year maturity bond D) rise less than the price of a two-year maturity bond E) not be affected, and neither will the price of a two-year maturity bond Ans: A

Difficulty: Easy 9. The relationship between the yields of government securities with different terms to maturity is called A) yield to maturity B) interest rate risk C) term structure of interest rates D) interest rate differential E) uncovered interest parity Ans: C

Difficulty: Easy 10. The term structure of interest rates A) is the relationship between interest rates on bonds of different maturities B) specifies the terms of a bank loan C) specifies the yield on stock holdings D) is the same as compounded interest E) is the same as yield to maturity Ans: A

Difficulty: Easy 11. If short-term interest rates over the next three years are assumed to be i1 = 4%, i2 = 5.5%, and i3 = 4%, what do you expect the three-year rate to be under the expectations theory? A) 5.5% B) 5.0% C) 4.0% D) 4.5% plus a term premium E) 5.5% minus a term premium Ans: D

Difficulty: Easy 12. The expectations theory of the term structure says that an upward-sloping yield curve means that financial markets expect

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A) yields on corporate bonds to be higher than yields on government bonds B) stock market values to increase drastically C) interest rates to go up in the future D) the economy to go into a recession E) none of the above Ans: C

Difficulty: Medium 13. A downward-sloping yield curve is often seen as an indication that A) a recession may be imminent B) a boom will soon be underway C) stock market values are about to increase D) bond values are about to decrease E) there is a high demand for short-term bonds Ans: A

Difficulty: Easy 14. If we compare the yield curve in January, 1981 with the yield curve in January, 2010, we see that A) they are both downward-sloping, since both were years in which we had a recession B) they were both upward-sloping since both years had strong growth C) interest rates were expected to go up in 1981 due to high inflation D) interest rates were expected to go down in 2010 due to low inflation E) 1981 was an unusual year, showing a downward-sloping yield curve Ans: E

Difficulty: Easy 15. If a previously upward-sloping yield curve starts to flatten out and eventually becomes downward sloping, what would you expect? A) stock values are likely to go up B) interest rates are likely to go up C) the economy is likely to enter a boom D) the economy is likely to enter a recession E) none of the above Ans: D

Difficulty: Medium 16. The expectations theory of the term structure asserts that

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A) short-term interest rates are always lower than long-term interest rates, since they have less risk B) long-term interest rates are always higher than short-term interest rates because you should always expect some inflation C) long-term interest rates are determined by the average of the current and future shortterm interest rates D) the lower the liquidity of a security, the higher the yield it has to pay to attract financial investors E) foreign securities often have to pay a risk premium to compensate for exchange rate uncertainties Ans: C

Difficulty: Medium 17. Assume you put $8,000 in a savings account and leave it there for four years. If you get a compounded yearly interest rate of 5% the first two years but only 4% the last two years, how much will be in the account after the four years? A) $9,640 B) $9,540 C) $9.340 D) $9,240 E) $9,040 Ans: B

Difficulty: Medium 18. Assume you have to make payments of $44,000 one year from now, another $48,400 in two years, and a final $39,930 in three years. If a bank paid a fixed interest rate of i = 10% over the next three years, how much money would you have to put into the bank now to be able to makes these payments? A) $132,330 B) $120,300 C) $120,000 D) $110,000 E) $100,000 Ans: D

Difficulty: Medium 19. Assume you put $2,000 in a bank account that pays a compounded yearly interest of 4%. Approximately how much would your savings be worth after four years? A) $2,380 B) $2,340

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C) $2,320 D) $2,300 E) $2,280 Ans: B

Difficulty: Medium 20. About how much should a financial investment of $10,000 be worth after six years if it earns a compounded yearly interest of 5%? A) $10,500 B) $12,500 C) $13,000 D) $13,400 E) $15,000 Ans: D

Difficulty: Medium 21. If the market interest rate is 10%, what is the price of a one-year maturity bond with a 15% coupon rate and a face value of $4,400? A) $4,000 B) $4,400 C) $4,600 D) $4,840 E) $5,060 Ans: C

Difficulty: Medium 22. Assume a two-year maturity bond with a face value of $1,000 and a coupon rate of 10%. If the current market interest rate is i = 8%, we know that the price of this bond will be A) $1,210 B) $1,124 C) $1,036 D) $984 E) $920 Ans: C

Difficulty: Difficult 23. Assume a relative has promised to pay you $10,000 exactly ten years from today. If

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you estimate that the market interest rate will average about 6% over the next ten years, approximately how much would the $10,000 be worth to you in today's money, assuming there were no inflation? A) $9,400 B) $8,800 C) $7,200 D) $5,600 E) $4,200 Ans: D

Difficulty: Difficult 24. Security A is a one-year maturity bond with a coupon rate of 10% and a face value of $2,000; Security B is a consol that pays $200 for each year you own it. If the market interest rate falls from 10% to 5%, by how much do the values of these two securities change? A) the value of A increases by $95; the value of B increases by $2,000 B) the value of A increases by $95; the value of B increases by $1,000 C) the value of A increases by $100; the value of B increases by $100 D) the value of A increases by $200; the value of B increases by $1,000 E) the value of A increases by $200; the value of B increases by $2,000 Ans: A

Difficulty: Medium 25. Assume you are promised that $40,000 will be paid to you three years from now. If the market interest rates remains i = 10% over these three years, what is the present discounted value of the $40,000? A) roughly $44,000 B) roughly $38,240 C) roughly $36,330 D) roughly $32,550 E) roughly $30,050 Ans: E

Difficulty: Easy 26. Assume a five-year maturity bond that pays a coupon valued at $80 each year and has a face value of $1,000. If the market interest rate is i = 8%, the current price of this bond is A) exactly $1,250 B) exactly $1,000 C) less than $1,000

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D) more than $1,000 E) somewhere between $1,000 and $1,250 Ans: B

Difficulty: Easy 27. Assume the market interest rate is 5% and a one-year maturity bond pays a coupon valued of $420. What would the face value of this bond have to be if the current price of the bond were $4,400? A) $4,000 B) $4,200 C) $4,400 D) $4,620 E) $4,820 Ans: B

Difficulty: Difficult 28. If you paid $6,000 for a two-year maturity bond with a face value of $8,640 and a zero percent coupon rate, what would be your rate of return? A) 25% B) 20% C) 15% D) 12% E) 8% Ans: B

Difficulty: Medium 29. Assume you own a consol (a perpetual bond) and a five-year maturity bond, each with the same current yield. What will happen if the market interest rate decreases from 10% to 8%? A) the value of the consol will decrease less than the value of the five-year bond B) the value of the consol will decrease more than the value of the five-year bond C) the value of the consol and the five-year bond will increase by the same amount D) the value of the consol will increase more than the value of the five-year bond E) the value of the consol will increase less than the value of the five-year bond Ans: D

Difficulty: Easy 30. If the market interest rate stays at i = 10% over the next four years, what is the net

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present discounted value of a bond that pays $100 in coupon payments for each of the next four years and has a face value of $1,000? A) $1,100 B) $1,000 C) $980 D) $900 E) $800 Ans: B

Difficulty: Difficult 31. Assume an investment costs you $8,800 right now and promises to pay back $5,500 after one year and another $4,840 after the second year. What is the highest market interest rate at which this investment project is still profitable? A) 15% B) 13% C) 11% D) 9% E) 7% Ans: C

Difficulty: Medium 32. Assume the market interest rates stays at 10% over the next two years. What is the present discounted value of a two-year maturity bond that has a coupon rate of 10% and a face value of $2,000? A) $1,760 B) $1,800 C) $2,000 D) $2,200 E) $2,440 Ans: C

Difficulty: Medium 33. Assume a consol, that is, a bond without maturity date that pays $800 for each year you own it. What is the current price of this consol, if the market interest rate is i = 8%? A) $10,000 B) $6,400 C) $4,000 D) $1,000 E) the price would depend on how long you plan to own this consol

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Ans: A

Difficulty: Medium 34. If a consol that pays $200 for each year you own it currently costs $5,000, what is the current market interest rate? A) 8.0% B) 6.0% C) 4.0% D) 2.5% E) 2.0% Ans: C

Difficulty: Medium 35. Suppose a consol (a perpetual bond) that sells for $2,000 promises to pay $80 a year forever. What is its yield? A) 12% B) 8% C) 6% D) 4% E) it cannot be determined with this data Ans: D

Difficulty: Medium 36. If a consol (perpetual bond) pays $250 a year and yields 5%, what is its present discounted value? A) $5,000 B) $2,500 C) $1,250 D) $1,000 E) it cannot be determined with this information Ans: A

Difficulty: Medium 37. Assume you bought rental property for $100,000. Approximately how much would you have to charge in monthly rent to get a 9% rate of return? A) $1,000 B) $900 C) $750

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D) $600 E) $450 Ans: C

Difficulty: Medium 38. Assume you would like to buy a stock that promises to pay a fixed dividend of $120 per year. If the current market interest rate is 6%, how much would you pay for this stock? A) $7,720 B) $7,200 C) $4,800 D) $2,000 E) $720 Ans: D

Difficulty: Easy 39. A booming stock market is good for capital investment since A) higher stock values now imply even higher stock values in the future B) an increase in wealth increases investment spending C) firms have an easier time raising equity capital D) whenever stock market values go up, the economy is sure to follow E) foreign capital will be attracted, raising interest rates Ans: C

Difficulty: Medium 40. Which of the following statements is FALSE? A) returns on stocks tend to be highly volatile B) a small rise in long-term interest rates can cause a huge drop in stock values C) the timing of stock market swings is unpredictable D) on average returns on stocks tend to be lower than returns on bonds E) the fact that stock market behavior is well understood makes future stock prices hard to predict Ans: D

Difficulty: Easy 41. Which of the following is generally true for the stock market? A) it takes time for new information to be reflected in new stock values B) a stock's dividend is the net present value of the stock's price

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C) stock market returns tend to be lower on average than the returns on Treasury bills D) stock market prices tend to fall when long-term interest rates rise E) stock market prices can be accurately predicted by carefully observing their long-term trend Ans: D

Difficulty: Easy 42. Which of the following statements is NOT accurate? A) financial markets are forward-looking B) new surprise information about firms changes the value of their stock C) if stocks did well last quarter they are likely to do well this quarter D) a random walk is a sign of market efficiency E) interest rate differentials between two countries are reflected in exchange rate movements Ans: C

Difficulty: Easy 43. Which of the following statements is FALSE? A) the timing of large stock market swings can often be predicted B) changes in stock values tend to affect the value of pensions for many people C) rates of return in financial markets feed back into goods markets D) asset prices and interest rates are inversely related E) many people see stock market volatility as a sign of market efficiency Ans: A

Difficulty: Medium 44. The efficient-markets hypothesis states that A) you can consistently outperform the stock market by efficient use of information B) financial markets are much more efficient than goods markets C) stock markets are only efficient if experts manage peoples portfolios D) stock prices rarely change significantly based on unexpected new information E) none of the above Ans: E

Difficulty: Medium 45. What would be true if stock prices did NOT follow a random walk? A) stock markets would work much more efficiently B) stock markets would outperform bond markets

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C) bond markets would outperform stock markets D) financial investors would not be able to outperform the stock market E) some financial investors could benefit by taking advantage of opportunities that have not been realized by others Ans: E

Difficulty: Easy 46. The fact that stock prices follow a random walk implies that A) stock markets are not efficient B) stock markets are efficient C) financial investors react very slowly to new information D) financial investors often ignore new information E) stock markets are not affected by changes in interest rates Ans: B

Difficulty: Medium 47. If interest rates in the U.S. increase but they stay the same in the rest of the world, then A) the exchange rate of foreign currency to U.S. dollars will increase B) the exchange rate of U.S. dollars to foreign currency will increase C) the U.S. dollar will depreciate D) U.S. bond prices are likely to increase E) U.S. stock market values are likely to increase sharply Ans: A

Difficulty: Medium 48. Assume U.S. interest rates decrease but interest rates in other countries remain the same. Which of the following is FALSE? A) the value of the U.S. dollar will decrease B) the exchange rate of foreign currency to U.S. dollars will increase C) the U.S. will experience an outflow of funds D) U.S. stock values will increase E) U.S. bond prices will increase Ans: B

Difficulty: Easy 49. The term uncovered interest parity refers to A) corporate stocks that pay a fixed dividend

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B) the inverse relationship between bond prices and interest rates C) the differential between stock returns and bond returns D) a downward-sloping yield curve E) the relation between exchange rate changes and international interest rate differentials Ans: E

Difficulty: Easy 50. The relation between international interest rate differentials and changes in exchange rates is called A) uncovered interest parity B) purchasing power parity C) the term structure of interest rates D) the yield curve E) none of the above Ans: A

Chapter 18: Financial Markets and Asset Prices

Difficulty: Easy 1. If we plot the interest rates on government securities with different terms to maturity over the last three decades, we can see that A) there is no clear pattern B) they are all volatile but follow a similar pattern C) 10-year bonds have always had a lower yield than three-month Treasury bills D) interest rates on average were lower in the 1980s than in the 1990s E) interest rates were at their highest around 1991 Ans: B

Difficulty: Easy 2. If your bank pays you a nominal interest rate of 2.5% on funds in your savings account and the rate of inflation is 4%, what is the real rate of return on your savings? A) +6.5% B) +2.5% C) +1.5% D) -1.5% E) -4.0% Ans: D

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Difficulty: Easy 3. The concept of arbitrage is very important to the understanding of financial markets since C) it can explain why U.S. government securities are much more desirable than securities from some foreign governments D) it explains why we are unable to predict future stock market swings C) it explains why the stock market reacts slowly to new information D) it says that, in equilibrium, asset prices will make financial investors equally willing to buy or sell an asset E) it says that future behavior of stock prices can be extrapolated from past behavior Ans: D

Difficulty: Easy 4. The concept of arbitrage A) applies to the stock, bond, and foreign currency markets B) only applies to the stock market C) only applies to the stock and bond markets D) only applies to the foreign currency market E) doesnt apply to any of these markets Ans: A

Difficulty: Easy 5. The concept of arbitrage implies that A) stock market prices cannot be accurately predicted B) financial markets are inefficient C) international interest rate differentials persist over the long run D) long-term bonds and short-term bonds have the same yield E) none of the above Ans: E

Difficulty: Easy 6. Generally one can expect the yield of a corporate bond to be higher A) if the maturity of a bond is shorter B) if the bond is more liquid C) if the bond is less liquid D) if the corporation has a better rating E) if the earnings of the corporation are higher Ans: C

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Difficulty: Easy 7. Payments made on government bonds in periodic instances (once a year, for example) are called A) face values B) par values C) dividends D) coupon payments E) none of the above Ans: D

Difficulty: Easy 8. If the current market interest rate rises from 4% to 5%, the price of a ten-year maturity bond will A) fall more than the price of a two-year maturity bond B) fall less than the price of a two-year maturity bond C) rise more than the price of a two-year maturity bond D) rise less than the price of a two-year maturity bond E) not be affected, and neither will the price of a two-year maturity bond Ans: A

Difficulty: Easy 9. The relationship between the yields of government securities with different terms to maturity is called A) yield to maturity B) interest rate risk C) term structure of interest rates D) interest rate differential E) uncovered interest parity Ans: C

Difficulty: Easy 10. The term structure of interest rates A) is the relationship between interest rates on bonds of different maturities B) specifies the terms of a bank loan C) specifies the yield on stock holdings D) is the same as compounded interest E) is the same as yield to maturity Ans: A

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Difficulty: Easy 11. If short-term interest rates over the next three years are assumed to be i1 = 4%, i2 = 5.5%, and i3 = 4%, what do you expect the three-year rate to be under the expectations theory? A) 5.5% B) 5.0% C) 4.0% D) 4.5% plus a term premium E) 5.5% minus a term premium Ans: D

Difficulty: Easy 12. The expectations theory of the term structure says that an upward-sloping yield curve means that financial markets expect A) yields on corporate bonds to be higher than yields on government bonds B) stock market values to increase drastically C) interest rates to go up in the future D) the economy to go into a recession E) none of the above Ans: C

Difficulty: Medium 13. A downward-sloping yield curve is often seen as an indication that A) a recession may be imminent B) a boom will soon be underway C) stock market values are about to increase D) bond values are about to decrease E) there is a high demand for short-term bonds Ans: A

Difficulty: Easy 14. If we compare the yield curve in January, 1981 with the yield curve in January, 2010, we see that A) they are both downward-sloping, since both were years in which we had a recession B) they were both upward-sloping since both years had strong growth C) interest rates were expected to go up in 1981 due to high inflation D) interest rates were expected to go down in 2010 due to low inflation

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E) 1981 was an unusual year, showing a downward-sloping yield curve Ans: E

Difficulty: Easy 15. If a previously upward-sloping yield curve starts to flatten out and eventually becomes downward sloping, what would you expect? A) stock values are likely to go up B) interest rates are likely to go up C) the economy is likely to enter a boom D) the economy is likely to enter a recession E) none of the above Ans: D

Difficulty: Medium 16. The expectations theory of the term structure asserts that A) short-term interest rates are always lower than long-term interest rates, since they have less risk B) long-term interest rates are always higher than short-term interest rates because you should always expect some inflation C) long-term interest rates are determined by the average of the current and future shortterm interest rates D) the lower the liquidity of a security, the higher the yield it has to pay to attract financial investors E) foreign securities often have to pay a risk premium to compensate for exchange rate uncertainties Ans: C

Difficulty: Medium 17. Assume you put $8,000 in a savings account and leave it there for four years. If you get a compounded yearly interest rate of 5% the first two years but only 4% the last two years, how much will be in the account after the four years? A) $9,640 B) $9,540 C) $9.340 D) $9,240 E) $9,040 Ans: B

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Difficulty: Medium 18. Assume you have to make payments of $44,000 one year from now, another $48,400 in two years, and a final $39,930 in three years. If a bank paid a fixed interest rate of i = 10% over the next three years, how much money would you have to put into the bank now to be able to makes these payments? A) $132,330 B) $120,300 C) $120,000 D) $110,000 E) $100,000 Ans: D

Difficulty: Medium 19. Assume you put $2,000 in a bank account that pays a compounded yearly interest of 4%. Approximately how much would your savings be worth after four years? A) $2,380 B) $2,340 C) $2,320 D) $2,300 E) $2,280 Ans: B

Difficulty: Medium 20. About how much should a financial investment of $10,000 be worth after six years if it earns a compounded yearly interest of 5%? A) $10,500 B) $12,500 C) $13,000 D) $13,400 E) $15,000 Ans: D

Difficulty: Medium 21. If the market interest rate is 10%, what is the price of a one-year maturity bond with a 15% coupon rate and a face value of $4,400? A) $4,000 B) $4,400 C) $4,600 D) $4,840 E) $5,060

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Ans: C

Difficulty: Medium 22. Assume a two-year maturity bond with a face value of $1,000 and a coupon rate of 10%. If the current market interest rate is i = 8%, we know that the price of this bond will be A) $1,210 B) $1,124 C) $1,036 D) $984 E) $920 Ans: C

Difficulty: Difficult 23. Assume a relative has promised to pay you $10,000 exactly ten years from today. If you estimate that the market interest rate will average about 6% over the next ten years, approximately how much would the $10,000 be worth to you in today's money, assuming there were no inflation? A) $9,400 B) $8,800 C) $7,200 D) $5,600 E) $4,200 Ans: D

Difficulty: Difficult 24. Security A is a one-year maturity bond with a coupon rate of 10% and a face value of $2,000; Security B is a consol that pays $200 for each year you own it. If the market interest rate falls from 10% to 5%, by how much do the values of these two securities change? A) the value of A increases by $95; the value of B increases by $2,000 B) the value of A increases by $95; the value of B increases by $1,000 C) the value of A increases by $100; the value of B increases by $100 D) the value of A increases by $200; the value of B increases by $1,000 E) the value of A increases by $200; the value of B increases by $2,000 Ans: A

Difficulty: Medium

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25. Assume you are promised that $40,000 will be paid to you three years from now. If the market interest rates remains i = 10% over these three years, what is the present discounted value of the $40,000? A) roughly $44,000 B) roughly $38,240 C) roughly $36,330 D) roughly $32,550 E) roughly $30,050 Ans: E

Difficulty: Easy 26. Assume a five-year maturity bond that pays a coupon valued at $80 each year and has a face value of $1,000. If the market interest rate is i = 8%, the current price of this bond is A) exactly $1,250 B) exactly $1,000 C) less than $1,000 D) more than $1,000 E) somewhere between $1,000 and $1,250 Ans: B

Difficulty: Easy 27. Assume the market interest rate is 5% and a one-year maturity bond pays a coupon valued of $420. What would the face value of this bond have to be if the current price of the bond were $4,400? A) $4,000 B) $4,200 C) $4,400 D) $4,620 E) $4,820 Ans: B

Difficulty: Difficult 28. If you paid $6,000 for a two-year maturity bond with a face value of $8,640 and a zero percent coupon rate, what would be your rate of return? A) 25% B) 20% C) 15% D) 12% E) 8%

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Ans: B

Difficulty: Medium 29. Assume you own a consol (a perpetual bond) and a five-year maturity bond, each with the same current yield. What will happen if the market interest rate decreases from 10% to 8%? A) the value of the consol will decrease less than the value of the five-year bond B) the value of the consol will decrease more than the value of the five-year bond C) the value of the consol and the five-year bond will increase by the same amount D) the value of the consol will increase more than the value of the five-year bond E) the value of the consol will increase less than the value of the five-year bond Ans: D

Difficulty: Easy 30. If the market interest rate stays at i = 10% over the next four years, what is the net present discounted value of a bond that pays $100 in coupon payments for each of the next four years and has a face value of $1,000? A) $1,100 B) $1,000 C) $980 D) $900 E) $800 Ans: B

Difficulty: Difficult 31. Assume an investment costs you $8,800 right now and promises to pay back $5,500 after one year and another $4,840 after the second year. What is the highest market interest rate at which this investment project is still profitable? A) 15% B) 13% C) 11% D) 9% E) 7% Ans: C

Difficulty: Medium 32. Assume the market interest rates stays at 10% over the next two years. What is the present discounted value of a two-year maturity bond that has a coupon rate of 10%

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and a face value of $2,000? A) $1,760 B) $1,800 C) $2,000 D) $2,200 E) $2,440 Ans: C

Difficulty: Medium 33. Assume a consol, that is, a bond without maturity date that pays $800 for each year you own it. What is the current price of this consol, if the market interest rate is i = 8%? A) $10,000 B) $6,400 C) $4,000 D) $1,000 E) the price would depend on how long you plan to own this consol Ans: A

Difficulty: Medium 34. If a consol that pays $200 for each year you own it currently costs $5,000, what is the current market interest rate? A) 8.0% B) 6.0% C) 4.0% D) 2.5% E) 2.0% Ans: C

Difficulty: Medium 35. Suppose a consol (a perpetual bond) that sells for $2,000 promises to pay $80 a year forever. What is its yield? A) 12% B) 8% C) 6% D) 4% E) it cannot be determined with this data Ans: D

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Difficulty: Medium 36. If a consol (perpetual bond) pays $250 a year and yields 5%, what is its present discounted value? A) $5,000 B) $2,500 C) $1,250 D) $1,000 E) it cannot be determined with this information Ans: A

Difficulty: Medium 37. Assume you bought rental property for $100,000. Approximately how much would you have to charge in monthly rent to get a 9% rate of return? A) $1,000 B) $900 C) $750 D) $600 E) $450 Ans: C

Difficulty: Medium 38. Assume you would like to buy a stock that promises to pay a fixed dividend of $120 per year. If the current market interest rate is 6%, how much would you pay for this stock? A) $7,720 B) $7,200 C) $4,800 D) $2,000 E) $720 Ans: D

Difficulty: Easy 39. A booming stock market is good for capital investment since A) higher stock values now imply even higher stock values in the future B) an increase in wealth increases investment spending C) firms have an easier time raising equity capital D) whenever stock market values go up, the economy is sure to follow E) foreign capital will be attracted, raising interest rates Ans: C

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Difficulty: Medium 40. Which of the following statements is FALSE? A) returns on stocks tend to be highly volatile B) a small rise in long-term interest rates can cause a huge drop in stock values C) the timing of stock market swings is unpredictable D) on average returns on stocks tend to be lower than returns on bonds E) the fact that stock market behavior is well understood makes future stock prices hard to predict Ans: D

Difficulty: Easy 41. Which of the following is generally true for the stock market? A) it takes time for new information to be reflected in new stock values B) a stock's dividend is the net present value of the stock's price C) stock market returns tend to be lower on average than the returns on Treasury bills D) stock market prices tend to fall when long-term interest rates rise E) stock market prices can be accurately predicted by carefully observing their long-term trend Ans: D

Difficulty: Easy 42. Which of the following statements is NOT accurate? A) financial markets are forward-looking B) new surprise information about firms changes the value of their stock C) if stocks did well last quarter they are likely to do well this quarter D) a random walk is a sign of market efficiency E) interest rate differentials between two countries are reflected in exchange rate movements Ans: C

Difficulty: Easy 43. Which of the following statements is FALSE? A) the timing of large stock market swings can often be predicted B) changes in stock values tend to affect the value of pensions for many people C) rates of return in financial markets feed back into goods markets D) asset prices and interest rates are inversely related E) many people see stock market volatility as a sign of market efficiency

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Ans: A

Difficulty: Medium 44. The efficient-markets hypothesis states that A) you can consistently outperform the stock market by efficient use of information B) financial markets are much more efficient than goods markets C) stock markets are only efficient if experts manage peoples portfolios D) stock prices rarely change significantly based on unexpected new information E) none of the above Ans: E

Difficulty: Medium 45. What would be true if stock prices did NOT follow a random walk? A) stock markets would work much more efficiently B) stock markets would outperform bond markets C) bond markets would outperform stock markets D) financial investors would not be able to outperform the stock market E) some financial investors could benefit by taking advantage of opportunities that have not been realized by others Ans: E

Difficulty: Easy 46. The fact that stock prices follow a random walk implies that A) stock markets are not efficient B) stock markets are efficient C) financial investors react very slowly to new information D) financial investors often ignore new information E) stock markets are not affected by changes in interest rates Ans: B

Difficulty: Medium 47. If interest rates in the U.S. increase but they stay the same in the rest of the world, then A) the exchange rate of foreign currency to U.S. dollars will increase B) the exchange rate of U.S. dollars to foreign currency will increase C) the U.S. dollar will depreciate D) U.S. bond prices are likely to increase E) U.S. stock market values are likely to increase sharply

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Ans: A

Difficulty: Medium 48. Assume U.S. interest rates decrease but interest rates in other countries remain the same. Which of the following is FALSE? A) the value of the U.S. dollar will decrease B) the exchange rate of foreign currency to U.S. dollars will increase C) the U.S. will experience an outflow of funds D) U.S. stock values will increase E) U.S. bond prices will increase Ans: B

Difficulty: Easy 49. The term uncovered interest parity refers to A) corporate stocks that pay a fixed dividend B) the inverse relationship between bond prices and interest rates C) the differential between stock returns and bond returns D) a downward-sloping yield curve E) the relation between exchange rate changes and international interest rate differentials Ans: E

Difficulty: Easy 50. The relation between international interest rate differentials and changes in exchange rates is called A) uncovered interest parity B) purchasing power parity C) the term structure of interest rates D) the yield curve E) none of the above Ans: A

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