C11+C12
14. Let's suppose you are a farmer and you want to protect yourself from the uncertainties of the market. To add an element of certainty to your business you enter into a ______ _______ with a bank. a. futures contract b. balloon payment c. vertical contract
A. A futures contract is a way to hedge your bets on some future event. In this case the farmer would agree to sell his crop for a set price on some date in the future. If the market price is greater than the agreed upon price the farmer makes less money than without the contract, and vice versa.
16. What is a hedge fund? a. An investment fund opened to a limited range of investors, professionals and wealthy people. b. A retirement fund like a teachers union. c. A federal bond that protects people from inflation. d. A financial instrument that offers high returns in the bond market.
A. A hedge fund attempts to establish a position on one market to offset price fluctuations in another market.
5. An over-the-counter derivatives market is a market where a. only the two parties are privy to the facts of the contract. b. the participants have to divulge extensive financial data to that the investors know what they are investing their money. c. both stocks and bonds are bought and sold. d. only the very wealthy can participate.
A. An over the counter market is a market void of an exchange whereby participants divulge financial information so that investors can make informed decisions. With an over-the-counter market there is no way of knowing the facts except what the seller wishes to divulge.
5. Which of the following is an example of an injection? a. Foreigners buy U.S. products. b. People put their savings into a bank. c. People pay their taxes.
A. When foreigners buy U.S. products money flows into our income stream, we thus call it an injection.
13. Basically Allen Greenspan, the Chairman of the Federal Reserve before the financial crises of 2007 - 2008, believed that a. greed is so strong in human nature that it is necessary to regulate markets. b. the market can solve all problems. c. a centrally controlled economy would be the most efficient economic system. d. big business is at the root of most of our economic problems.
B. He believed in totally free markets void of any government restrictions or regulation.
6. Gross Domestic Product (GDP) is defined as the market value of all a. resources produced in one year by U.S. firms. b. final goods and services produced in one year by all resources located in the U.S., regardless of who owns these resources. c. final goods and services produced in one year in the U.S. by resources owned by U.S. citizens.
B. This is the official definition of GDP.
7. What makes the investment sector so unstable? a. It is the largest sector of GDP. b. It takes time to decide what to do about an investment. c. Decisions are based on expectations of what investors think is going to happen in the future. d. all of the above.
C. Because decisions based on expectations and because so many thingares can influence expectations, the investment sector tends to be unstable.
20. What was the Financial Services Modernization Act of 1999? This act a. gave more teeth to the Glass-Steagall Act of 1932. b. made it so that banks could participate in the derivatives market the same as investment banks. c. Allowed commercial banks to take depositors money and put it at great risk, similar to the way they did leading up to the Great Depression of the 1930s.
C. Both b and c are answers. The FSMA obliterated the safety measures of the Glass-Steagall Act of 1932.
1. What is the basic idea behind Keynesian Economics? a. If we let the natural adjustments to take place the economy will repair itself. b. Because the economy is always tending toward a full employment equilibrium we should let the economy correct any malfunctions itself without government intervention. c. When the economy is tending toward a less than full employment equilibrium we should use our discretionary fiscal policies to push the economy to a full employment equilibrium.
C. Fiscal policies can shift the aggregate demand curve to the right and thus shift the equilibrium to full employment.
19. What was the purpose of the Glass-Steagall Act of 1932? a. This act gave banks more opportunities to invest in the derivatives market. b. This act merged investment banks with commercial banks. c. This act separated commercial banks from investment banks.
C. One of the causes of the Great Depression of the 1930s was that banks were taking depositors money and putting the money in highly leveraged and risky investments. This act prevented this practice by commercial banks but allowed investment banks a free hand.
10. Which of the following is an example of the acceleration principle? a. The bank lends out money and the borrower buys something with the money. b. Apple invents a new product and Best Buy increases its' sales volume. c. The state builds a new highway and as a result several gas stations are built along the highway.
C. The acceleration affect takes place due to induced investments. The gas stations were induced from the investment of building the highway.
15. By 2007 Long Term Capital, a hedge fund, had highly leveraged its bets. This means that Long Term Capital a. never took risks. b. had deep pockets. c. made risky bets with borrowed money. d. was very careful with its money.
C. To be highly leveraged means that you put at risk a huge amount of money but only have a small amount of money on hand to back up any bad bets.
4. Which of the following is an example of a leakage? a. Banks lend money out a business owner. b. Foreigners buy U.S. products. c. People put their savings in a bank.
C. When money leaves the income stream, that is it no longer circulates, we call it a leakage.
12. When Brooksley Born was investigating the derivatives market as head of the Commodities Futures Trading Commission a. there were some spectacular failures by entities that were speculating with little restraint. b. almost no one in government were familiar with derivatives. c. all the biggest banks were dealers in the derivatives market. d. all of the above.
D. Despite the enormity of the derivatives problem all the big players in government and banks vilified her for her attempt to rein in the excess of this market.
18. Many events transpired between 2000 and 2010 which greatly aggravated the financial melt down. Which of the following events transpired? a. The government took no action to regulate the market. b. Wall Street firms were showering Washington with $1.7 billion in campaign contributions and $3.4 billion on lobbyists. c. The practice of rent seeking was excessive. d. all of the above.
D. Self explanatory
17. What was the purpose of the Commodity Futures Trading Act of 2000? a. To give the Commodity Futures Trading Commission a free hand to regulate the derivatives market. b. Stripped the CFTC of all responsibility over the derivatives market. c. Banned states from interfering with the derivatives market. d. Both b and c are answers.
D. The CFTA gave banks total freedom in the derivatives market, which is today a $600 trillion market.
1. A derivative is a. the type of stock that pays dividends. b. a bond that has value derived from the profits of a government or a corporation. c. a financial instrument whose value is derived from tax revenues. d. a financial product whose value is derived from the price of something else.
D. The word derivative comes from the word derived, the value is derived from some other event. For example, you and I make a bet on the weather next Monday, if I am correct you owe me $100, if you are correct I owe you $100. So this contract has value because of an event that will take place next Monday.
3. Because of the Keynesian successes during the 1930s and the 1960s we know now that we can control the economy by controlling demand.
False When stagflation hit us in the 1970s we learned that because the problem was a supply problem we could not solve it with demand remedies.
15. Consumer demand for durable goods tend to be more stable than the demand for nondurable goods.
False A durable good is a good that lasts for a long time, like an automobile. A nondurable good lasts for a short time, like food. When consumer's expectations change or their incomes change, purchases of nondurables will not change very much, but the demand for durables will change a lot.
22. Big tax breaks for the first time home buyers have a positive impact on the economy and lead to an increase in home ownership and more jobs over the long run.
False Both Austrian and Keynesian economists recognize that consumers make most of their decisions based on their expectations of future income, not necessarily on their present income. If people expect a large income tax return, they will tend to increase their present spending in anticipation of that future income. Likewise, if consumers are pessimistic about the future, they will tend to curtail their spending, regardless of their present income.
2. A derivative is simply an agreement between two parties betting on some outcome that will occur in the future, the agreement is binding and cannot be transferred to a third party.
False Derivative contracts can be bought and sold multiple times before the strike date, the date the agreement becomes binding.
8. Fannie Mae and Freddie Mac are two government agencies who make mortgage loans.
False Fan and Fred do not make loans, they purchase mortgage loans from banks. The purpose is to increase the flow of funds in the mortgage market. Instead of a bank receiving monthly payments over a long time period, they could get their money right away and thus have more cash to relend.
26. It was Executive Order 11,110 of President Kennedy in the 1969's that repealed the Glass-Steagall Act.
False The Gramm-Leach Bliley Act of 1999 repealed the Glass-Steagall Act, thus eliminating the divide between commercial banks and investment banks. Executive Order 11,110 of 1963 gave the U.S. Treasury the explicit order to "issue silver certificates against any silver bullion in the Treasury," thus replacing real money with the fiat currency of a federal reserve note.
27. It was Executive Order 11,110 of President Kennedy in the 1969's that repealed the Glass-Steagall Act.
False The Gramm-Leach Bliley Act of 1999 repealed the Glass-Steagall Act, thus eliminating the divide between commercial banks and investment banks. Executive Order 11,110 of 1963 gave the U.S. Treasury the explicit order to "issue silver certificates against any silver bullion in the Treasury," thus replacing real money with the fiat currency of a federal reserve note.
9. A decrease in interest rates will lead to an increase in investments.
False The answer is false because it is not true all of the time. If expectations are very negative, then a decline in interest rates may not be sufficient to spur on investments, but we say that everything else is equal, then a decline in interest rates should lead to an increase in investments.
25. Austrian economists tend to support the Full-employment and Balanced Growth Act of 1978.
False The idea that the government can take action to ensure full employment and stable prices is the antithesis of Austrian economics. Austrians tend support policies that ensure a level playing field and a flexible economy fueled by market forces. Keynesians would more likely support a larger role of the federal government in their belief that as long as we can control demand we can control the economy.
16. When you withdraw money from savings economists say that you have dissaved.
True Savings is the act of putting money into savings, dissaving is the act of taking money out of savings.
24. A collateralized debt obligation (CDO) is a type of structured asset backed by security whose value and payments are derived from a portfolio of fixed income assets.
True A CDO is a collection of debts, like mortgages, whereby payments are made from this income stream to purchasers of the CDO. It is like the CDO is a pizza and the pizza is divided into pieces. Instead of purchasing the whole pizza, people can purchase just a slice of the pizza.
21. In its simplest form the credit default swap (CDS) is a bet on a future outcome. The party that bets correctly makes a profit and the party the bets incorrectly suffers a loss.
True A credit default swap is what is says, it swaps the risk of default from one party to another. It is like insurance. The purchaser of the CDS pays the seller money in the event of a default on stipulated investments. If no default occurs, the seller keeps the money. If a default does occur, the seller makes good on the money that was owed to the purchaser of the CDS.
22. With a debt to capital ratio of 40 to 1 in 2007, when the economy went south, this excessive leverage led to the collapse of all five investment banks.
True A debt to capital ratio of 40 to 1 means that an investment bank could lend out $40 with only $1 in reserve against the $40. This excessive leverage enabled these firms to make excessive profits when times were good, but when the economy slumped, losses were magnified.
7. A subprime mortgage is a mortgage made to persons with poor credit histories.
True A prime loan is a loan made to credit worthy individuals. Subprime loans are more risky due to the poor credit histories of the people the loans are given to.
24. Monetary and fiscal policies tend to be pro-cyclical because of lag effects.
True A pro-cyclical policy is a policy that accentuates the wide swings of the business cycle. A counter-cyclical policy would be a policy that tempers the wide swings of a business cycle. In a perfect situation with perfect control and knowledge monetary and fiscal policies would be counter-cyclical. But because we live in a democracy and because our knowledge is not perfect, we experience lag effects anytime a change occurs. These lag effects can work at cross purposes to our intentions.
21. The concepts of the liquidity trap and the balanced budget multiplier are debunked by Austrian economists.
True Because Austrian economists extoll the ideas of savings and investing to grow the economy, they believe that a dollar in the hands of government will be spent on programs that may be politically motivated, but not conducive to economic growth over the long term. Austrian economists also debunk the idea of the liquidity trap because they believe that the free market will drive down interest rates during recessions, giving investors more incentive to borrow and invest.
8. Fear and uncertainty are the twin killers of investment.
True Because investments are based partly on future expectations doubt and fear of what might happen will put a tamper on investments.
23. Lag effects can be a cushioning effect on the economy in the short run but can cause wider swings in the business cycle over the long run.
True Because it takes time to recognize there is a problem, to make a decision of what to do about the problem, and to put into action the agreed upon remedy, months or even years may go by. In the short run these lag effects may cushion any wide swings because they temper any radical short run changes. However, in the long run they can be a destabilizing force because events can change radically between the time that the problem was recognized and when the proposed solution takes effect.
3. Because no one can accurately predict the future and with so many uncertainties, the buyers and sellers of derivatives would often rely on some complicated mathematical model to determine future value.
True Because the value of derivative contracts depend on some future event, and because no one can for certain predict the future, participants in this market often relied on some formula derived by mathematical wizards called Quants, like the Black Scholes Formula, to base their predictions on.
2. The idea behind Keynesian Economics is that if we can manage demand we can manage the economy.
True By managing demand using our discretionary fiscal policies it was thought that we could manage the economy and guide
9. Prior to 1992, the government required Fannie Mae and Freddie Mac to buy only prime mortgages. After 1992, Congress required Fan and Fred to purchase subprime loans as well.
True Congress was eager to make almost everyone in American a home owner. Thus they pressured Fan and Fred to make more subprime loans to qualify more people for mortgage loans. In turn, banks came up withingenious, and sometimes fraudulent, ways to convince people to borrow money.
11. Conditions during the Great Depression of the 1930s were fertile ground for the ideas of John Maynard Keynes, and the age of demand management economics was born.
True During the 1930s the economy was in a deep depression and President Franklin Roosevelt supported the ideas of deficit spending and an enlargement of government programs, both of which supported the ideas of Keynesian economics.
4. In 1996, Bankers Trust settled with Proctor and Gamble, forgiving most of the $200 billion lost in the derivatives market.
True In 1994 the Federal Reserve raised interest rates, an invent that caused Proctor and Gamble to lose on a derivative bet. Proctor and Gambles losses mounted as the Fed raised interest rates several more times. To avoid a legal lawsuit and bad publicity, Bankers Trust decided to take the loss instead of Proctor and Gamble.
11. A hedge is a position established in one market in an attempt to offset exposure in price fluctuations in another market.
True Just as farmers use hedging to stabilize events, hedge funds (investment companies) will play off one possible scenario against another to protect themselves from any sudden market changes. Just like with the farmer, the main objective is stability. A key element in successful investing to avoid losses. Goldman Sachs Group, Inc. makes investments in things where profit is a certainty.
14. Because of the unusually long economic expansion from 1961 to 1969, fine tuning of the economy was widely accepted.
True Nothing succeeds like success, or so it appears. The expanding economy during the 1960s helped solidify the dominance of Keynesian economics both in Washington DC and at most of the mature universities in the nation. Harvard University became the leading university supporting the Keynesian philosophy with the University of Chicago being one of the few universities supporting Austrian economics.
13. By the 1960s most economists embraced the ideas of Keynes and believed in demand management economics.
True The 1960s was a decade when the ideas of demand management economics favored by Keynes became widely accepted by academia and Washington DC.
6. Congress passed the Commodity Futures Modernization Act of 2000, which stripped the Commodity Futures Trading Commission of all responsibility over the derivatives market and forbade the SEC from interfering with over-the-counter derivatives.
True The Commodity Futures Modernization Act of 2000 closed the door to any government oversight of the derivatives market.
12. The Employment Act of 1946 committed the federal government to ensure maximum employment, production, and purchasing power.
True The Employment Act of 1946 represented the first time that the federal government codified into law its responsibility to achieve full employment by way of active fiscal policies.
20. The belief in the balanced budget multiplier has led to huge increases in government borrowing and spending since the 1960s.
True The balanced budget multiplier recognizes that when individuals have a dollar they will spend most of it, but save some of it. But, when the government has the money, it will spend all of it. Therefore, there is a larger multiplier effect on the economy when the government has the dollar instead of individuals.
17. A cornerstone of Keynesian economics is the belief that without government borrowing money can get trapped in banks and not circulate in the economy where the money is needed. Keynes called this a liquidity trap.
True The belief in the liquidity trap is a main reason why Keynesian economics was accepted by academia. If banks could not lend out enough money to consumers and business, then it was up to the federal government to borrow the money and inject it into the income stream.
18. The investment sector of the economy tends to be very unstable, whereas the consumption sector tends to be very stable.
True The consumption sector is very stable because consumers tend to be very habitual. When events change, their actions do not change right away. Because of savings and dissavings consumers will maintain their previous spending habits, at least for awhile. But because investors make their decisions based on their expectations of future events, any change that will cause them to be more pessimistic or optimistic will have a profound effect on the level of investments.
19. Along with the concept of a liquidity trap, the Keynesian multiplier is the second biggest reason why economists and politicians support Keynesian economics. This is what economists call the "balanced budget multiplier."
True The idea that that a dollar in the hands of the government has a greater stimulative impact on the economy then that dollar in the hands of individuals garnered wide spread support for increasing the national debt and increasing government spending.
10. The practice of hedging one's exposure to risk goes back hundreds, if not thousands of years, whereby farmers would hedge against possible future losses.
True The practice of hedging is a sound business practice and has a lot more to do with stability than it does with gambling. Farmers will enter into a futures contract with someone by agreeing to sell their produce at a certain price (called the strike price) in the future regardless of what happens in the market. In this fashion the farmer is protected from the vagaries of the market. At times the strike price is lower than the market price and at other times it can be higher than the market price.
25. A collateralized debt obligation (CDO) is a financial instrument that pools loans together and divides them into different risk classes, called tranches, whereby the senior tranches were considered the safest and the junior tranches were considered the most risky.
True The senior tranches paid out less than the junior tranches because there was less risk to the buyer. The junior tranches paid out a higher return to compensate the purchaser for the higher risk of loss. However, when the CDO experienced losses due to people not making their payments, like on a mortgage, the investors who bought from the junior tranches were the first who experienced losses.
23. We experienced a big mortgage problem starting in 2007 partly because of the abundance of adjustable rate mortgages and the proliferation of Alt-A, sometimes called Liar Loans.
True When mortgage lending companies made it easy to obtain a mortgage with very generous terms in the early years of the loan, many people flocked to take out mortgages. But the terms worked against them soon after as the interest rate increased. When banks added the feature of letting people borrow money with no due diligence by the banks, millions of people were trapped in loans they could not afford.
