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

==> k-1/2 = (n + d)/s = (0.07 + 0.03)/(.2) = 1/2 ==> k1/2 = 2 = y ==> k = 4 .

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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 PROBLEMSTechnical Problems

1. Assume the Fed sells Treasury bills valued at $10 (million) to a bank.

Fed Balance Sheet: Assets Liabilities Govt. securities - $10 Currency 0 Other assets 0 Bank deposits - $10

Bank Balance Sheet: Assets Liabilities Deposits at the Fed - $10 Deposits 0 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 Liabilities Reserves - $10 Deposits - $10 Other assets 0

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 Liabilities Gold + $10 Currency 0 Other assets 0 Member bank deposits + $10

The purchase of gold increased the monetary base (bank reserves) by $10 million.

Fed Balance Sheet After Sterilization: Assets Liabilities

Gold + $10 Bank deposits (+10 -10) = $0 Govt. securities - $10

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

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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 monetary base targeting

i IS LM2 i IS1 IS1 LMLM1 = LM3

i2

i2

i1 i1

0 0 Y2 Y1 Y Y1 Y2 Y

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CHAPTER 18 TECHNICAL PROBLEMSTechnical 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,

10

i10 = (1/10) it.

t = 1

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,

10 10

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

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 PROBLEMSTechnical 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 bank’s balance Assets Liabilities sheet before sterilization: foreign exchange - 10 member bank deposits - 10

other reserves 0 currency 0

monetary base - 10 monetary base - 10 The central bank’s balance Assets Liabilities sheet after sterilization: foreign exchange - 10 member bank deposits 0

govt. securities + 10 currency 0

monetary base 0 monetary base 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.

i ISo LMo

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i1 BB' = 0

io BB = 0

0 Y* Y

3.b. i IS' LM' ISo LMo

i1 BB' = 0

io BB = 0

0Y* Y

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

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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 full-

employment level.

i IS1 LMo(po) = LM1(p1) ISo

LM1(po) 4

i1 1 = 5 3 io i2

2

0 Yo Y2Y4 Y3 Y

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Chapter 3: Growth and Accumulation

Difficulty: Medium1. 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 futureC) 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: Easy2. 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 functionB) aggregate production functionC) aggregate investment functionD) marginal product of laborE) marginal product of capital Ans: B

Difficulty: Medium3. 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 AB) multiplying the growth rate of capital by capital's share in productionC) subtracting the growth rate of labor from the rate of technological advancementD) multiplying the capital-labor ratio by the level of outputE) multiplying total factor productivity with capital’s share in productionAns: B

Difficulty: Easy4. For the U.S. economy, we can assume thatA) output grows at the same rate as both capital and labor

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

Difficulty: Easy5. Which of the following is NOT a source of long-term output growth?A) growth in consumption expendituresB) growth in labor inputsC) growth in capital inputsD) improved technological efficiencyE) growth in the stock of knowledgeAns: A

Difficulty: Medium6. Which of the following is NOT a source of increased factor productivity?A) advances in knowledgeB) growth in the size of the labor forceC) more efficient resource allocationD) improved methods of productionE) technological progressAns: B

Difficulty: Easy7. Which of the following economists contributed greatly to neoclassical growth theory

in the 1950s and 1960s?A) Robert BarroB) Robert LucasC) Gregory Mankiw D) Paul Romer E) Robert Solow Ans: E

Difficulty: Easy8. Changes in total factor productivity are also called A) the marginal product of labor B) the marginal product of capital

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C) changes in input costsD) the Cobb-Douglas residual E) the Solow residualAns: E

Difficulty: Easy9. Which of the following is NOT a source of increased factor productivity?A) an increase in average years of schoolingB) an increase in on-the-job trainingC) increased investment in healthD) an increase in the size of the capital stock E) an increase in the rate of innovationAns: D

Difficulty: Easy10. 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: Easy11. 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 0.35C) the share of capital is 0.45 and the share of labor is 0.55D) 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

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Difficulty: Medium12. 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/4NC) (3/4)N D) 3K/4N E) 3N/4Y Ans: B

Difficulty: Medium13. 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/KB) 5Y/K C) Y/4KD) Y/5KE) Y/KAns: D

Difficulty: Difficult14. 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: Difficult15. 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%

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

Difficulty: Difficult16. 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: Difficult17. 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: Medium18. 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 capital’s share and there are constant returns to scale?

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

Difficulty: Medium19. 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: Medium20. 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: Difficult21. 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

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of technological advance is 1.2%, roughly how many years would it take to double the

current level of output?

A) 12B) 18C) 23D) 35E) 48Ans: B

Difficulty: Difficult22. 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) 7B) 10C) 19D) 23E) 33Ans: C

Difficulty: Difficult23. 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) 0.5B) 1 C) 2D) 4E) 5Ans: 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: Easy25. Which of the following countries had the lowest ratio of investment to GDP in 1992?A) JapanB) NorwayC) SingaporeD) Taiwan E) United StatesAns: E

Difficulty: Easy26. 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: Easy27. Which of the following is FALSE? A) a high level of investment generally does not lead to a higher living standardB) in industrial countries the amount of labor is less important than the skills and talent

of the work forceC) a country that possesses rich natural resources should have a high standard of livingD) 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

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capital and thus raise overall living standards Ans: A

Difficulty: Medium28. 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 incomeB) the country with the higher rate of population growth will have a higher per-capita

incomeC) the country with the lower rate of population growth will have a higher per-capita

incomeD) the country with the highest depreciation rate will have the highest per-capita incomeE) both C) and D)Ans: C

Difficulty: Medium29. In the neoclassical growth model, an increase in the savings rateA) raises the steady-state level of outputB) lowers the steady-state level of outputC) raises the long-term economic growth rateD) lowers total factor productivityE) both A) and C)Ans: A

Difficulty: Medium30. In the neoclassical growth model, if a nation's savings rate decreases, we should

expect thatA) the long-run income per capita will increaseB) the long-run capital-labor ratio will increaseC) the growth rate of output will temporarily decrease but eventually return to its long-

run trendD) all of the aboveE) none of the aboveAns: C

Difficulty: Medium

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31. In the neoclassical growth model, an increase in the rate of population growth willA) raise the growth rate of outputB) increase the level of output per capitaC) increase the steady-state capital-labor ratioD) all of the aboveE) only B) and C)Ans: A

Difficulty: Medium32. 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: Medium33. 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 madeB) 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 growthD) all of the aboveE) none of the aboveAns: E

Difficulty: Medium34. In a neoclassical growth model, if the capital-labor ratio is lower than the

(optimal) steady-state level, we should expect that

A) saving is smaller than the investment requirementB) output per capita will temporarily grow at a rate lower than population growthC) income per capita will decreaseD) there will be a temporary increase in the capital stock that is greater than the increase

in population

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E) all of the aboveAns: D

Difficulty: Medium35. The convergence to a steady-state capital-labor ratio k* is ensured by the fact that if k

is at a levelA) lower than k*, saving will exceed the investment required to maintain a constant k,

causing k to riseB) lower than k*, investment will exceed saving, leading to an increase in the capital

stockC) lower than k*, saving will exceed the investment required to maintain a constant k,

causing output per capita to declineD) higher than k*, the rate of depreciation will be higher than the savings rate, causing k

to decreaseE) higher than k*, output per capita will continue to increase until a new steady-state

equilibrium is reachedAns: A

Difficulty: Difficult36. 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 decreasesB) the rate of depreciation decreasesC) the rate of population growth decreasesD) technological advances are madeE) all of the aboveAns: A

Difficulty: Medium37. 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: Medium38. 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) increaseB) decreaseC) stay the sameD) temporarily increase, but then go back to its original level E) most likely change but we cannot say for sure how Ans: E

Difficulty: Medium39. 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 incomeB) an increase in the savings rate will permanently increase the growth rate of outputC) an increase in the depreciation rate will increase the capital-labor ratioD) technological advances will have no effect on the long-run growth rate of outputE) none of the aboveAns: A

Difficulty: Medium40. The idea of a steady state is thatA) the capital-labor ratio grows at a constant rateB) output per capita grows at a constant rateC) output, capital, and labor all grow at the same rateD) an increase in the savings rate will not affect the capital-labor ratio E) real output cannot growAns: C

Difficulty: Easy41. According to the neoclassical growth model, a one-time technological advance willA) shift the investment requirement line up B) increase the long-term growth rate of outputC) have no effect on the steady-state capital-labor ratio

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D) lead to a decrease in the rate of depreciationE) none of the aboveAns: E

Difficulty: Medium42. 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)kD) sy = nk + dE) y = f(k) = sk + ndAns: B

Difficulty: Medium43. 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: Easy44. In a neoclassical growth model in which a one-time advance in technology occurs we

could expectA) 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 increaseD) all of the above E) none of the above

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Ans: D

Difficulty: Easy45. 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 stateB) output per head is constantC) capital per head is constantD) capital is growing at the same rate as the populationE) all of the aboveAns: E

Difficulty: Medium46. 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

outputB) 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

capitaD) if poor countries save at the same rate as rich countries and have access to the same

technology, they will eventually catch upE) long-run growth results from improvements in technology Ans: A

Difficulty: Medium47. 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 growthE) both A) and C)Ans: E

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Difficulty: Medium48. 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 + dB) sy/(n – d)C) sy/(n + d)D) sa - (n + d)E) s - (n + d)Ans: A

Difficulty: Medium49. 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 + dB) n - dC) s(n + d)D) sa/(n + d)E) sa/(n - d)Ans: A

Difficulty: Medium50. The golden-rule capital stock (k**) corresponds to A) the highest permanently sustainable level of steady-state consumptionB) the point at which a marginal increase in capital produces just enough extra output to

cover the increased investment requirementC) the point on the production function y = f(k), where the slope of f(k) is equal to (n +

d)D) all of the aboveE) none of the aboveAns: D

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Chapter 16: The Fed, Money, and Credit

Difficulty: Easy1. While the Fed can influence the money stock, the ratio of currency to deposits in the

country at any given time is determinedA) by banksB) jointly by the Treasury and the Fed C) only by lending institutions which provide banking servicesD) only by the actions of the Treasury Department E) by the public, as households and businesses hold money in the form they preferAns: E

Difficulty: Medium2. 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 increaseC) money supply will decrease, given a fixed monetary baseD) the currency-deposit ratio will increaseE) the reserve-deposit ratio will decreaseAns: B

Difficulty: Medium3. The assumption that banks hold less excess reserves and consumers hold less

currency when market interest rates increase implies thatA) the size of the money multiplier decreases as interest rates riseB) the Fed has total control over the supply of moneyC) changes in money supply occur as economic conditions changeD) monetary policy is totally ineffectiveE) none of the aboveAns: C

Difficulty: Easy4. The relationship between the stock of money and the monetary base isA) determined solely by the reserve-deposit ratioB) determined solely by the currency-deposit ratioC) between zero and oneD) the money multiplier

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E) the income velocity of money Ans: D

Difficulty: Easy5. High-powered moneyA) earns more interest than other forms of moneyB) consists of currency held by the public and bank reserves C) consists of currency held by the public and demand deposits at banksD) includes time and demand deposits held at banksE) is created whenever the Fed sells government bondsAns: B

Difficulty: Medium6. The size of the money multiplierA) cannot be influenced by actions of the FedB) declines with a decrease in high-powered moneyC) declines as the currency-deposit ratio decreasesD) increases as the reserve-deposit ratio decreasesE) increases as the reserve requirement is increasedAns: D

Difficulty: Medium7. The money multiplier will increase ifA) the Fed decides to buy government securitiesB) the Fed decides to sell government securitiesC) consumers decide to hold less currency relative to depositsD) consumers decide to hold more currency relative to depositsE) the Fed increases the reserve requirementAns: C

Difficulty: Medium8. Other things remaining the same, the smaller the currency-deposit ratio,A) the larger the reserve-deposit ratioB) the smaller the reserve-deposit ratio C) the larger the money multiplierD) the smaller the money multiplierE) the larger the monetary baseAns: C

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Difficulty: Medium9. The reserve ratio-deposit is likely to increase wheneverA) uncertainty about the net flow of bank deposits increasesB) the market interest rate increasesC) the Fed lowers reserve requirementsD) the Fed increases the discount rateE) the Fed undertakes open market salesAns: A

Difficulty: Medium10. The size of the money multiplier is likely to increaseA) as market interest rates increaseB) as market interest rates decreaseC) as the Fed undertakes open market purchasesD) as the Fed undertakes open market sales E) as the currency-deposit ratio increases Ans: A

Difficulty: Easy11. 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: Medium12. An increase in the market interest rate will increase the size of the money multiplier

sinceA) the reserve-deposit ratio will decreaseB) the currency-deposit ratio will increaseC) the demand for money will decrease D) banks will earn more interest on their existing assetsE) banks will get more interest on the deposits they hold at the FedAns: A

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Difficulty: Easy13. Banks have an incentive to minimize their excess reserves sinceA) they earn only a very low interest rate on the reserves they hold at the FedB) larger reserves mean less liquidityC) deposits are bank assets while reserves are notD) the higher the reserve-deposit ratio, the weaker the bank's financial positionE) it makes banks less vulnerable in case there is a run on banksAns: A

Difficulty: Easy14. Banks tend to hold some excess reservesA) for precautionary purposes to reduce the probability of illiquidityB) to avoid the costs of borrowing from other banks at the federal funds rateC) to avoid the costs of borrowing from the Fed at the discount rateD) all of the aboveE) none of the aboveAns: D

Difficulty: Easy15. The introduction of federal deposit insurance after the Great Depression causedA) an increase in the excess reserve ratioB) an increase in the currency-deposit ratioC) a decrease in the size of the money multiplierD) the money multiplier to become more stableE) all of the aboveAns: D

Difficulty: Medium16. In which of the following years was the discount rate (also known as the primary

credit rate) at its lowest level? A) 1985B) 1991 C) 1995D) 2000E) 2008Ans: E

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Difficulty: Easy17. 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 operationsE) both A) and D)Ans: A

Difficulty: Medium18. If the currency-deposit ratio is 23% and the reserve-deposit ratio is 7%, the size of the

money multiplier isA) 0.3B) 2.0C) 3.0D) 3.3 E) 4.1Ans: E

Difficulty: Medium19. 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 isA) 1,000B) 1,200C) 1,600D) 2,000E) 4,000Ans: C

Difficulty: Medium20. The stock of high-powered money is increased when the FedA) sells securities in the open marketB) increases the reserve requirementC) sells foreign exchange (francs, yen, etc.)D) makes loans to banksE) none of the aboveAns: D

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Difficulty: Medium21. The stock of high-powered money is reduced whenA) the Fed buys foreign currency in the foreign exchange marketB) the Fed lends to member banksC) the Treasury deposits funds in its account at the FedD) the Fed buys government securities from the publicE) all of the aboveAns: C

Difficulty: Difficult22. 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 = 820B) the money multiplier is 2.5 and bank deposits are D = 720C) the money multiplier is 1.4 and bank deposits are D = 860D) the money multiplier is 1.4 and bank deposits are D = 820E) the money multiplier is 1.7 and bank deposits are D = 720Ans: A

Difficulty: Difficult23. 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 billionB) $165 billionC) $330 billionD) $400 billionE) $800 billionAns: D

Difficulty: Difficult24. 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 billionB) -$60 billion C) +$40 billion D) +$60 billion

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E) +$100 billionAns: A

Difficulty: Medium25. 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 2.5C) the reserve-deposit ratio is 10% and the money multiplier is 4D) the reserve-deposit ratio is 10% and the money-multiplier is 2.5E) the reserve-deposit ratio is 10% and the money multiplier is 1.5Ans: D

Difficulty: Easy26. The Federal Reserve can decrease bank reserves byA) selling bonds to the publicB) lowering the reserve requirementsC) lowering the discount rate (the primary credit rate)D) buying foreign exchangeE) making open market purchasesAns: A

Difficulty: Medium27. The federal funds rate A) is not affected by open market operationsB) is also known as the primary credit rate C) is the rate that banks have to pay if they borrow from the FedD) is the rate a bank has to pay if it borrows funds temporarily from another bankE) none of the above Ans: D

Difficulty: Medium28. 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 1D) both A) and B)E) none of the above

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Ans: E

Difficulty: Medium29. If the Fed decreases the reserve requirement, A) market interest rates will go upB) national income is likely to decrease at least in the short runC) the Fed is probably trying to fight inflationD) bank profits are likely to increaseE) all of the aboveAns: D

Difficulty: Easy30. If the Fed imposed a 100% reserve requirement, it would imply that A) the Fed had no control over money supplyB) the Fed would no longer be able to conduct any open market operations C) the money multiplier would be equal to oneD) the money multiplier would be equal to zeroE) banks would become completely obsoleteAns: C

Difficulty: Easy31. The federal funds rate is the rate thatA) banks are charged if they borrow funds from the FedB) the Fed pays on reserves held as deposits in its accountC) banks charge each other, usually for large overnight loansD) banks charge their best customers E) the FDIC charges to insure deposits Ans: C

Difficulty: Medium32. 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 fundsB) to avoid a recession that may be caused by the reduction in money supply resulting

from the purchase of foreign currencyC) it wants to isolate the domestic economy from foreign competitionD) 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: Medium33. 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 rateB) buy government securities, raise reserve requirements, and raise the discount rateC) buy government securities, lower reserve requirements, and raise the discount rateD) sell government securities, raise reserve requirements, and raise the discount rateE) sell government securities, lower reserve requirements, and raise the discount rate Ans: D

Difficulty: Easy34. If the Federal Reserve wanted to reduce inflation, the most effective policies would

be toA) sell government securities and raise reserve requirements B) sell government securities and lower reserve requirementsC) buy government securities and lower reserve requirementsD) buy government securities and raise reserve requirementsE) buy government securities and keep reserve requirements the same Ans: A

Difficulty: Medium35. Difficulties for the Fed in conducting successful monetary policy arise from the fact

thatA) 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 anticipatedD) FOMC has to vote on policy changes before they are implementedE) both C) and D) Ans: C

Difficulty: Easy36. 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 reservesC) the amount of excess reserves held by banksD) the size of the money multiplier E) the currency-deposit ratioAns: B

Difficulty: Medium37. The effect of an increase in government spending on aggregate demand is greatest if

the government finances it by A) increasing taxesB) borrowing from the domestic publicC) borrowing indirectly from the FedD) selling Treasury bills to banksE) issuing long-term government bondsAns: C

Difficulty: Medium38. If the Fed wanted to maintain a constant interest rate after an increase in government

spending, it would need toA) buy government securities in open market operationsB) sell government securities in open market operationsC) raise reserve requirementsD) increase the primary credit rate (the discount rate)E) increase the currency-deposit ratioAns: A

Difficulty: Medium39. If the Fed wanted to keep income at the original level after a tax increase, it would

need toA) buy government securities in open market operationsB) sell government securities in open market operationsC) raise reserve requirementsD) raise the primary credit rate (the discount rate) E) raise the currency-deposit ratioAns: A

Difficulty: Difficult40. If most economic disturbances are the result of shifts in money demand, the Fed

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shouldA) target money supply to regain economic stabilityB) sell government securities whenever interest rates increaseC) conduct open market purchases whenever interest rates increaseD) target the total amount of reserves available to the banking systemE) none of the aboveAns: C

Difficulty: Medium41. If most disturbances in our economy are coming from the expenditure sector, the Fed

shouldA) buy government securities whenever interest rates go up to keep income stableB) sell government securities whenever interest rates go up to keep interest rates stableC) follow money supply targets rather than interest rate targetsD) follow interest rate targets rather than money supply targetsE) change reserve requirements more frequentlyAns: C

Difficulty: Medium42. If a central bank were to set an interest rate target and stick to it, A) much of the economy's instability would be eliminatedB) the central bank would no longer be able to control money supplyC) the central bank would never be able to provide sufficient money for economic

growth to get the economy out of a recessionD) inflation would no longer be a problem since the central bank would have credibilityE) velocity would become very stable even in the short runAns: B

Difficulty: Medium43. During the financial crisis that started in 2008, the FedA) 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 long-

term interest rates downC) started to pay interest to banks on the reserves they held with the Fed D) all of the aboveE) none of the aboveAns: D

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Difficulty: Medium44. 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 increaseC) borrowing will increase in anticipation of higher inflationD) all of these are possibleE) none of these are possibleAns: D

Difficulty: Easy45. When conducting monetary policy, the Fed should not just look at the total amount of

money but also at the total amount of credit, sinceA) the link between money and nominal GDP is insignificantB) if not enough credit is available investment will be reduced, affecting GDP negativelyC) banks can ration credit, affecting the impact of monetary policyD) all of the aboveE) only B) and C)Ans: E

Difficulty: Medium46. If the Fed is trying to peg the interest rate, itA) needs to sell government securities whenever interest rates go upB) needs to tie the discount rate to the three-month Treasury-bill rate C) loses control over money supplyD) needs to restrict money supply whenever interest rates increaseE) none of the aboveAns: C

Difficulty: Medium47. Which of the following is an intermediate target of the Fed?A) high-powered money B) bank reservesC) the federal funds rateD) money supplyE) price stability Ans: D

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Difficulty: Difficult48. 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 inelasticC) when consumer spending is very predictable D) when uncertainties and fluctuations are coming mainly from the expenditure sectorE) when uncertainties and fluctuations are coming mainly from changes in money

demandAns: D

Difficulty: Medium49. Between 1990 and 1992, the Fed conducted monetary policy almost entirely with

reference to interest rates sinceA) banks rationed credit B) the economy grew at a very fast pace C) the growth rates of different monetary aggregates diverged widelyD) the objective was to increase the profitability of banksE) the objective was to keep money supply stableAns: C

Difficulty: Medium50. One of the problems that the Fed has when conducting monetary policy is thatA) it can control the supply of high-powered money but cannot always accurately predict

the size of the money multiplierB) it can control the size of the money multiplier but cannot always control the amount

of high-powered moneyC) it cannot influence the federal funds rate by its open market operationsD) it can set the discount rate but cannot influence the federal funds rate, which is

determined by banksE) velocity is stable in the short run but not in the long runAns: A

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Chapter 18: Financial Markets and Asset Prices

Difficulty: Easy1. If we plot the interest rates on government securities with different terms to maturity

over the last three decades, we can see thatA) 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 billsD) interest rates on average were lower in the 1980s than in the 1990sE) interest rates were at their highest around 1991Ans: B

Difficulty: Easy2. 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: Easy3. 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 swingsC) 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 assetE) it says that future behavior of stock prices can be extrapolated from past behavior Ans: D

Difficulty: Easy4. 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 marketsD) only applies to the foreign currency marketE) doesn’t apply to any of these markets Ans: A

Difficulty: Easy5. The concept of arbitrage implies that A) stock market prices cannot be accurately predictedB) financial markets are inefficientC) international interest rate differentials persist over the long run D) long-term bonds and short-term bonds have the same yieldE) none of the above Ans: E

Difficulty: Easy6. Generally one can expect the yield of a corporate bond to be higherA) if the maturity of a bond is shorterB) if the bond is more liquid C) if the bond is less liquidD) if the corporation has a better rating E) if the earnings of the corporation are higherAns: C

Difficulty: Easy7. 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 aboveAns: D

Difficulty: Easy8. If the current market interest rate rises from 4% to 5%, the price of a ten-year

maturity bond willA) 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 bondE) not be affected, and neither will the price of a two-year maturity bond Ans: A

Difficulty: Easy9. The relationship between the yields of government securities with different terms to

maturity is called A) yield to maturityB) interest rate riskC) term structure of interest ratesD) interest rate differentialE) uncovered interest parityAns: C

Difficulty: Easy10. The term structure of interest rates A) is the relationship between interest rates on bonds of different maturitiesB) specifies the terms of a bank loanC) specifies the yield on stock holdingsD) is the same as compounded interestE) is the same as yield to maturityAns: A

Difficulty: Easy11. 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 premiumE) 5.5% minus a term premium Ans: D

Difficulty: Easy12. 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 drasticallyC) interest rates to go up in the futureD) the economy to go into a recessionE) none of the aboveAns: C

Difficulty: Medium13. A downward-sloping yield curve is often seen as an indication thatA) a recession may be imminent B) a boom will soon be underwayC) stock market values are about to increaseD) bond values are about to decreaseE) there is a high demand for short-term bondsAns: A

Difficulty: Easy14. 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 growthC) interest rates were expected to go up in 1981 due to high inflationD) interest rates were expected to go down in 2010 due to low inflationE) 1981 was an unusual year, showing a downward-sloping yield curveAns: E

Difficulty: Easy15. 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 boomD) the economy is likely to enter a recession E) none of the above Ans: D

Difficulty: Medium16. 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 short-term 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: Medium17. 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) $9,640B) $9,540C) $9.340D) $9,240E) $9,040Ans: B

Difficulty: Medium18. 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) $132,330B) $120,300C) $120,000D) $110,000E) $100,000Ans: D

Difficulty: Medium19. 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) $2,380B) $2,340

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

Difficulty: Medium20. 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) $12,500C) $13,000D) $13,400E) $15,000Ans: D

Difficulty: Medium21. 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: Medium22. 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: Difficult23. 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: Difficult24. 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 $2,000B) 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 $100D) 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: Medium25. 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 $38,240C) roughly $36,330D) roughly $32,550E) roughly $30,050Ans: E

Difficulty: Easy26. 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 $1,000C) less than $1,000

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

Difficulty: Easy27. 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: Difficult28. 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: Medium29. 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 bondB) the value of the consol will decrease more than the value of the five-year bondC) the value of the consol and the five-year bond will increase by the same amountD) the value of the consol will increase more than the value of the five-year bondE) the value of the consol will increase less than the value of the five-year bondAns: D

Difficulty: Easy30. 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) $1,100B) $1,000C) $980D) $900 E) $800Ans: B

Difficulty: Difficult31. 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: Medium32. 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) $1,760B) $1,800C) $2,000D) $2,200E) $2,440Ans: C

Difficulty: Medium33. 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: Medium34. 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: Medium35. 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 dataAns: D

Difficulty: Medium36. If a consol (perpetual bond) pays $250 a year and yields 5%, what is its present

discounted value?A) $5,000B) $2,500C) $1,250D) $1,000E) it cannot be determined with this informationAns: A

Difficulty: Medium37. 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: Medium38. 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: Easy39. A booming stock market is good for capital investment sinceA) higher stock values now imply even higher stock values in the futureB) an increase in wealth increases investment spendingC) firms have an easier time raising equity capitalD) whenever stock market values go up, the economy is sure to followE) foreign capital will be attracted, raising interest rates Ans: C

Difficulty: Medium40. Which of the following statements is FALSE?A) returns on stocks tend to be highly volatileB) a small rise in long-term interest rates can cause a huge drop in stock valuesC) the timing of stock market swings is unpredictable D) on average returns on stocks tend to be lower than returns on bondsE) the fact that stock market behavior is well understood makes future stock prices hard

to predict Ans: D

Difficulty: Easy41. Which of the following is generally true for the stock market?A) it takes time for new information to be reflected in new stock valuesB) 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 riseE) stock market prices can be accurately predicted by carefully observing their long-term

trendAns: D

Difficulty: Easy42. Which of the following statements is NOT accurate? A) financial markets are forward-lookingB) 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: Easy43. 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 peopleC) rates of return in financial markets feed back into goods marketsD) asset prices and interest rates are inversely relatedE) many people see stock market volatility as a sign of market efficiencyAns: A

Difficulty: Medium44. 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 people’s portfolios D) stock prices rarely change significantly based on unexpected new information E) none of the aboveAns: E

Difficulty: Medium45. What would be true if stock prices did NOT follow a random walk? A) stock markets would work much more efficientlyB) stock markets would outperform bond markets

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C) bond markets would outperform stock marketsD) financial investors would not be able to outperform the stock marketE) some financial investors could benefit by taking advantage of opportunities that have

not been realized by othersAns: E

Difficulty: Easy46. 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 informationE) stock markets are not affected by changes in interest ratesAns: B

Difficulty: Medium47. If interest rates in the U.S. increase but they stay the same in the rest of the world,

thenA) the exchange rate of foreign currency to U.S. dollars will increaseB) the exchange rate of U.S. dollars to foreign currency will increaseC) the U.S. dollar will depreciateD) U.S. bond prices are likely to increase E) U.S. stock market values are likely to increase sharplyAns: A

Difficulty: Medium48. 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 decreaseB) the exchange rate of foreign currency to U.S. dollars will increaseC) the U.S. will experience an outflow of fundsD) U.S. stock values will increaseE) U.S. bond prices will increase Ans: B

Difficulty: Easy49. 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 ratesC) the differential between stock returns and bond returnsD) a downward-sloping yield curve E) the relation between exchange rate changes and international interest rate differentialsAns: E

Difficulty: Easy50. The relation between international interest rate differentials and changes in exchange

rates is calledA) uncovered interest parity B) purchasing power parity C) the term structure of interest ratesD) the yield curveE) none of the aboveAns: A

Chapter 18: Financial Markets and Asset Prices

Difficulty: Easy1. If we plot the interest rates on government securities with different terms to maturity

over the last three decades, we can see thatA) 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 billsD) interest rates on average were lower in the 1980s than in the 1990sE) interest rates were at their highest around 1991Ans: B

Difficulty: Easy2. 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: Easy3. 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 swingsC) 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 assetE) it says that future behavior of stock prices can be extrapolated from past behavior Ans: D

Difficulty: Easy4. 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 marketsD) only applies to the foreign currency marketE) doesn’t apply to any of these markets Ans: A

Difficulty: Easy5. The concept of arbitrage implies that A) stock market prices cannot be accurately predictedB) financial markets are inefficientC) international interest rate differentials persist over the long run D) long-term bonds and short-term bonds have the same yieldE) none of the above Ans: E

Difficulty: Easy6. Generally one can expect the yield of a corporate bond to be higherA) if the maturity of a bond is shorterB) if the bond is more liquid C) if the bond is less liquidD) if the corporation has a better rating E) if the earnings of the corporation are higherAns: C

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Difficulty: Easy7. 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 aboveAns: D

Difficulty: Easy8. If the current market interest rate rises from 4% to 5%, the price of a ten-year

maturity bond willA) fall more than the price of a two-year maturity bond B) fall less than the price of a two-year maturity bondC) rise more than the price of a two-year maturity bond D) rise less than the price of a two-year maturity bondE) not be affected, and neither will the price of a two-year maturity bond Ans: A

Difficulty: Easy9. The relationship between the yields of government securities with different terms to

maturity is called A) yield to maturityB) interest rate riskC) term structure of interest ratesD) interest rate differentialE) uncovered interest parityAns: C

Difficulty: Easy10. The term structure of interest rates A) is the relationship between interest rates on bonds of different maturitiesB) specifies the terms of a bank loanC) specifies the yield on stock holdingsD) is the same as compounded interestE) is the same as yield to maturityAns: A

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Difficulty: Easy11. 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 premiumE) 5.5% minus a term premium Ans: D

Difficulty: Easy12. The expectations theory of the term structure says that an upward-sloping yield curve

means that financial markets expectA) yields on corporate bonds to be higher than yields on government bonds B) stock market values to increase drasticallyC) interest rates to go up in the futureD) the economy to go into a recessionE) none of the aboveAns: C

Difficulty: Medium13. A downward-sloping yield curve is often seen as an indication thatA) a recession may be imminent B) a boom will soon be underwayC) stock market values are about to increaseD) bond values are about to decreaseE) there is a high demand for short-term bondsAns: A

Difficulty: Easy14. 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 growthC) interest rates were expected to go up in 1981 due to high inflationD) 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 curveAns: E

Difficulty: Easy15. 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 boomD) the economy is likely to enter a recession E) none of the above Ans: D

Difficulty: Medium16. 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 short-

term 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

uncertaintiesAns: C

Difficulty: Medium17. 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) $9,640B) $9,540C) $9.340D) $9,240E) $9,040Ans: B

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Difficulty: Medium18. 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) $132,330B) $120,300C) $120,000D) $110,000E) $100,000Ans: D

Difficulty: Medium19. 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) $2,380B) $2,340C) $2,320D) $2,300E) $2,280Ans: B

Difficulty: Medium20. 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) $12,500C) $13,000D) $13,400E) $15,000Ans: D

Difficulty: Medium21. 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: Medium22. 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: Difficult23. 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: Difficult24. 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 $2,000B) 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 $100D) 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 $38,240C) roughly $36,330D) roughly $32,550E) roughly $30,050Ans: E

Difficulty: Easy26. 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 $1,000C) less than $1,000 D) more than $1,000E) somewhere between $1,000 and $1,250Ans: B

Difficulty: Easy27. 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: Difficult28. 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: Medium29. 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 bondB) the value of the consol will decrease more than the value of the five-year bondC) the value of the consol and the five-year bond will increase by the same amountD) the value of the consol will increase more than the value of the five-year bondE) the value of the consol will increase less than the value of the five-year bondAns: D

Difficulty: Easy30. 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) $1,100B) $1,000C) $980D) $900 E) $800Ans: B

Difficulty: Difficult31. 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: Medium32. 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) $1,760B) $1,800C) $2,000D) $2,200E) $2,440Ans: C

Difficulty: Medium33. 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 consolAns: A

Difficulty: Medium34. 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: Medium35. 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 dataAns: D

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Difficulty: Medium36. If a consol (perpetual bond) pays $250 a year and yields 5%, what is its present

discounted value?A) $5,000B) $2,500C) $1,250D) $1,000E) it cannot be determined with this informationAns: A

Difficulty: Medium37. 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: Medium38. 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: Easy39. A booming stock market is good for capital investment sinceA) higher stock values now imply even higher stock values in the futureB) an increase in wealth increases investment spendingC) firms have an easier time raising equity capitalD) whenever stock market values go up, the economy is sure to followE) foreign capital will be attracted, raising interest rates Ans: C

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Difficulty: Medium40. Which of the following statements is FALSE?A) returns on stocks tend to be highly volatileB) a small rise in long-term interest rates can cause a huge drop in stock valuesC) the timing of stock market swings is unpredictable D) on average returns on stocks tend to be lower than returns on bondsE) the fact that stock market behavior is well understood makes future stock prices hard

to predict Ans: D

Difficulty: Easy41. Which of the following is generally true for the stock market?A) it takes time for new information to be reflected in new stock valuesB) 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 riseE) stock market prices can be accurately predicted by carefully observing their long-term

trendAns: D

Difficulty: Easy42. Which of the following statements is NOT accurate? A) financial markets are forward-lookingB) 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: Easy43. 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 peopleC) rates of return in financial markets feed back into goods marketsD) asset prices and interest rates are inversely relatedE) many people see stock market volatility as a sign of market efficiency

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Ans: A

Difficulty: Medium44. 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 people’s portfolios D) stock prices rarely change significantly based on unexpected new information E) none of the aboveAns: E

Difficulty: Medium45. What would be true if stock prices did NOT follow a random walk? A) stock markets would work much more efficientlyB) stock markets would outperform bond marketsC) bond markets would outperform stock marketsD) financial investors would not be able to outperform the stock marketE) some financial investors could benefit by taking advantage of opportunities that have

not been realized by othersAns: E

Difficulty: Easy46. 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 informationE) stock markets are not affected by changes in interest ratesAns: B

Difficulty: Medium47. If interest rates in the U.S. increase but they stay the same in the rest of the world,

thenA) the exchange rate of foreign currency to U.S. dollars will increaseB) the exchange rate of U.S. dollars to foreign currency will increaseC) the U.S. dollar will depreciateD) 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: Medium48. 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 decreaseB) the exchange rate of foreign currency to U.S. dollars will increaseC) the U.S. will experience an outflow of fundsD) U.S. stock values will increaseE) U.S. bond prices will increase Ans: B

Difficulty: Easy49. The term “uncovered interest parity” refers to A) corporate stocks that pay a fixed dividend B) the inverse relationship between bond prices and interest ratesC) the differential between stock returns and bond returnsD) a downward-sloping yield curve E) the relation between exchange rate changes and international interest rate differentialsAns: E

Difficulty: Easy50. The relation between international interest rate differentials and changes in exchange

rates is calledA) uncovered interest parity B) purchasing power parity C) the term structure of interest ratesD) the yield curveE) none of the aboveAns: A

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