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Answers - Selected Problems 1 through 8 (BUS G-345; Money, Banking; and Capital Markets; Self)

Answers - Selected Problems 1 through 8 (BUS G-345; Money, Banking; and Capital Markets; Self)

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Unformatted text preview: Answers Business G345, summe: Suggested problems from chapters 1 through 8 Chapter 1, Questions and Problems page 19, questions 1, 2, 4, 6, 8, 9, and 15. l. Omitted 2.The data in Figures 1, 2, 3, and 4 suggest that real output, the inflation rate, and interest rates would all fall. 4. You might be more likely to buy a house or a car because the cost of financing them would fall, or you might be less likely to save because you earn less on your savings. 6. No. It is true that people who borrow to purchase a house or a car are worse off because it costs them more to finance their purchase; however, savers benefit because they can earn higher interest rates on their savings. 7. The basic activity of banks is to accept deposits and make loans. 8. They channel finds from people who do not have a productive use for them to people who do, thereby resulting in hifier economic efficiency. 9. The interest rate on three-month Treasury bills fluctuates more than the other interest rates and is lower on average. The interest rate on Baa corporate bonds is higher on average than the other interest rates. 15. When the dollar increases in value, foreign goods become less expensive relative to American goods; thus you are more likely to buy French-made jeans than American-made jeans. The resulting drop in demand for American-made jeans because of the strong dollar hurts American jeans manufacturers. On the other hand, the American company that imports jeans into the United States now finds that the demand for its product has risen, so it is better off when the dollar is strong. Chapter 2, Questions and Problems page 51, questions 2, 3, 5, 6, 7, 10, 13, and 14. 2. Yes, I should take out the loan, because I will be better off as a result of doing so. My interest payment will be $4,500 (90% of $5,000), but as a result, I will earn an additional $10,000, so I will be ahead of the game by $5,500. Since Larry’s loan—sharking business can make some people better off, as in this example, loan sharking may have social benefits. (One argument against legalizing loan sharking, however, is that it is frequently a violent activity.) 3. Yes, because the absence of financial markets means that funds cannot be channeled to people who have the most productive use for them. Entrepreneurs then cannot acquire funds to set up businesses that would help the economy grow rapidly. Answers Page 2 of 5 Page 1 of 7 5. This statement is false. Prices in secondary markets determine the prices that firms issuing securities receive in primary markets. In addition, secondary markets make securities more liquid and thus easier to sell in the primary markets. Therefore, secondary markets are, if anything, more important than primary markets. 6. You would rather hold bonds, because bondholders are paid off before equity holders, who are the residual claimants. 7. Because you know your family member better than a stranger, you know more about the borrower’s honesty, propensity for risk taking, and other traits. There is less asymmetric infomation than with a stranger and less likelihood of an adverse selection problem, with the result that you are more likely to lend to the family member. 10. They might not work hard enough while you are not looking or may steal or commit fraud. 13. Because the costs of making the loan to your neighbor are high (legal fees, fees for a credit check, and so on), you will probably not be able earn 5% on the loan after your expenses even though it has a 10% interest rate. You are better off depositing your savings with a financial intermediary and earning 5% interest. In addition, you are likely to bear less risk by depositing your savings at the bank rather than lending them to your neighbor. 14. A ranking from most liquid to least liquid is (a),.(b), (c), and (d). The ranking is similar for the safest to the least safe. Chapter 3, Questions and Problems page 65 and 66, questions 2, 6, 8, 10, 14, and 15 2. Because the orchard owner likes only bananas but the banana grower doesn’t like apples, the banana grower will not want apples in exchange for his bananas, and they will not trade. Similarly, the chocolatier will not be willing to trade with the banana grower because she does not like bananas. The orchard owner will not trade with the chocolatier because he doesn’t like chocolate. Hence, in a barter economy, trade among these three people may well not take place, because in no case is there a double coincidence of wants. However, if money is introduced into the economy, the orchard owner can sell his apples to the chocolatier and then use the meney to buy bananas fiom the banana grower. Similarly, the banana grower can use the money she receives from the orchard owner to buy chocolate from the chocolatier, and the chocolatier can use the money to buy apples from the orchard owner. The result is that the need for a double coincidence of wants is eliminated, and everyone is better off because all three producers are now able to eat what they like best. 6. Because money was losing value at a slower rate (the inflation rate was lower) in the 19505 than in the 19705, it was then a better store of value, and you would have been willing to hold more of it. 8. The ranking from most liquid to least liquid is: (a), (c), (e), (f), (b), and (d). 10. Because of the rapid inflation in Brazil, the domestic currency, the real, is a poor store of value. Thus many people would rather hold dollars, which are a better store of value, and use them in their daily shopping. Answers Page 3 of 5 Page 2 of 7 14. (a) M] and w, (b) M2, (0) M2, 05) M1 and M2. 15. Revisions are not a serious problem for long—run movements of the money supply, because revisions for short-run (one-month) movements tend to cancel out. Revisions for long-run movements, such as one- year growth rates, are thus typically quite small. Chapter 4, Questions and Problems page 88, questions 1, 3, 4, 7, 8, 9, l3, and 15 l. = 0.10) = $0.91, whenthe interest rate is 10%. 3. 2 3 = $3,000 4. The yield to maturity is less than 10 percent. Only if the interest rate was less than 10 percent would the present value of the payments add up to $4,000, which is more than the $3,000 present value in the previous problem. 7. 14.9%, derived as follows: The present value of the $2 million payment five years from now is r‘)5 million, which equals the $1 million loan. Thus I = 2')5. Solving for 1' £)5 = 2, so that 5 2 I 0.149 14.9%. :i 8. Ifthe interest rate were 12 percent, the present discounted value of the payments on the government loan are necessarily less than the $1,000 loan amount because they do not sum for two- years. Thus the yield to maturity must be lower than 12 percent in order for the present discounted value of these payments to add up to $1,000. 9. If the one- $800)f $8 = 0.25 = 25%. Because it does have a coupon payment, its yield to maturity must be greater than 25%. However, because the ctu‘rent yield is a good approximation of the yield to maturity for a twenty-year bond, we know that the yield to maturity on this bond is approximately 15%. Therefore, the oneyear bond has a higher yield to maturity. 13. No. If interest rates rise sharply in the future, long-temi bonds may suffer such a sharp fall in price that their return might be quite low—possibly even negative. 15. The economists are right. They reason that nominal interest rates were below expected rates of inflation in the late 1970s, making real interest rates negative. The expected inflation rate, however, fell much faster than nominal interest rates in the mid-19805, so nominal interest rates were above the expected inflation rate and real rates became positive. Chapter 5, Questions and Problems page 119 and 120, questions 2, 3, 6, 8, 9, 14, 19, and 20 2. (a) More, because your wealth has increased; (b) more, because the house has become more liquid,- (0) less, because its expected return has fallen relative to Microsoft stock; ((1) more, because it has become less risky relative to stocks; (e) less, because its expected return has fallen. Answers Page 4 of 5 Page 3 of 7 3. (a) More, because it has become more liquid; (b) less, because it has become more 6. When the Fed sells bonds to the public, it increases the supply of bonds, thus shifting the supply curve B: to the right. The result is that the intersection of the supply and demand curves Br and Ba occurs at a lower price and a higher equilibrium interest rate, and the interest rate rises. With the liquidity preference framework, the decrease in the money supply shifts the money supply curve ME to the left, and the equilibrium interest rate rises. The answer from bond supply and demand analysis is consistent with the answer from the liquidity preference fiamework. 8. When the price level rises, the quantity of money in real terms falls (holding the nominal supply of money constant); to restore their holdings of money in real terms to their former level, people will want to hold a greater nominal quantity of money. Thus the money demand curve Md shifts to the right, and the interest rate rises. 9. Omitted 14. The price level effect has its maximum impact by the end of the first year, and since the price level does not fall further, interest rates will not fall further as a result of a price level effect. On the other hand, expected inflation returns to zero in the second year, so that the expected inflation effect returns to zero. One factor producing lower interest rates thus disappears, so, in the second year, interest rates may rise somewhat fiom their low point at the end of the second year. 19. Interest rates will rise. When bond prices become volatile and bonds become riskier, the demand for bonds will fall. The demand curve 30' will shift to the left, the price will fall, and the equilibrium interest rate will rise. 20. The slower rate of money growth will lead to a liquidity effect, which raises interest rates, while the lower price level, income, and inflation rates in the future will tend to lower interest rates. There are three possible scenarios for what will happen: (a) if the liquidity effect is larger than the other effects, then interest rates will rise; (b) if the liquidity effect is smaller than the other effects and expected inflation adjusts slowly, then interest rates will rise at first but will eventually fall below their initial level; and (c) if the liquidity effect is smaller than the expected inflation effect and there is rapid adjustment of expected inflation, then interest rates will immediately fall. Chapter 6, Questions and Problems page 143 and 144, questions 3, 5, 6, 8, 9, 13, and 15 3. During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premimn. Similarly, during recessions, default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms. S. If yield curves on average were flat, this would suggest that the risk premium on long—term relative to short-term bonds would equal zero and we would be more willing to accept the expectations hypothesis. Answers Page 5 of 5 Page 4 of 7 6. (a) The yield to maturity would be 5% for a one-year bond, 6% for a two-year bond, 6.22% for a three- year bond, 6.5% for a four-year bond, and 6.6% for a five—year bond. (b) The yield to maturity would be 5% for a one-year bond, 4.5% for a two-year bond, 4.33% for a three-year bond, 4.25% for a four-year bond, and 4.2% for a five-year bond. The upward sloping yield curve in (a) would be even steeper if people preferred short-term bonds over long-term bonds, because long-term bonds would then have a positive liquidity premium. The downward-sloping yield curve in (b) would be less steep and might have a slight positive upward slope if the long—tenn bonds have a positive liquidity preinitun. 8. The flat yield curve at shorter maturities suggests that short-term interest rates are expected to fall moderately in the near firture, while the steep upwards slope of the yield curve at longer maturities indicates that interest rates further into the future are expected to rise. Because interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to fall moderately in the near future but to rise later on. 9. The steep upward-sloping yield curve at shorter maturities suggests that short—term interest rates are expected to rise moderately in the near future because the initial, steep upward slope indicates that the average of expected short-term interest rates in the near fiiture is above the current short—term interest rate. The downward slope for longer maturities indicates that short—term interest rates are eventually expected to fall sharply. With a positive risk premium on long~term bonds, as in the preferred habitat theory, a dowuward slope of the yield curve occurs only if the average of expected short—temi interest rates is declining, which occurs only if short-term interest rates far into the future are falling. Since interest rates and expected inflation move together, the yield curve suggests that the market expects inflation to rise moderately in the near future but fall later on. 13. Abolishing the tax~exempt feature of municipal bonds would make them less desirable relative to Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise the interest rates on municipal bonds, while the interest rates on Treasury bonds would fall. 15. The slope of the yield curve would fall because the drop in expected future short rates means that the average of expected future short rates falls so that the long rate falls. Chapter 7, Questions page 164 and 165, questions 1, 3, 4, 6, 8, 9, 11, 14, 15, and 20. 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. $1r(1 +0.15) +$20r(1 +0.15) =$18.26 4. P, =$3x(1.07)r0.1s-0.07=$29.18 6. False. Expectations can be highly inaccurate and still be rational, because optimal forecasts are not necessarily accurate: A forecast is optimal if it is the best possible even if the forecast errors are large. 8. No, because he could improve the accuracy of his forecasts by predicting that tomorrow’s interest rates will be identical to today’s. His forecasts are therefore not optimal, and he does not have rational eXpectations. Page 5 of 7 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. 1 1. 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. 14. No, if the person has no better information than the rest of the market. An expected price rise of 10% over the next month implies over a 100% annual return on Google stock, which certainly exceeds its equilibrium return. This would mean that there is an unexploited profit opportunity in the market, which would have been eliminated in an efficient market. The only time that the person’s expectations could be rational is if the person had information unavailable to the market that allowed him or her to beat the market. 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. 20. False. Although human fear may be the source of stock market crashes, that does not imply that there are unexploited profit opportunities in the market. Nothing in rational expectations theory rules out large changes in stock prices as a result of fears on the part of the investing public. Chapter 8, Questions and Problems page 191, questions 3, 5, 6, 8, 9, 13, and 15. 3 .No. If the lender knows as much about the borrower as the borrower does, then the lender is able to screen out the good from the bad credit risks and so adverse selection will not be a problem. Similarly, if the lender knows what the borrower is up to, then moral hazard will not be a problem because the lender can easily stop the borrower from engaging in moral hazard. 5. The lemons problem would be less severe for firms listed on the New York Stock Exchange because they are typically larger corporations that are better known in the market place. Therefore it is easier for investors to get information about them and figure out whether the firm is of good quality or is a lemon. This makes the adverse selection—lemons problem less severe. 6.Smaller firms that are not well known are the most likely to use bank financing. Because it is harder for investors to acquire information about these firms, it will be hard for the firms to sell securities in the financial markets. Banks that specialize in collecting information about smaller firms will then be the only outlet these firms have for financing their activities. 8. Yes. The person who is putting her life savings into her business has more to lose if she takes on too much risk or engages in personally beneficial activities that don’t lead to higher profits. So she will act more in the interest of the lender, making it more likely that the loan will be paid off. Page 6 of 7 9. Yes, this is an example of an adverse selection problem. Because a person is rich, the people who are most likely to want to marry him or her are gold diggers. Rich people thus may want to be extra. careful to screen out those who are just interested in their money from those who want to many for love. 13. Because one information resource can be used in providing the several services, thus lowering the cost for each. 15. Conflicts of interest lead to a substantial reduction in the quality of information so that asymmetric information problems become worse, which prevents financial markets from channeling funds into productive investment opportunities. The result is that financial markets become less efficient. Page 7 of 7 ...
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