Series 7: Analysis (Economic Analysis)

The Federal Reserve will lend funds at the discount rate to:

commercial banks Only commercial banks are members of the Federal Reserve System. Member banks can borrow reserves from the Fed at the discount rate.

During prolonged periods of economic expansion, interest rates can be expected to:

increase During prolonged periods of economic expansion, interest rates rise. This occurs because the Federal Reserve tightens credit to keep the economy from growing too fast; and because demand for loans rises as business activity rises.

Keynesian Theory states that the economy is stimulated by:

increased Government spending Keynesian Economic Theory states that economic growth is controlled by government spending and transfer payments (e.g., Social Security). This theory gained adherents in the 1930s during the Great Depression. With the private economy shattered at that time, the only way out was to have the government employ workers in large projects. This increased Government spending; and helped to stimulate economic activity as earnings were placed in individual pockets.

During periods of falling unemployment claims, rising consumer spending, and increased business spending, the Federal Reserve's actions would attempt to minimize the chances of:

inflation The conditions stated, of falling unemployment claims, rising consumer spending and increased business spending, all point to a rapidly expanding Gross Domestic Product. In these conditions, the Federal Reserve is concerned with inflation, and would attempt to dampen activity somewhat to lessen the chances of inflation.

The "real" interest rate is the yield to maturity:

minus the inflation rate Interest rates consist of a component for the true "cost" of money and another component for expected inflation. The higher the expected inflation rate, the higher the interest rate. To get the "real" cost of funds, the inflation rate must be deducted out of the yield.

All of the following are lagging economic indicators EXCEPT:

Building Permits Lagging indicators include reported corporate profits (showing what was already earned in the last quarter); commercial loans outstanding (showing what has been borrowed and presumably spent); and employment duration (showing how long someone was employed before being terminated). Building permits are a leading indicator, showing planned future production.

In a deflationary period, which security would be most negatively affected?

Common stock In a deflationary period, interest rates will fall, raising the prices of fixed income securities. Thus, fixed income securities are defensive securities in times of deflation. Remember that preferred stock, which pays a fixed dividend rate, is a fixed income security. In contrast, common stock price movements will depend on the state of the economy at the time deflation occurs, and thus would not be defensive during deflationary periods.

Monetary policy is set by:

Federal Reserve action Monetary policy is set by the Federal Reserve Board. The Federal Reserve can either tighten; or loosen; credit by using any of its 4 tools, which can be memorized as "DORM." D is Discount rate; O is Open Market Operations; R is Reserve Requirements; and M is Margin on securities.

Gross Domestic Product (GDP) consists of all of the following EXCEPT:

Foreign Government spending Gross domestic product is the entire output of the U.S. economy. It includes individual consumption, government spending, and fixed investment. Since it measures output within the United States only, foreign spending and investment is excluded.

If factory inventory levels are decreasing which of the following statements are TRUE? I Economic conditions are improving II Economic conditions are deteriorating III Consumer demand is increasing IV Consumer demand is decreasing

I and III If inventory levels are decreasing, this is a sign that demand is increasing (people are buying), and therefore, economic conditions are good (expansion is occurring).

Which of the following statements are TRUE regarding the "help wanted" advertising index? I If the number of advertisements is increasing, the economy is growing II If the number of advertisements is increasing, the economy is contracting III The index is a leading economic indicator IV The index is a lagging economic indicator

I and III The amount of "help wanted" advertising shows the current demand for labor. If the number of advertisements is increasing, this would show that employers plan future production and the economy is doing well. If it is decreasing, it shows that future production will be slowing. Thus it is a leading indicator, though is not included as one of the 10 leading economic indicators reported monthly.

The tools of the Federal Reserve include which of the following? I Setting the Reserve Requirement II Setting the Federal Funds Rate III Setting the Discount Rate IV Setting the Prime Rate

I and III only While the Federal Reserve actions can influence the Federal Funds Rate (which is the overnight loan rate charged by banks to banks when money is borrowed to meet Reserve Requirements) and the Prime Rate (loans made by banks to their best corporate clients), the Fed does not set these rates. These rates are market driven. The Fed does, however, set the Reserve Requirement (member banks must maintain this percentage of deposits "on reserve" and can lend out the balance); and the Discount Rate (which is the rate charged to member banks to borrow reserves from the Fed). To memorize the 4 tools of the Fed, remember "DORM." D is Discount rate; O is Open Market Operations; R is Reserve Requirements; and M is Margin on securities.

If the Federal Reserve Board tightens credit via open market operations, which of the following will be the slowest to respond? I Credit card interest rates II Federal funds rate III Broker loan rate IV Passbook savings rates

I and IV Consumer rates, such as passbook savings rates and credit card interest rates are fairly constant. Banks do not adjust these rates because consumers are not as sensitive to interest rate changes and are uncomfortable with rapidly changing market rates. If the Federal Reserve tightens credit via open market operations (to do this, it would use reverse repurchase agreements), market driven rates will be the first to respond. The Federal Funds rate (overnight loans of reserves from bank to bank) and the broker loan rate (loans to brokers with securities as collateral) would respond almost instantly.

Federal Reserve actions can directly influence which of the following? I Discount Rate II Federal Funds Rate III Money Multiplier IV Money Velocity

I, II, III, IV Federal Reserve actions can directly influence the discount rate, which can be raised or lowered by the Federal Reserve. The discount rate is the rate charged to member banks to borrow reserves from the Fed. The Federal Reserve directly influences the Federal Funds rate by its daily open market operations. To raise the Federal Funds rate (overnight loan rate for reserves bank to bank), the Fed will engage in reverse repos (matched sales) with bank dealers. To lower the Federal Funds rate, the Fed will engage in repurchase agreements with bank dealers. The Fed can directly influence the money multiplier by changing reserve requirements of member banks. The larger the percentage reserve requirement, the lower the money multiplier (since banks must keep a larger portion of deposits on reserve, and so, can loan out less). The Federal Reserve can also directly influence the velocity of money. This is the speed with which deposits clear from bank to bank. The Fed imposes maximum clearance times among member banks, and can tighten or loosen these. (The "faster" the velocity, the greater the aggregate funds available at any moment in time.)

Which of the following are included in the 10 leading economic indicators? I Standard and Poor's 500 Index II Supplier Delivery Delays III Consumer Price Index IV Initial Unemployment Claims

I, II, IV Leading economic indicators include stock prices (as stock prices rise, people feel richer and spend more), supplier delivery delays (as capacity tightens, delays increase), and initial unemployment claims (high levels indicate future production cutbacks). The consumer price index is not a future indicator.

Which of the following tools are used by the Federal Reserve to control the money supply? I Setting reserve requirements II Setting the federal funds rate III Setting the discount rate IV Open market operations

I, III and IV Monetary policy tools of the Fed include setting reserve requirements, setting the discount rate, setting margin rates, and conducting open market operations. The federal funds rate is the charge for overnight loans of reserves from bank to bank. It responds to Fed actions, but is not set by the Fed. To memorize the 4 tools of the Fed, remember "DORM." D is Discount rate; O is Open Market Operations; R is Reserve Requirements; and M is Margin on securities.

To slow down economic growth using Fiscal Policy, which of the following actions could be taken? I Tax rates could be reduced II Tax rates could be increased III Government spending could be reduced IV Government spending could be increased

II and III Fiscal policy is set through Government actions (approved by Congress) that influence economic activity. To slow down the economy, tax rates can be increased, transfer payments such as social security, can be reduced, and Government spending can be reduced. To stimulate the economy, the reverse occurs.

In a period of inflation, which of the following corporate actions is likely to occur? I Issuers are more likely to sell fixed income securities II Issuers are less likely to sell fixed income securities III If debt securities are sold, callable issues are likely IV If debt securities are sold, non-callable issues are likely

II and III In inflationary periods, interest rates rise. As interest rates rise, issuers are less likely to sell fixed income securities - it costs them more to finance. If issues are sold, issuers are likely to sell callable issues. Callable issues are generally sold in periods of high interest rates, so the issuer can call in the securities if interest rates fall subsequently.

The rate of inflation as measured by the Consumer Price Index has been rising rapidly over the last months. Ignoring other factors, the effect will be to: I raise stock market values II lower stock market values III raise bond market values IV lower bond market values

II and IV A rising inflation rate is a "lose-lose" situation for both the stock and long term bond markets. If the inflation rate rises, then interest rates are likely to rise, with short term rates rising more than long term rates (the yield curve "flattens" as the Fed tightens credit to tame inflation, with short term rates rising more than long term rates). If interest rates rise, then long term bond prices will fall fastest, and long bondholders will have large losses on their positions. Furthermore, during periods of inflation, corporate earnings tend to fall, because companies are not able to keep raising prices at the same pace as their costs rise. This lowered earnings outlook depresses stock prices. Thus, both stock and long bond prices tend to fall in inflationary periods. Instead, during these periods of high inflation, investors "flee to safety" - they abandon the stock and long term bond markets, and put money in short term money market instruments, which offer safety and relatively high interest rates during inflationary periods; and they also put money into real estate and other "hard" assets that tend to keep pace with inflation.

A decreasing Consumer Confidence Index indicates that: I consumers are confident in the overall economy II consumers are not confident in the overall economy III future spending is likely to increase IV future spending is likely to fall

II and IV If the index is falling, then consumer confidence is low and future spending will be reduced. Conversely, an increasing index indicates that consumers are "confident," and thus are likely to spend money - resulting in increased future output.

Which of the following actions by the Federal Reserve will increase interest rates? I Purchases of securities as directed by the FOMC II Sales of securities as directed by the FOMC III Repurchase agreements with U.S. Government dealers and banks IV Reverse repurchase agreements with U.S. Government dealers and banks

II and IV To increase interest rates, the Federal Open Market Committee must direct a tightening of the money supply. Sales of securities by the Fed drains cash from the dealers, and tightens available credit. Reverse repos by the Fed do the same thing. In a reverse repo the Fed sells government securities to the bank dealers, with an agreement to buy them back (usually the next day). For that day, the bank is drained of cash and credit availability is tightened.

Arrange the following in the usual order of the economic cycle: I Prosperity II Expansion III Recession IV Recovery

II, I, III, IV The normal sequence of the economic cycle is a period of expansion, followed by a period of economic prosperity, followed by a decline in economic activity (recession), followed by an economic recovery leading to further expansion, etc.

Rank the following interest rates from highest to lowest: I Discount Rate II Federal Funds Rate III Broker Loan Rate IV Prime Rate

IV, III, I, II The lowest rate is the Federal Funds Rate. This is the rate on overnight loans of reserves from bank to bank. The next highest rate is the Discount Rate. This is the rate that the Federal Reserve charges member banks for borrowing reserves from the Fed. The next highest rate is the Broker Loan Rate. This is the rate that brokerage firms can borrow from banks using securities as collateral. The highest rate is the Prime Rate. This is the rate for unsecured borrowing from banks by the best corporate customers.

Which of the choices given is a coincident economic indicator?

Index of Industrial Production Durable goods orders are a leading economic indicator, on the assumption that the goods are yet to be produced. Thus, the economic activity associated with these orders will happen in the future. The Index of Industrial Production is a coincident indicator - it is showing economic activity at the moment. Consumer debt levels and reported corporate profits are lagging indicators. They show the results of past activity - e.g., consumers have already bought the goods on credit, thus their debt has risen.

A change in each of the following is a lagging economic indicator EXCEPT:

Initial Claims for Unemployment Initial Claims for Unemployment is a leading economic indicator (since high initial claims indicate coming production cutbacks). Employment Duration (showing how long someone was employed before being terminated), Reported Corporate Profits (showing what was already earned in the last quarter), and the Inventory to Sales Ratio (showing what was produced and in inventory, relative to current sales) are all lagging indicators.

The broadest measure of the money supply is:

L The broadest measure of the money supply is "L." L consists of M-3 plus money market instruments and government savings bonds. Note that the Federal Reserve no longer computes M-3 or L, but these may still be tested.

The use of which tool of the Federal Reserve has the smallest impact on money supply levels?

Margin on securities Monetary policy tools of the Fed include setting reserve requirements, open market operations, setting the discount rate, and setting margin rates on securities. Changing margin rates on securities has the smallest impact on money supply levels, since the securities market is not that large relative to the government bond and credit markets.

Which economic theory postulates that production and economic growth are stimulated by lower interest rate levels, and can be managed by Federal Reserve actions?

Monetarist Theory Monetarist Theory states that economic growth is controlled by the Federal Reserve's actions. If the Federal Reserve allows the money supply to grow at a pace consistent with real economic growth, there is balance. The theory holds that if the Federal Reserve allows the money supply to grow more rapidly than real economic growth, interest rates will fall, stimulating borrowing and investment. Conversely, if the Federal Reserve allows the money supply to grow more slowly than real economic growth, interest rates will rise, reducing borrowing and investment.

A change in each of the following is a coincident economic indicator EXCEPT:

Money Supply as measured by M-2 The money supply level as measured by M-2 is a leading economic indicator, since if the money supply is rising, there is easy credit, encouraging spending. Personal income levels, the index of industrial production, and employment levels all show current activity and are coincident indicators.

Which tool of the Federal Reserve is used most frequently?

Open market operations Monetary policy tools of the Fed include setting reserve requirements, open market operations, setting the discount rate, and setting margin rates on securities. Open market operations (repurchase and reverse repurchase agreements with government dealers) are conducted by the Fed daily. This is the most frequently used tool of the Federal Reserve to control money supply levels.

The interest rate charged from commercial banks to their best customers is the:

Prime Rate The lowest rate is the Federal Funds Rate. This is the rate on overnight loans of reserves from bank to bank. The next highest rate is the Discount Rate. This is the rate that the Federal Reserve charges member banks for borrowing reserves from the Fed. The next highest rate is the Broker Loan Rate. This is the rate that brokerage firms can borrow from banks using securities as collateral. The highest rate is the Prime Rate. This is the rate for unsecured borrowing from banks by the best corporate customers.

During which phase of the economic cycle would one most likely find monetary "deflation" starting to occur?

Recession During the recession phase of an economic cycle is when price deflation begins to occur. As output falls and there are fewer employed workers, pressure is put on employees for wage concessions. As output falls, decreased demand for goods and services also causes prices to fall. Thus, deflation tends to occur.

The use of which tool of the Federal Reserve has the biggest impact on money supply levels?

Reserve requirements Monetary policy tools of the Fed include setting reserve requirements, open market operations, setting the discount rate, and setting margin rates on securities. Changing reserve requirements has the largest impact on money supply levels, due to the effect of the "money multiplier." Because only a small percentage of deposits are retained on reserve, the amount that is lent out by the bank "multiplies out" as it is deposited to another bank, which retains a portion and lends out the balance, which is deposited to another bank, which retains a portion and lends out the balance, etc. Changing the reserve requirement would have an enormous expansionary or contractionary effect on money supply levels - hence this tool of the Federal Reserve is almost never changed.

The "effective" Federal Funds Rate is the:

daily average rate of member banks of the Reserve System The "effective" Federal Funds Rate is the daily average rate for overnight loans of reserves from member bank to member bank within the Reserve system.

All of the following tools are used by the Federal Reserve to control the money supply EXCEPT:

setting the federal funds rate Monetary policy tools of the Fed include setting reserve requirements, open market operations, setting the discount rate, and setting margin rates. The federal funds rate is the charge for overnight loans of reserves from bank to bank. It responds to Fed actions, but is not set by the Fed. To memorize the 4 tools of the Fed, remember "DORM." D is Discount rate; O is Open Market Operations; R is Reserve Requirements; and M is Margin on securities.

Supply Side Theory states that the economy is stimulated by:

tax rate reductions Supply Side Theory states that economic growth is controlled by individual initiative. If individuals are given the incentive to produce, they will, and the economy will grow. To give this incentive, the theory holds that government spending, and the tax collections necessary to support that government spending, should be reduced. This leaves the individual with an economic incentive to produce, since less of his or her income is being taxed.

All of the following statements are true about Federal Reserve open market trading activities EXCEPT open market operations affect:

the National Debt Open market operations do not affect the national debt. The issuance and redemption of government securities by the Treasury determines the national debt level. Open market operations affect monetary levels such as M1 (currency in circulation and demand deposits); affect the business cycle; and affect the Treasury's accounts, since FRB funding for its trading activities is provided through the Treasury.

The Federal Reserve might consider an easing of credit if all of the following decline EXCEPT:

unemployment levels Declining unemployment means that the economy is chugging along nicely and does not need the stimulus of credit easing. Lower GDP indicates that a credit stimulus may be needed; stock prices fall in response to either higher interest rates or other bad economic news - the Fed may attempt to correct the situation by easing credit. If the Consumer Price Index is falling, inflation is lower, and credit can be eased without kindling inflationary fears.