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Mishkin Solutions Ch 7-10

Mishkin Solutions Ch 7-10 - Solutions to Chapter Problems...

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Solutions to Chapter Problems: Chapters 7-10 Chapter 7 The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 1. The value of any investment is found by computing the value today of all cash flows the investment will generate over its life. 3. $1/(1 + 0.15) + $20/(1 + 0 .15) = $18.26 5. A stock market bubble can occur if market participants either believe that dividends will have rapid growth or if they substantially lower the required return on their equity investments, thus lowering the denominator in the Gordon model and thereby causing stock prices to climb. By raising interest rates the central bank can cause the required rate of return on equity to rise, thereby keeping stock prices from climbing as much. Also raising interest rates may help slow the expected growth rate of the economy and hence of dividends, thus also keeping stock prices from climbing. 7. Although Joe’s expectations are typically quite accurate, they could still be improved by his taking account of a snowfall in his forecasts. Since his expectations could be improved, they are not optimal and hence are not rational expectations. 9. True, as an approximation. If large changes in a stock price could be predicted, then the optimal forecast of the stock return would not equal the equilibrium return for that stock. In this case, there would be unexploited profit opportunities in the market and expectations would not be rational. Very small changes in stock prices could be predictable, however, and the optimal forecast of returns would equal the equilibrium return. In this case, an unexploited profit opportunity would not exist. 11. The stock price will rise. Even though the company is suffering a loss, the price of the stock reflects an even larger expected loss. When the loss is less than expected, efficient markets theory then indicates that the stock price will rise. 13. Probably not. Although your broker has done well in the past, efficient markets theory suggests that she has probably been lucky. Unless you believe that your broker has better information than the rest of the market, efficient markets theory indicates that you cannot expect the broker to beat the market in the future. 15. False. All that is required for the market to be efficient so that prices reflect information on the monetary aggregates is that some market participants eliminate unexploited profit opportunities. Not everyone in a market has to be knowledgeable for the market to be efficient. 17. Because inflation is less than expected, expectations of future short-term interest rates would be lowered, and as we learned in Chapter 7, long-term interest rates would fall. The decline in long- term interest rates implies that long-term bond prices would rise.
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19. No, because this expected change in the value of the dollar would imply that there is a huge unexploited profit opportunity (over a 100% expected return at an annual rate). Since rational
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Mishkin Solutions Ch 7-10 - Solutions to Chapter Problems...

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