Unit 6 - Basic Economic Concepts

Increases in which of the following indicators are regarded as predictors of the level of business activity? A) Building permits B) Levels of inventories C) Corporate profits D) Personal incomes

A) Building permits Increases in building permits are indicative of increased future business activity and therefore are considered a leading economic indicator. Increases in personal income reflect current, not future, activity and are therefore considered a coincident indicator. Increases in inventories indicate that goods are not being sold in anticipated quantities, so they function as a disincentive to manufacturing. Buildup in inventories is a lagging economic indicator. Corporate profits are not included in the Conference Board's list of economic indicators. LO 6.d

Which of the following industries would be least cyclical? A) Heavy equipment B) Automobile manufacturing C) Supermarket chain D) Leisure products

C) Supermarket chain Industrial activity usually follows business cycles, which have more impact on some industries than others. The food industry is one for which the demand is not generally based on economic conditions. LO 6.a

With respect to the fiscal policy of the United States, the annual budget request is submitted by the A) Internal Revenue Service. B) Congress. C) Federal Reserve Board. D) president.

D) president. The president of the United States is responsible for submitting the country's annual budget request to Congress for its approval, and Congress ultimately sends the annual budget back to the president for his signature. LO 6.c

To stimulate a sluggish economy using fiscal policy measures, policymakers would A) increase the money supply. B) increase income taxes. C) reduce the money supply. D) reduce income taxes.

D) reduce income taxes. Reducing income taxes is a fiscal policy tool intended to increase overall demand for goods and services. Think about it. If income taxes were reduced, you'd have more money in your pocket to spend. Adjusting the money supply is a monetary policy tool. LO 6.c

What generally happens to outstanding fixed-income securities when the rate of inflation slows? A) Prices go up. B) Yields go up. C) Short-term securities are affected the most. D) Coupon rates go up.

A) Prices go up. When the rate of inflation slows and is expected to remain stable, coupons on new issue bonds will often decline to offer lower yields. The prices of outstanding bonds will go up to adjust to the lower yields on bonds of similar quality. LO 6.d

Which of the following best describes the economic phase in which unemployment increases and businesses operate at their lowest capacity levels? A) Trough B) Peak C) Contraction D) Expansion

A) Trough A trough in a business cycle occurs at the end of a contraction phase when businesses are operating at their lowest capacity levels. LO 6.a

If the Consumer Price Index (CPI) is up and consumer demand is also up, the economy is likely in which stage of the business cycle? A) Peak to contraction B) Expansion to peak C) Recovery to trough D) Contraction to trough

B) Expansion to peak As prices trend higher and consumer demand increases, the economy is moving from expansion to a peak. As demand continues to increase, assuming supply remains constant, upward pressure will be put on prices through the expansion to the peak. LO 6.a

Which of the following is a component of U.S. fiscal policy? A) Reserve requirements B) Money supply C) Discount rate D) Taxes and budgeting

D) Taxes and budgeting U.S. fiscal policy is determined by the president and Congress through budgeting and taxation. The other choices are monetary policies employed by the Fed. LO 6.c

An investor regularly reads financial blogs on the internet, and they are filled with articles suggesting that the economy is headed for a slump. Some are even saying that there will be price deflation. If these projections are accurate, the best place for the investor to place funds would probably be A) gold. B) common stock. C) commercial real estate. D) U.S. Treasury bonds.

D) U.S. Treasury bonds. When the economy is headed downward, safety is the imperative, and nothing is as safe (at least for exam purposes) as U.S. Treasuries. Gold and most other commodities are a hedge against inflation, not deflation. In down times, real estate—both residential and commercial—usually underperforms. LO 6.d

The primary function of the Federal Reserve System (the Fed) is to A) manage the revenues and expenditures of the federal government. B) implement fiscal policy. C) issue bonds to the general public. D) carry out monetary policy.

D) carry out monetary policy. The Federal Reserve controls the money supply, enabling it to significantly affect interest rates. The Fed will follow a loose, or easy, monetary policy when it wants to increase the money supply to expand the levels of income and employment. In times of inflation, when it wants to constrict the money supply, the Fed will follow a tight monetary policy. The U.S. Treasury issues bonds to the general public to finance the budget deficits of the federal government. LO 6.c

When the value of the U.S. dollar decreases, A) domestic manufactures will likely not be affected. B) foreign manufacturers will likely export more to the United States. C) domestic manufacturers will likely increase their imports. D) domestic manufacturers will likely increase their exports.

D) domestic manufacturers will likely increase their exports. When the U.S. dollar decreases against other currencies, foreign goods become more expensive. On the other hand, domestically produced goods are cheaper for those buying with foreign currencies, so we can expect the exporting of goods made in the United States to increase. LO 6.d

An upward-sloping yield curve represents all of the following except A) increased risk of default over time. B) inflation expectations. C) time value of money. D) foreign interest rate differentials.

D) foreign interest rate differentials. Foreign interest rate differentials are not reflected in an upward-sloping yield curve. Interest rate differentials between countries reflect differences in domestic monetary and fiscal conditions. The time value of money is reflected in the upward-sloping yield curve. Longer-term rates require higher rates to compensate for loss of current buying power and liquidity. Longer-term funds bear a higher risk of default than do shorter-term funds and, as a result, command higher rates. Increasing inflation expectations cause the yield curve to slope upward to compensate lenders for the loss of future buying power. This is an example of how you get a question correct by process of elimination. LO 6.b

A recession is defined as a drop in GDP for A) two consecutive quarters. B) three consecutive quarters. C) four consecutive quarters. D) six consecutive quarters.

A) two consecutive quarters. A recession is a drop in GDP for two consecutive quarters. LO 6.a

What generally happens to outstanding fixed-income securities when the rate of inflation slows? A) Short-term securities are affected the most. B) Prices go up. C) Coupon rates go up. D) Yields go up.

B) Prices go up. When the rate of inflation slows and is expected to remain stable, coupons on new issue bonds will often decline to offer lower yields. The prices of outstanding bonds will go up to adjust to the lower yields on bonds of similar quality. LO 6.d

Proponents of the concept of inflation inertia believe that A) the rate of inflation will parallel the Consumer Price Index. B) prices will rise rapidly and then begin to contract. C) prices will rise slowly and then begin to increase at a faster rate. D) prices will remain the same for a protracted period of time.

C) prices will rise slowly and then begin to increase at a faster rate. The concept of inflation inertia is that prices will rise slowly during an initial period of inflation and then begin to pick up steam as a result of some economic shock. LO 6.d

Among the effects of a country devaluating its currency is that there will probably be which of these? I A credit to that nation's trade account balance II A debit to that nation's trade account balance III An increase in that nation's exports IV An increase in that nation's imports A) II and III B) I and III C) I and IV D) II and IV

B) I and III When a currency is devalued by a country, it means that foreigners will find their money has more buying power in that country. Therefore, it would be expected that foreigners would buy more goods produced in that country, causing an increase in exports. Those exports result in a credit to the country's trade account balance. LO 6.c

A bond analyst reports that there is currently an inverted yield curve. That would mean A) the closer the bond is to its maturity date, the higher the yield. B) the closer the bond is to its maturity date, the lower the yield. C) bonds with intermediate maturities have the highest yields. D) the further the bond is from its maturity date, the higher the yield.

A) the closer the bond is to its maturity date, the higher the yield. An inverted yield curve shows near-term maturities with higher yields than those of long-term maturities. Sometimes called a negative yield curve, it is usually an indication that interest rates are near a peak and the trend should soon reverse. LO 6.b

During the past two quarters, the GDP declined by 3%, the unemployment rate rose by 0.7%, and the Consumer Price Index fell by 1.3%. This economic condition is called A) depression. B) inflation. C) recession. D) stagflation.

C) recession. Two consecutive quarters of economic decline, as measured by the gross domestic product (GDP), is termed a recession. Six quarters would be considered a depression, and an increasing CPI could be considered a sign of inflation. LO 6.a

The research department of an investment advisory firm forecasts that the current business cycle should reach its peak within the next two months. Under such circumstances, which of the following portfolio adjustments would be most suitable for the firm's customers who actively invest in common stocks? A) Defensive stocks B) Aggressive growth stocks C) Corporate bonds D) Cyclical stocks

A) Defensive stocks The concept of sector rotation involves moving assets from those sectors that are close to their peak and into those sectors that will benefit from the next move in the business cycle. Defensive stocks—such as food, pharmaceuticals, and public utilities—would most likely be suitable for investors who believe the cycle is near its peak. Defensive stocks are least likely to be affected by a reversal in the business cycle. LO 6.a

A bond analyst reports that there is currently an inverted yield curve. That would mean A) the further the bond is from its maturity date, the higher the yield. B) bonds with intermediate maturities have the highest yields. C) the closer the bond is to its maturity date, the higher the yield. D) the closer the bond is to its maturity date, the lower the yield.

C) the closer the bond is to its maturity date, the higher the yield. An inverted yield curve shows near-term maturities with higher yields than those of long-term maturities. Sometimes called a negative yield curve, it is usually an indication that interest rates are near a peak and the trend should soon reverse. LO 6.b

A fixed-income investor notices that the short, intermediate, and long ends of the yield curve reflect a similar return. This would be typical of A) a positive yield curve. B) an inverted yield curve. C) a flat yield curve. D) a normal yield curve.

C) a flat yield curve. If you were to plot this curve, what would it look like? It would be a flat line because, regardless of the maturities, all of the yields are the same. In an inverted (or negative) yield curve, the short end of the curve has higher yields than the long end. A normal (or positive) yield curve slopes upward, with lower yields at the short end and higher yields at the long end. LO 6.b

If a customer purchases a food company stock and a utility stock, the customer's portfolio is A) defensive. B) balanced. C) diversified. D) cyclical.

A) defensive. Food company stocks and utilities are defensive investments. Defensive investments are those that tend to hold up well in economic downturns. LO 6.a

All of the following are tools that may be employed by the Federal Reserve in an effort to control the economy except A) the discount rate. B) open market operations buying and selling Treasury securities. C) the prime rate. D) the reserve requirements.

C) the prime rate. The prime rate is set by money center commercial banks. All of the others are under the control of the Fed. LO 6.c

An investor using yield curve analysis would expect to view bonds of A) a single issuer over varying maturities. B) varying quality over a number of maturities. C) varying quality of similar maturities. D) similar quality over varying maturities.

A) a single issuer over varying maturities. The most common yield curves are drawn using U.S. Treasury securities. The curve is plotted using maturities ranging from the short-term T-bills to the long bonds. There are other curves drawn with bonds from other sectors, such as corporate bonds, to show the yield spread, but that is going beyond the scope of this question. LO 6.b

During the past two quarters, the GDP declined by 3%, the unemployment rate rose by 0.7%, and the Consumer Price Index fell by 1.3%. This economic condition is called A) inflation. B) recession. C) depression. D) stagflation.

B) recession. Two consecutive quarters of economic decline, as measured by the gross domestic product (GDP), is termed a recession. Six quarters would be considered a depression, and an increasing CPI could be considered a sign of inflation. LO 6.a

When investors tend to increase their investments in debt securities on the short end of the spectrum, it generally leads to A) a positive yield curve. B) short-term yields that exceed long-term yields. C) an inverted yield curve. D) a flat yield curve.

A) a positive yield curve. Investors buying short-term debt rather than long-term debt will have the effect of driving the prices of short-term instruments up and, as a result, their yields down. This will produce a normal, or positive, yield. It is when the demand for bonds on the long end of the spectrum exceeds the demand for those in the near term that short-term yields exceed those of long-term yields. This creates an inverted or negative yield curve. LO 6.b

Over time, a country's trade deficit will lead to a decline in the value of its currency because A) the country's imports will exceed exports, creating selling pressure on its currency. B) domestic goods will become too expensive for foreigners to buy. C) the country's exports will exceed its imports. D) the money supply will decrease.

A) the country's imports will exceed exports, creating selling pressure on its currency. When a country's imports exceed its exports, a trade deficit will occur. This causes selling pressure on the country's currency, therefore lowering its exchange rate against other currencies. When a country's currency declines in price relative to other currencies, exports tend to increase over time because they become less expensive in terms of foreign currency, thus reversing the trade deficit. LO 6.c

Over time, a country's trade deficit will lead to a decline in the value of its currency because A) the country's imports will exceed exports, creating selling pressure on its currency. B) the money supply will decrease. C) domestic goods will become too expensive for foreigners to buy. D) the country's exports will exceed its imports.

A) the country's imports will exceed exports, creating selling pressure on its currency. When a country's imports exceed its exports, a trade deficit will occur. This causes selling pressure on the country's currency, therefore lowering its exchange rate against other currencies. When a country's currency declines in price relative to other currencies, exports tend to increase over time because they become less expensive in terms of foreign currency, thus reversing the trade deficit. LO 6.c

Ana is a bond analyst who notices a wider credit spread between Treasury bonds and AAA corporate debt. From this, she would be most likely to infer A) the economy is weakening. B) corporate bond prices are increasing. C) corporate earnings are reaching record highs. D) interest rates on Treasury bonds are increasing.

A) the economy is weakening. The reason the spread gets wider is that investors are getting out of corporate bonds and getting into Treasuries. Why would they do that? Because, as the industry says, "It is an escape to quality." When there are economic clouds on the horizon, like a recession, you would much rather have your money invested in U.S. Treasuries because you know they will pay off. Higher corporate yields come from lower market prices. LO 6.b

Which of the following statements regarding the economics of fixed-income securities are true? I Short-term interest rates are more volatile than long-term rates. II Long-term interest rates are more volatile than short-term rates. III Short-term bond prices react more than long-term bond prices given a change in interest rates. IV Long-term bond prices react more than short-term bond prices given a change in interest rates. A) II and III B) I and IV C) II and IV D) I and III

B) I and IV There are two separate issues in this question: the volatility of rates and the volatility of bond prices. Short-term rates are more volatile than long-term rates and move more quickly than long-term rates. Often the most volatile interest rate is the federal funds rate, which is an overnight rate of interest. Given a change in rates, long-term bond prices move more than short-term bond prices because of the compounding effect over a much longer period. LO 6.b

Expansions in the business cycle are characterized by A) an increase in want ads in newspapers and a decrease in nonfarm jobs. B) increasing consumer demand for goods and services, increasing industrial production, and rising stock markets and property values. C) higher consumer debt and rising inventories. D) increasing college enrollments and enlistment in military service.

B) increasing consumer demand for goods and services, increasing industrial production, and rising stock markets and property values. Expansions in the business cycle are characterized by increasing consumer demand for goods and services, increasing industrial production, and rising stock markets and property values. Simply stated, business activity is expanding. LO 6.a

A decrease in the value of the monetary unit is just a way of defining A) a likely decrease in exports. B) inflation. C) a decrease in consumer demand. D) deflation.

B) inflation. What causes the value of the money unit (the dollar in the United States) to decrease? Inflation—it takes more dollars to pay for goods and services. This is usually caused by an increase in consumer demand. If the value of the currency declines, exports generally rise because domestically produced goods are less expensive to those using foreign currency. LO 6.d

Stock market indices have a variety of uses. Which of the following is least accurate regarding the use of stock market indices? A) They act as the basis of ETFs. B) They act as a market barometer. C) They are a lagging indicator of an economy's corporate performance. D) They help in portfolio performance measurement.

C) They are a lagging indicator of an economy's corporate performance. The stock market and market indices are leading indicators of the economy's corporate and financial performance. LO 6.d

Some prominent stock market pundits are predicting that the economy will slide into a recession in the near future. Furthermore, they are expecting moderate deflation during the same period. If this were to happen, your clients would probably enjoy the greatest overall return from investing in A) common stock. B) real estate. C) U.S. Treasury bonds. D) commodities.

C) U.S. Treasury bonds. The combination of recession and deflation leads us to a security with the highest safety. The other three choices tend to rise with inflation and, therefore, are often thought of as inflation hedges. However, deflation is the opposite; you'd want to be in fixed investments because their purchasing power will increase. LO 6.a

A bond analyst notices that the yield spread between corporate bonds and government bonds is widening. This is typically predictive of A) increased concern over the national debt. B) an expanding economy. C) an economic slowdown. D) increasing interest rates.

C) an economic slowdown. A widening yield spread shows that the difference in yield between corporate bonds and U.S. Treasury bonds is increasing. This is usually caused by a flight to quality, the pattern of investors moving their investments to the safety of Treasury securities. This is commonly felt to be a prediction of a future recession or economic slowdown. During a slowdown, interest rates generally decline. LO 6.b

An investor purchasing gold bullion is most likely looking for an investment that is A) income producing. B) cyclical. C) countercyclical. D) exchange traded.

C) countercyclical. Countercyclical assets are those whose prices tend to move in the opposite direction of the overall economy. Historically, the price of precious metals, especially gold (and stock in gold-mining companies), moves up when the economy enters the contraction phase and moves in the reverse direction during expansion. Cyclical stocks follow the cycle. There is no "gold bullion exchange." It is a dealer market with bullion dealers all over the world setting their own spreads. A bar of gold does not provide income. LO 6.a