Finance test one

Offer an argument for why the terrorist attack on the United States on September 11, 2001 could have placed downward pressure on U.S. interest rates. Offer an argument for why those attacks could have placed upward pressure on U.S. interest rates.

: The terrorist attack could cause a reduction in spending related to travel (airlines, hotels), and would also reduce the expansion by those types of firms. This reflects a decline in the demand for loanable funds, and places downward pressure on interest rates. Conversely, the attack increases the amount of government borrowing needed to support a war, and therefore places upward pressure on interest rates.

Describe the characteristics that a measure of money should have if it is to be manipulated by the Fed.

A desirable measure of money is one that can be precisely controlled by the Fed and has a predictable impact on economic variables.

. If a downward-sloping yield curve is mainly attributed to segmented markets theory, what does that suggest about the demand for and supply of funds in the short-term and long-term maturity markets?

A downward-sloped yield curve suggests that the demand for short-term funds is high relative to the supply of short-term funds, causing a high yield. In addition, the demand for long-term funds is low relative to the supply of long-term funds, causing a low yield.

If liquidity and interest rate expectations are both important for explaining the shape of a yield curve, what does a flat yield curve indicate about the market's perception of future interest rates?

A flat yield curve without consideration of a liquidity premium would represent no expected change in interest rates according to the pure expectations theory. Therefore, if the flat yield curve reflects the existence of a liquidity premium, this curve would actually have a slight downward slope when removing the liquidity premium. This suggests expectations of a slight decline in future interest rates.

. What is the function of a mutual fund? Why are mutual funds popular among investors? How does a money market mutual fund differ from a stock or bond mutual fund?

A mutual fund sells shares to investors, pools the funds, and invests the funds in a portfolio of securities. Mutual funds are popular because they can help individuals diversify while using professional expertise to make investment decisions.

What is the policy directive, and who carries it out?

A policy directive is established by the Fed and submitted to the Trading Desk. The manager of the Trading Desk must ensure that the directive is achieved.

When economic crises in countries are due to a weak economy, local interest rates tend to be very low. However, if the crisis is caused by an unusually high rate of inflation, the interest rate tends to be very high. Explain why.

A weak economy causes a reduction in the demand for loanable funds, because corporations reduce their expansion plans as they anticipate a reduced demand for their products. The reduced demand for loanable funds results in lower interest rates. However, if a crisis is caused by high inflation, corporations and households engage in heavy borrowing and spending before prices rise further. Thus, the strong demand for loanable funds places upward pressure on interest rates.

14. Interpreting the Fed's Monetary Policy. When the Fed increases money supply to lower the federal funds rate, do you think this will the cost of capital of U.S. companies be reduced? Explain how the segmented markets theory regarding the term structure of interest rates (as explained in Chapter 3) could influence the degree to which the Fed's monetary policy affects long-term interest rates.

ANSWER: A change in the federal funds rate will likely cause a change in other short-term interest rates. However, it might not result in a change in long-term interest rates, because the direct impact is only on short-term rates. To the extent that maturity markets are segmented, the effect will be isolated on short-term rates.

18. Economic Indicators. Stock market conditions serve as a leading economic indicator. Assuming the U.S. economy is in a recession, what are the implications of this indicator? Why might this indicator be inaccurate?

ANSWER: If stock prices are a leading economic indicator, then the stock market will move up before the economy begins to recover from a recession. An improvement in the stock market may signal that the economy is about to recover. This indicator may be inaccurate because the investors who push stock prices higher may have had unrealistic expectations.

20. Impact of Inflation Targeting by the Fed. Assume that the Fed adopts an inflation-targeting strategy. If oil prices rise abruptly by 15 percent in response to an oil shortage, describe how the Fed's monetary policy would be affected by this situation. Do you think the inflation-targeting strategy would be more or less effective in this case than if the Fed balances its inflation concerns with unemployment concerns? Explain.

ANSWER: If the Fed uses an inflation targeting strategy, it will need to use a tight (restrictive) monetary policy in response to the oil price shock so that it can attempt to slow economic growth and reduce pressure on inflation. However, in this situation, the inflation is caused by an oil shortage, not by an excessive demand for products. Therefore, the policy will not necessarily cure the oil price shock and could also cause a recession.

2. Tradeoffs of Monetary Policy. Describe the economic tradeoff faced by the Fed in achieving its economic goals.

ANSWER: In general, a stimulative monetary policy can increase economic growth and reduce unemployment but may increase inflation. A restrictive monetary policy can keep inflationary pressure low but may cause low economic growth and higher unemployment.

9. Monitoring Money Supply. Why do financial market participants closely monitor money supply movements?

ANSWER: Money supply movements can affect interest rates and other economic variables that influence security prices. Therefore, financial market participants can monitor money policy to develop forecasts of future security prices.

Response of Firms to a Stimulative Monetary Policy In a weak economy, the Fed commonly implements a stimulative monetary policy to lower interest rates and presumes that firms will be more willing to borrow money. Even if banks are willing to lend such funds, why might such a presumption about the willingness of firms to borrow be wrong? What are the consequences if the presumption is wrong?

ANSWER: The presumption about firms borrowing may be wrong because in a weak economy, firms may be concerned that they may fail if they increase their debt. They may prefer not to borrow more funds until the economy improves. Consequently, firms will not correct the weak economy by spending more money, and the Fed's stimulative policy may be ineffective.

7. Lagged Effects of Monetary Policy. Compare the recognition lag and the implementation lag.

ANSWER: The recognition lag represents the time from when a problem exists until it is recognized by the Fed. It occurs because the economic statistics that are monitored to detect problems are only reported periodically.

The Fed's Impact on Unemployment. Explain how the Fed's monetary policy affects the unemployment level.

ANSWER: The Fed's monetary policy affects interest rates, which affect the cost of borrowing by households and businesses, and therefore affect their level of spending for products and services. The aggregate demand for products and services affects the number of people employed by businesses and therefore affects the unemployment level.

1. Impact of Monetary Policy. How does the Fed's monetary policy affect economic conditions?

ANSWER: The Fed's monetary policy can affect the supply of loanable funds available in financial markets and therefore may affect interest rates. It may also affect inflation (with a lag) and therefore affect the demand for loanable funds by influencing inflationary expectations.

16. The Fed's Impact on Security Prices. Explain how the Fed's monetary policy may indirectly affect the prices of equity securities.

ANSWER: The Fed's monetary policy influences the aggregate demand for products and services, and therefore affects the cash flows generated by publicly-traded businesses. The value of the stock of a business is influenced by expectations of its future cash flows.

Non-depository Institutions. Compare the main sources and uses of funds for finance companies, insurance companies, and pension funds.

Finance companies sell securities to obtain funds, while insurance companies receive insurance premiums and pension funds receive employee/employer contributions. Finance companies use funds to provide direct loans to consumers and businesses. Insurance companies and pension funds purchase securities.

Integrate the roles of accounting, regulations, and financial market participation. That is, explain how financial market participants rely on accounting, and why regulatory oversight of the accounting process is necessary.

Financial market participants rely on financial information that is provided by firms. The financial statements of firms must be audited to ensure that they accurately represent the financial condition of the firm. However, the accounting standards are loose, so financial market participants can benefit from strong accounting skills that may allow them to more properly interpret financial statements.

Do investors in high tax brackets or those in low tax brackets benefit more from tax-exempt securities? Why? Do municipal bonds or corporate bonds offer a higher before-tax yield at a given point in time? Why? Which has the higher after-tax yield? If taxes did not exist, would Treasury bonds offer a higher or lower yield than municipal bonds with the same maturity? Why?

High-tax bracket investors benefit more from tax-exempt securities because their tax savings from avoiding taxes is greater.

Explain why financial markets may be less liquid if companies are not forced to provide accurate financial reports

If companies are allowed to engage in fraudulent financial reporting by exaggerating earnings or hiding debt, this could cause investors to overpay when purchasing securities issued by those companies. If investors recognize that they cannot trust financial disclosure by companies, they may be unwilling to participate in financial markets. The lack of trust can cause markets to be less liquid, because of very limited investor participation.

. Estimate the real interest rate over the last year. If financial market participants overestimate inflation in a particular period, will real interest rates be relatively high or low? Explain.

If inflation is overestimated, the real interest rate will be relatively high. Investors had required a relatively high nominal interest rate because they expected inflation to be high (according to the Fisher effect).

Explain the liquidity premium theory.

If investors believe that securities with larger maturities are less liquid, they will require a premium when investing in such securities to compensate. This theory can be combined with the other theories to explain the shape of a yield curve.

Explain the meaning of efficient markets. Why might we expect markets to be efficient most of the time? In recent years, several securities firms have been guilty of using inside information when purchasing securities, thereby achieving returns well above the norm (even when accounting for risk). Does this suggest that the security markets are not efficient?

If markets are efficient then prices of securities available in these markets properly reflect all information. We should expect markets to be efficient because if they weren't, investors would capitalize on the discrepancy between what prices are and what they should be. This action would force market prices to represent the appropriate prices as perceived by the market.

Would increasing the money supply growth place upward or downward pressure on interest rates?

If one believes that higher money supply growth will not cause inflationary expectations, the additional supply of funds places downward pressure on interest rates. However, if one believes that inflation expectations do erupt as a result, demand for loanable funds will also increase, and interest rates could increase (if the increase in demand more than offsets the increase in supply).

Suppose that the U.S. Treasury decided to finance its deficit with mostly long-term funds. How could this decision affect the term structure of interest rates? If short-term and long-term markets are segmented, would the Treasury's decision have a more or less pronounced impact on the term structure? Explain

If the Treasury borrowed heavily in the long-term markets, it could place upward pressure on long-term rates without having as much of an impact on short-term rates. If the markets are segmented, the effect of the Treasury's actions would be more pronounced.

Why might you expect the interest rate movements of various industrialized countries to be more highly correlated in recent years than they were in earlier years?

Interest rates among countries are expected to be more highly correlated in recent years because financial markets are more geographically integrated. More international financial flows will occur to capitalize on higher interest rates in foreign countries, which affects the supply and demand conditions in each market. As funds leave a country with low interest rates, this places upward pressure on that country's interest rates. The international flow of funds caused this type of reaction.

. How does high credit risk affect the yield on securities?

Investors require a higher risk premium on securities with a high default risk.

Discuss why many financial institutions have expanded internationally in recent years. What advantages can be obtained through an international merger of financial institutions?

Many financial institutions have expanded internationally to capitalize on their expertise. Commercial banks, insurance companies, and securities firms have expanded through international mergers. An international merger between financial institutions enables the merged company to offer the services of both entities to its entire customer base.

Explain why mortgage defaults during the credit crisis in 2008 and 2009adversely affected financial institutions that did not originate the mortgages. What role did these institutions play in financing the mortgages?

Some financial institutions participated by issuing mortgage-backed securities that represented mortgages originated by mortgage companies. Mortgage-backed securities performed poorly during the credit crisis in 2008 because of the high default rate on mortgages. Some financial institutions that held a large amount of mortgage-backed securities suffered major losses at this time.

Explain the meaning of surplus units and deficit units. Provide an example of each. Which types of financial institutions do you deal with? Explain whether you are acting as a surplus unit or a deficit unit in your relationship with each financial institution.

Surplus units provide funds to the financial markets while deficit units obtain funds from the financial markets. Surplus units include households with savings, while deficit units include firms or government agencies that borrow funds.

Explain how the Fed increases the money supply through open market operations.

The Fed can increase money supply by purchasing securities in the secondary market.

Describe the purpose of the Fed's lending facility.

The Fed maintains a lending facility in which it provides short-term loans (usually overnight) to depository institutions.

Monetary Policy During the Credit Crisis. Describe the Fed's monetary policy response to the credit crisis that began in 2008.

The Fed used a stimulative monetary policy during the credit crisis because economic conditions were very weak. Specifically, the Fed's policy resulted in lower interest rates in the U.S.

What was the purpose of the Securities Act of 1933? What was the purpose of the Securities Exchange Act of 1934? Do these laws prevent investors from making poor investment decisions? Explain.

The Securities Act of 1933 was intended to assure complete disclosure of relevant financial information on publicly offered securities and prevent fraudulent practices when selling these securities. The Securities Exchange Act of 1934 extended the disclosure requirements to secondary market issues. It also declared a variety of deceptive practices illegal but does not prevent poor investments.

Describe how a country's laws can influence the degree of its financial market liquidity.

The financial markets are much more developed in some countries than in others, and they also vary in terms of their liquidity. Each country has its own laws regarding shareholder rights. Investors may be more willing to participate in their local country's financial markets if they have the right to take civil action against a local firm that engaged in fraudulent financial disclosure. Each country also has its own level of enforcement of securities laws. Investors may be more willing to participate in their local country's financial markets if they believe that their local government enforces the securities laws that are imposed in that country.

What is the meaning of the forward rate in the context of the term structure of interest rates? Why might forward rates consistently overestimate future interest rates? How could such a bias be avoided?

The forward rate is the expected interest rate at a future point in time.

Discuss the relationship between the yield and the liquidity of securities.

The greater the liquidity of a security, the lower is the yield, other things being equal.

Explain how the expected interest rate in one year depends on your expectation of economic growth and inflation.

The interest rate in the future should increase if economic growth and inflation are expected to rise or decrease if economic growth and inflation are expected to decline.

What are the main goals of the Federal Open Market Committee? How does it attempt to achieve these goals?

The main goals of the FOMC are to promote high employment, economic growth, and price stability.

During some crises, investors shift their funds out of the stock market and into money market securities for safety, even if they do not fear that interest rates will rise. Explain how and why these actions by investors affect the yield curve. Is the shift due to the expectations theory, liquidity premium theory, or segmented markets theory?

The movement into money market securities results in a larger supply of short-term funds and lowers short-term interest rates. Thus, the yield curve becomes more steeply sloped. The shift in the yield curve is due to a preference for investors to move their funds into safe short-term securities, which reflects segmented markets theory, a preference for liquidity.

What is the difference between the nominal interest rate and real interest rate? What is the logic behind the implied positive relationship between expected inflation and nominal interest rates?

The nominal interest rate is the quoted interest rate, while the real interest rate is defined as the nominal interest rate minus the expected rate of inflation. The real interest rate represents the recent nominal interest rate minus the recent inflation rate.

. Explain how a yield curve would shift in response to a sudden expectation of rising interest rates, according to the pure expectations theory.

The supply of short-term loanable funds would increase, placing downward pressure on the short-term interest rate. The supply of long-term loanable funds would decrease, placing upward pressure on the long-term interest rate . If the yield curve was originally upward sloped, it would now have a steeper slope as a result of the expectation. If it was originally downward sloped, it would now be more horizontal (less steep) or may have even become upward sloping.

Assume that (1) investors and borrowers expect that the economy will weaken and that inflation will decline, (2) investors require a small liquidity premium, and (3) markets are partially segmented and the Treasury currently has a preference for borrowing in short-term markets. Explain how each of these forces would affect the term structure, holding other factors constant. Then explain the effect on the term structure overall.

The weak economy creates the expectation of a decline in interest rates, so according to expectations theory, there would be a downward-sloping yield curve.

21. The Fed's Trading of Long-term Treasury Securities Why did the Fed purchase long-term Treasury securities in 2010, and how did this strategy differ from the Fed's usual operations?

ANSWER: The Fed's purchases of long-term Treasury securities differed from its normal open market operations, which focus on short-term Treasury securities. By purchasing long-term securities, the Fed hoped to reduce long-term Treasury bond yields, which would ultimately result in lower long-term borrowing rates. These lower borrowing rates would in turn stimulate the economy by encouraging more long-term borrowing by firms for capital expenditures and by individuals to purchase homes.

19. Consumer Financial Protection Bureau. As a result of the Financial Reform Act of 2010, the Consumer Financial Protection Bureau was established, and housed within the Federal Reserve. Explain the role of this bureau.

ANSWER: The bureau is responsible for regulating financial products and services, including online banking, certificates of deposit, and mortgages. The existence of a bureau can act more quickly to protect consumers from deceptive practices than waiting for Congress to pass new laws.

Identify the relevant characteristics of any security that can affect the security's yield.

1. default risk 2. liquidity 3. tax status 4.maturity

. Jayhawk Forecasting Services analyzed several factors that could affect interest rates in the future. Most factors were expected to place downward pressure on interest rates. Jayhawk also expected that although the annual budget deficit was to be cut by 40 percent from the previous year, the deficit would still be very large. Because Jayhawk believed that the deficit's impact would more than offset the effects of other factors, it forecast interest rates to increase by 2 percent. Comment on Jayhawk's logic.

: A reduction in the deficit should free up some funds that had been used to support the government borrowings. Thus, there should be additional funds available to satisfy other borrowing needs. Given this situation plus the other information, Jayhawk should have forecasted lower interest rates.

What is the purpose of the economic presentations made during a POMC meeting?

: Economic presentations offer the FOMC information about the prevailing economic conditions, so that the FOMC can decide whether it should attempt to revise money supply growth in order to improve the economy.

What is the Beige book and why is it important to the FOMC?

: The Beige book is a consolidated report of regional economic conditions in each of the 12 districts. This book is sent to FOMC members before their meeting so that they are updated on regional conditions before they decide on monetary policy.

How might expectations of higher prices in the U.S. affect the demand for loanable funds, the supply of loanable funds, and interest rates in the U.S.? Offer a logical explanation of why such an impact on interest rates in the U.S. might spread to other countries.

: The expectations of higher prices will cause concern about the possible increase in inflation. Since higher inflation can increase interest rates, it will cause an expectation of higher interest rates in the U.S. Firms and government agencies may borrow more funds now before prices increase and before interest rates increase. Consumers may use their savings now to buy products before the prices increase. Therefore, the demand for loanable funds should increase, the supply of loanable funds should decrease, and interest rates should increase in the U.S.

Explain the preferred habitat theory.

: The preferred habitat theory suggests that while investors and borrowers may prefer a natural maturity, they may wander from that maturity under conditions where they can benefit from selecting a different maturity.

25. Stimulative Monetary Policy During a Credit Crunch. Explain why a stimulative monetary policy might not be effective during a weak economy in which there is a credit crunch.

ANSWER: A credit crunch implies that banks are very careful in their credit analysis of potential borrowers and are restricting the amount of credit they will provide. The ability of the Fed to stimulate the economy is partially influenced by the willingness of banks to lend funds. Even if the Fed increases the level of bank funds during a weak economy, banks may be unwilling to extend credit to some potential borrowers. In a weak economy, the future cash flows of many potential borrowers are more uncertain, causing a reduction in loan applications (demand for loans) and in the number of loan applicants that meet a bank's qualification standards.

13. Fed Response to Fiscal Policy. Explain how the Fed's monetary policy could depend on the fiscal policy that is implemented. [

ANSWER: A fiscal policy that involves much government borrowing could place upward pressure on interest rates. If the Fed wants to keep interest rates low in order to stimulate the economy, it may need to use a loose monetary policy to offset the fiscal policy effect on interest rates.

5. Passive Monetary Policy. Describe a passive monetary policy.

ANSWER: A passive monetary policy means that the Fed does not attempt to adjust money supply in order to improve economic conditions.

27. Impact of Monetary Policy on Cost of Capital Explain the effects of a stimulative monetary policy on a firm's cost of capital.

ANSWER: A stimulative monetary policy is normally intended to reduce interest rates. Since lower interest rates tend to reduce the cost of debt and the cost of equity, a stimulative monetary policy reduces the cost of capital.

3. Choice of Monetary Policy. When does the Fed use a stimulative monetary policy and when does it use a restrictive-monetary policy? What is a criticism of a stimulative monetary policy? What is the risk of using a monetary policy that is too restrictive?

ANSWER: A stimulative monetary policy may be used to stimulate the economy, especially if inflation is not a concern. A restrictive monetary policy may be used to slow economic growth in order to reduce inflationary fears.

21. The Fed's Purchases of Commercial Paper Why and how did the Fed intervene in the commercial paper market during the credit crisis?

ANSWER: After Lehman Brothers failed in 2008, thereby defaulting on the commercial paper it had issued, investors feared that other financial institutions with large holdings of mortgage-backed securities might default on their commercial paper. Therefore, investors stopped buying commercial paper in the secondary market, causing it to become illiquid and making credit increasingly hard to obtain. The Fed purchased large amounts of commercial paper to boost investor confidence and restore liquidity to the market.

4. Active Monetary Policy. Describe an active monetary policy.

ANSWER: An active monetary policy reflects actions taken by the Fed to adjust money supply in order to affect economic conditions.

11. Impact of Money Supply Growth. Explain why an increase in the money supply can affect interest rates in different ways. Include the potential impact of the money supply on the supply of and the demand for loanable funds when answering this question.

ANSWER: An increase in money supply increases the supply for loanable funds and therefore can place downward pressure on interest rates. Yet, it can also cause inflationary expectations, resulting in an increased demand for loanable funds and upward pressure on interest rates.

12. Confounding Effects. Which factors might be considered by financial market participants who are assessing whether an increase in money supply growth will affect inflation?

ANSWER: Any factors that could offset or magnify the impact should be considered, such as expected oil prices, the strength or weakness of the dollar, and the strength of the economy.

16. Impact of Foreign Policies. Why might a foreign government's policies be closely monitored by investors in other countries, even if the investors plan no investments in that country? Explain how monetary policy in one country can affect interest rates in other countries.

ANSWER: Country economies have become highly integrated over time, so that one country's economy can affect others. Thus, a foreign country's government policies may affect its own economy, which in turn affects other economies and therefore security prices.

Targeted Federal Funds Rate. The Fed uses a targeted federal funds rate when implementing monetary policy. However, the Fed's main purpose in its monetary policy is typically to have an impact on the aggregate demand for products and services. Reconcile the Fed's targeted federal funds rate with its goal of having an impact on the overall economy.

ANSWER: Even though the federal funds rate is the interest rate that is targeted by the Fed, other interest rates are affected as well because they are also affected by supply and demand for funds in the banking system. When depository institutions experience an increase in supply of funds due to the Fed's stimulative monetary policy, they have more funds than they need, and reduce the deposit rate that they are willing to offer on new bank deposits. They also reduce their rates on loans in order to attract more potential borrowers so that they can make use of the funds that they have available. The lower loan rates cause a higher demand for loanable funds by households and businesses, which can increase aggregate demand for products and services.

27. Fed Policy Focused on Long-term Interest Rates Why might the Fed want to focus its efforts on reducing long-term interest rates rather than short-term interest rates during a weak economy? Explain how it might use a monetary policy focused on influencing long-term interest rates. Why might such a policy also affect short-term interest rates in the same direction?

ANSWER: Firms incur a cost of debt that is highly influenced by the long-term Treasury rates, not the short-term Treasury rates. If the Fed wants to encourage them to borrow more funds, it may want to focus on lowering long-term interest rates.

17. Impact of FOMC Statement. How might the FOMC statement (issued following the committee's meeting) stabilize financial markets more than if no statement were provided?

ANSWER: If a statement was not provided, investors would have to guess at the conclusion of the FOMC meeting, and there would be more uncertainty regarding the Fed's future monetary policy. The statement makes the Fed's plans more transparent.

17. Monetary Policy During a War. Consider a discussion during FOMC meetings in which there is a weak economy and a war, with potential major damage to oil wells. Explain why this possible effect would have received much attention at the FOMC meetings. If this situation was perceived to be highly likely at the time of the meetings, explain how it may have complicated the decision about monetary policy at that time. Given the conditions stated in this question, would you suggest that the Fed use a restrictive monetary policy, or a stimulative monetary policy? Support your decision logically and acknowledge any adverse effects of your decision.

ANSWER: Normally a weak economy will cause FOMC members to push for a loose money policy that is intended to reduce interest rates, encourage more borrowing (and spending), and stimulate the U.S. economy. However, if oil wells were damaged, there could be an oil shortage. Under these conditions, oil prices would rise, and inflation would likely rise as well. The Fed usually does not want to use a loose money policy in a period when there is high inflation. Thus, it has a dilemma of either adding fuel to the higher inflation with a loose monetary policy or leaving the money supply as is, which offers no cure for the slow economy.

11. Fed's Indirect Influence on Many Types of Interest Rates The Fed focuses its control on the federal funds rate, yet indirectly influences many other types of interest rates. Explain.

ANSWER: Since banks now have more funds available, they may want to use their excess funds by offering new loans to businesses and households. They may lower their loan rates in order to appeal to potential borrowers. They may also lower the interest rates offered on deposits.

Bailouts by the Fed. Do you think that large financial institutions should have been rescued by the Fed during the credit crisis?

ANSWER: Some supporters of a government rescue would argue that the credit crisis would be worse if the large financial institutions were not rescued. However, others might argue that the government rescue encourages financial institutions to take risk, with the hope of being bailed out if the strategies backfire.

Explain how the Fed uses open market operations to reduce the money supply.

ANSWER: The Fed can sell holdings of its existing Treasury securities to various depository institutions, which will cause a reduction in the account balances of these institutions.

18. Fed Facility Programs During the Credit Crisis. Explain how the Fed's facility programs improved liquidity in some debt markets.

ANSWER: The Fed established facilities that provided loans to financial institutions that were willing to invest in some types of debt securities, such as bonds that were backed by consumer loans. In this way, the Fed increased the liquidity of these markets, which allowed easier access for consumers who wanted to borrow funds. The Fed also used some of its own funds to purchase commercial paper, which restored the liquidity of the commercial paper market.

6. Fed Control. Why might the Fed have difficulty in controlling the economy in the manner desired? Be specific.

ANSWER: The Fed has difficulty in controlling the economy because it cannot always maintain money growth within its target boundaries. In addition, the impact of monetary growth on the economy may be different than what was anticipated.

15. The Fed's Impact on Home Purchases. Explain how the Fed influences the monthly mortgage payments on homes. How might the Fed indirectly influence the total demand for homes by consumers?

ANSWER: The Fed influences interest rates, which affect the rate paid by homeowners on mortgages. When the Fed reduces interest rates, it reduces the monthly payment to be made on new mortgages. Thus, it may increase the demand for homes by consumers. If it increases interest rates, it may reduce the demand for homes.

22. The Fed's Impact on the Housing Market. In periods when home prices declined substantially, some homeowners blamed the Fed. In other periods when home prices increased, homeowners gave credit to the Fed. How can the Fed have such a large impact on home prices? How could news of a substantial increase in the general inflation level affect the Fed's monetary policy and thereby affect home prices?

ANSWER: The Fed influences interest rates, which affects the cost of borrowing, and this affects the ability of consumers to purchase a home. If interest rates are too high, some consumers are unable to afford the type of home they wish to purchase, because they can not afford the monthly payments on the mortgage.

The Fed versus Congress. Should the Fed or Congress decide the fate of large financial institutions that are near bankruptcy?

ANSWER: The Fed might argue that the credit crisis is a threat to the financial system and that it needed to intervene to prevent a bigger crisis. Some critics might argue that the Fed has too much power and that Congress should be involved in decisions regarding the use of taxpayer funds to rescue financial institutions.

Monetary Policy During Credit Crisis. During the credit crisis of 2008, the Fed used a stimulative monetary policy. Why do you think the total amount of loans to households and businesses did not increase as much as the Fed had hoped? Are the lending institutions to blame for the relatively small increase in the total amount of loans extended to households and businesses?

ANSWER: The Fed was successful at reducing interest rates. However, under very bad economic conditions, many potential business projects may not be feasible even at the lower cost of borrowing, because the potential cash flows from these projects are not sufficient to make the projects worthwhile. Also, the lending institutions were cautious when granting loans because of the high potential for default risk when lending to households or businesses during such a weak economy. Lending institutions should not extend loans unless they have confidence that the loans will be repaid.

21. Predicting the Fed's Actions. Assume the following conditions. The last time the FOMC met, it decided to raise interest rates. At that time economic growth was very strong, and inflation was relatively high. Since the last meeting, economic growth has weakened, and the unemployment rate will likely rise by one percentage point over the quarter. The FOMC's next meeting is tomorrow. Do you think the FOMC will revise its targeted federal funds rate? If so, how?

ANSWER: The Fed would likely not change the target. It probably raised interest rates at the last meeting in order to reduce inflation. It realizes that the use of a restrictive monetary policy may reduce economic growth, so it will not feel the need to correct a slowdown in the economy in this situation.

21. The Fed's Power. What should be the Fed's role? Should it focus only on monetary policy? Or should it engage in the trading of various types of securities in an attempt to stabilize the financial system when securities markets are suffering from investor fears and the potential for high credit (default) risk?

ANSWER: This is open ended, as there is no perfect answer. Students should recognize that the Fed's role during the financial crisis went far beyond monetary policy. Yet, it can be argued that if the Fed did not take such an initiative, the adverse impact of the crisis on financial markets could have been much worse. The Fed's intervention appeared to stabilize financial markets.

15. Monetary Policy Today. Assess the economic situation today. Is the current presidential administration more concerned with reducing unemployment or inflation? Does the Fed have a similar opinion? If not, is the administration publicly criticizing the Fed? Is the Fed publicly criticizing the administration? Explain.

ANSWER: This question allows students to understand how the goals of the administration and the goals of the Fed can differ.

19. How the Fed Should Respond to Prevailing Conditions. Consider the existing economic conditions, including inflation and economic growth. Do you think the Fed should increase interest rates, reduce interest rates, or leave interest rates at their present levels? Offer some logic to support your answer.

ANSWER: This question is open-ended. It requires students to apply the concepts that were presented in this chapter in order to develop their own view. This question can be useful for class discussion because it will likely lead to a variety of answers, which reflects the dispersed opinions of market participants.

8. Fed's Control of Inflation. Assume that the Fed's primary goal is to reduce inflation. How can it achieve its goal? What is a possible adverse effect of such action by the Fed (even if it achieves this goal)?

ANSWER: To cure inflation, the Fed may use a restrictive monetary policy, which will reduce economic growth and inflationary pressure. A possible adverse effect is an increase in the unemployment rate.

20. Eurozone Monetary Policy. Explain why participating in the eurozone causes a country to give up its independent monetary policy and control over its domestic interest rates.

ANSWER: When a country adopts the euro as its currency, it is subject to the monetary policy of the European Central Bank (ECB), which controls the supply of euros in the banking system. The ECB influences the interest rate on euros regardless of the country. If the interest rate on euros was higher in one eurozone country, funds would flow to that country until the supply and demand conditions caused the interest rate there to be the same as in other euro countries.

10. Open Market Operations. Why do the Fed's open market operations have a different effect on money supply than do transactions between two depository institutions?

ANSWER: When the Fed engages in a purchase of Treasury securities from a depository institution, money is transferred to the depository institution without any offset at another institution. However, a similar transaction between depository institutions would increase the account balance at one institution and decrease the account balance at the other institution.

Why is it important for long-term debt securities to have an active secondary market?

An active secondary market is especially desirable for debt securities that have a long-term maturity, because it allows investors flexibility to sell them at any time prior to maturity. Many investors would not even consider investing in long-term debt securities if they were forced to hold these securities until maturity.

If the federal government planned to expand the space program, how might this change affect interest rates?

An expanded space program would (a) force the federal government to increase its budget deficit, (b) possibly force any firms involved in facilitating the program to borrow more funds. Consequently, there is a greater demand for loanable funds. The additional spending could cause higher income and additional saving. Yet, this impact is not likely to be as great. The likely overall impact would therefore be upward pressure on interest rates.

. If the segmented markets theory causes an upward-sloping yield curve, what does this imply? If markets are not completely segmented, should we dismiss the segmented markets theory as even a partial explanation for the term structure of interest rates? Explain.

An upward-sloped yield curve caused by segmented markets implies that the demand for short-term funds is low relative to the supply of short-term funds. In addition, the demand for long-term funds is high relative to the supply of long-term funds.

Assume that if the U.S. dollar strengthens, it can place downward pressure on U.S. inflation. Based on this information, how might expectations of a strong dollar affect the demand for loanable funds in the United States and U.S. interest rates? Is there any reason to think that expectations of a strong dollar could also affect the supply of loanable funds? Explain.

As a strong U.S. dollar dampens U.S. inflation, it can reduce the demand for loanable funds, and therefore reduce interest rates. The expectations of a strong dollar could also increase the supply of funds because it may encourage saving (there is less concern to purchase goods before prices rise when inflationary expectations are reduced). In addition, foreign investors may invest more funds in the United States if they expect the dollar to strengthen, because that could increase their return on investment.

With regard to the profit motive, how are credit unions different from other financial institutions?

Credit unions are non-profit financial institutions

Which factors influence a security's liquidity?

Debt securities with shorter maturities are more liquid. Debt securities and stocks with a more active secondary market are more liquid.

Classify the types of financial institutions mentioned in this chapter as either depository or nondepository. Explain the general difference between depository and nondepository institutions as sources of funds.

Depository institutions include commercial banks, savings and loan associations, and credit unions. These institutions differ from nondepository institutions in that they accept deposits. Nondepository institutions include finance companies, insurance companies, pension funds, mutual funds, and money market funds.

. Explain why interest rates tend to decrease during recessionary periods. Review historical interest rates to determine how they react to recessionary periods. Explain this reaction.

During a recession, firms and consumers reduce their amount of borrowing. The demand for loanable funds decreases and interest rates decrease as a result.

Explain what is meant by interest elasticity. Would you expect federal government demand for loanable funds to be more or less interest-elastic than household demand for loanable funds? Why?

Explain what is meant by interest elasticity. Would you expect federal government demand for loanable funds to be more or less interest-elastic than household demand for loanable funds? Why?

21. Fed Purchases of Mortgage-Backed Securities Explain the motivation behind the Fed's policy of purchasing massive amounts of mortgage-backed securities during the 2008 credit crisis. What could this policy accomplish that its traditional monetary policy might not accomplish?

Many financial institutions were heavily exposed to mortgages during the credit crisis, but were able to reduce their exposure as a result of selling some of their holding of mortgage-backed securities to the Fed. As the Fed increased its purchases of mortgage-backed securities, the prices of these securities increased. In addition, other investors slowly began to return to the risky debt securities markets, which resulted in higher liquidity in the market for these securities. The Fed's actions stabilized the housing market.

Distinguish between primary and secondary markets. Distinguish between money and capital markets.

Primary markets are used for the issuance of new securities while secondary markets are used for the trading of existing securities.

Explain the primary use of funds for commercial banks versus savings institutions.

Savings institutions have traditionally concentrated in mortgage lending, while commercial banks have concentrated in commercial lending. Savings institutions are now allowed to diversify their asset portfolio to a greater degree and will likely increase their concentration in commercial loans (but not to the same degree as commercial banks).

Commercial banks use some funds to purchase securities and other funds to make loans. Why are the securities more marketable than the loans in the secondary market?

Securities are more standardized than loans and therefore can be more easily sold in the secondary market. The excessive documentation on commercial loans limits a bank's ability to sell loans in the secondary market.

What are the functions of securities firms? Many securities firms employ brokers and dealers. Distinguish between the functions of a broker and those of a dealer and explain how each type of professional is compensated

Securities firms provide a variety of functions (such as underwriting and brokerage) that either enhances a borrower's ability to borrow funds or an investor's ability to invest funds.

What type of information do investors rely on in order to determine the proper value of stocks?

Since the valuation of a stock at a future point in time is uncertain, so is the selling price of a stock at a future point in time. Investors often rely on financial statements by firms in order to assess how stock prices might change in the future. In particular, investors rely on accounting reports of a firm's revenue, expenses, and earnings as a basis for estimating its future cash flows. Firms with publicly traded stock are required to disclose financial information and financial statements.

The interest rate on a one-year loan can be decomposed into a one-year risk-free (free from default risk) component and a risk premium that reflects the potential for default on the loan in that year. A change in economic conditions can affect the risk-free rate and the risk premium. The risk-free rate is usually affected by changing economic conditions to a greater degree than the risk premium. Explain how a weaker economy will likely affect the risk-free component, the risk premium, and the overall cost of a one-year loan obtained by (a) the Treasury, and (b) a corporation. Will the change in the cost of borrowing be more pronounced for the Treasury or for the corporation? Why?

The weaker economy will likely reduce the risk-free component and will increase the risk premium. The overall cost of borrowing is reduced for a loan to the Treasury and a loan to a corporation. There is a partial offsetting effect on the interest rate of the loan to the corporation. However, the Treasury does not have risk of default so there is no effect on the risk premium on a loan to the Treasury. The weaker economy will have a more pronounced impact on the interest rate of the loan to the Treasury, because there is no offsetting effect

What factors influence the shape of the yield curve? Describe how financial market participants use the yield curve.

The yield curve's shape is affected by the demand and supply conditions for securities in various maturity markets. Expectations of interest rates, the desire for liquidity, and the desire by investors or borrowers for a specific maturity will influence the demand and supply conditions.

Assume that the yield curves in the United States, France, and Japan are flat. If the U.S. yield curve suddenly becomes so positively sloped, do you think the yield curves in France and Japan would be affected? If so, how?

The yield curves in other countries would also be affected if the event precipitating the shift in the U.S. yield curve affects either actual or expected interest rates in other countries. If long-term interest rates in the United States rise in response to a greater U.S. demand for long-term funds, then the yield curve may have an upward slope. To the extent that this event attracts long-term funds in other countries, there would be a smaller supply of long-term funds in those countries, which could cause higher long-term rates there. Consequently, their yield curves would have an upward slope.

Briefly describe the origin of the Federal Reserve System. Describe the functions of the Fed district banks.

Two attempts to establish a central bank in the 1800s had failed. In the late 1800s and early 1900s, several bank panics occurred, which encouraged another attempt. In 1913, the Federal Reserve Act was passed and specified 12 districts across the United States, as well as a city in each district where a Federal Reserve district bank was to be established.

Why do forecasts of interest rates made by experts differ?

Various factors may influence interest rates, and changes in these factors will affect interest rate movements. Experts disagree about how various factors will change. They also disagree about the specific influence these factors have on interest rates.

. Explain how consideration of a liquidity premium affects the estimate of a forward interest rate.

When considering a liquidity premium, the estimate of a forward interest rate will be reduced.

During periods when investors suddenly become fearful that stocks are overvalued, they dump their stocks, and the stock market experiences a major decline. During these periods, interest rates also tend to decline. Use the loanable funds framework discussed in this chapter to explain how a massive selloff of stocks leads to lower interest rates

When investors shift funds out of stocks, they move it into money market securities, causing an increase in the supply of loanable funds, and lower interest rates.

Distinguish between perfect and imperfect security markets. Explain why the existence of imperfect markets creates a need for financial intermediaries.

With perfect financial markets, all information about any securities for sale would be freely available to investors, information about surplus and deficit units would be freely available, and all securities could be unbundled into any size desired. In reality, markets are imperfect, so that surplus and deficit units do not have free access to information, and securities cannot be unbundled as desired.