65- sec. 8: Basic Economic Concepts

Q: If the Consumer Price Index (CPI) is down but consumer demand is up, the economy is likely in which stage of the business cycle? A. recovery to expansion B. peak to contraction C. recovery to trough D. contraction to trough

A prices trend downward and consumer demand increases when the economy is moving from recovery to expansion

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

B What causes the value of the money unit (in the United States it is the dollar) 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.

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

A Reducing income taxes is a fiscal policy tool intended to increase overall demand for goods and services. Adjusting the money supply is a monetary policy tool.

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

A The president of the United States is responsible for submitting the country's annual budget request to Congress for their approval and ultimately sent back to the president for signature.

If disposable personal income has fallen steadily over the past year, which of the following is most likely going to be affected? A) Tobacco industry B) Firms that produce nondurable consumer goods C) Automotive industry D) Defense industry

C The automobile industry is cyclical and of the choices, the most likely to be affected by a change in the business cycle as indicated by declining personal income.

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

D 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.

4 stages of business cycle

expansion, peak, contraction, trough EXPANSION/RECOVERY is characterized by increasing business activity throughout the economy. When GDP increases rapidly and business reach their production capacity, the economy is said to have reached its PEAK. When businesses then decline from their peak, the economy is CONTRACTING. When business activity then stops declining and levels off, the cycle makes a TROUGH

Balance of Payments

the difference between the amount of money that comes into a country and the amount that goes out of it

nominal interest rate

the interest rate actually paid for a loan -if inflation is expected, it is likely that interest rates are going to increase. This means that new loans (bonds) will carry a higher nominal rate that the bonds currently available -As a result, as interest rates rise, market forces will lead to the price of those older and lower interest rate bonds to decline

Yield Curve Analysis

-plots the difference between long and short term rates, also reflection of investor expectations of inflation (expect high inflation: need high rates of interest) -normal yield curve is upward sloping when LT interest rates are higher than ST interest rates -lenders must be compensated for: 1. time value of money 2. reduced buying power from inflation 3. increased risk of default over long periods 4. loss of liquidity -if corporate vs. government bonds yield spread is: A.Widening -a recession is expected -investors chose government bonds (safe) over high yield corporates which occurs in a slowing economy B. Narrowing -expansion is expected -investors are willing to take risks Usually constructed w/ bonds of single issuer over varying maturities

3 indicators for economic activity

1. Leading indicators -Turn down before the beginning of recession/turn up before beginning of business expansion -Used to predict future direction of economy 4-6 months BEFORE -money supply, stock prices 2. Coincident (current) -economic measurements that change simultaneously with the business cycle -Personal income 3. Lagging indicators -measurements that change 4-6 AFTER economy has begun a new trend -avg duration of unemployment, avg prime rate, change in CPI

Fiscal Policy fundamentals

-Actions of Congress and President -Governments spending and taxation

Which of the statements below best describes why a normal yield curve is positively sloped? A) Investors logically demand higher returns from government securities than they do from corporate securities. B) Stocks generally have lower yields than bonds, although their total returns may be higher. C) Short-term bonds generally fluctuate in price more than long-term bonds. D) Investors demand higher interest when lending their money for longer periods.

D When the yield curve is positively sloped (and thus normal), long-term bonds carry higher interest rates than short-term bonds of the same quality.

If the value of the U.S. dollar were to increase with respect to other currencies, it would make I. U.S. exports, like heavy equipment, more competitive in foreign markets II. U.S. exports, like heavy equipment, less competitive in foreign markets III. foreign imports into the United States, such as cars, less competitive in U.S. markets IV. foreign imports into the United States, such as cars, more competitive in U.S. markets

II and IV

Monetarist Theory

Idea that quantity of money (money supply) determines the overall price levels and economic activity. -Too many dollars & few goods = inflation -few dollars & too many goods = deflation

Monetary Policy

Refers to the central bank's actions that affect the quantity of money and credit in an economy to influence activity. Monetary policy is said to be: -EXPANSIONARY (easy) when central bank INCREASES quantity of money and credit in an economy -CONTRACTIONARY (restrictive) when central bank REDUCES the quantity of money and credit in the economy *Monetary policy is under the control of the Federal Reserve Board (the Feds)

Changes in reserve requirements (Fed tool 1)

-By RAISING the amount of funds commercial banks must leave on deposit with the Fed, the amount of money available for these banks to lend out is DECREASED -Shrinkage of money supply --> higher interest rates -Increasing money supply--> lower interest rate

Open-market operations (Fed tool 3)

-Fed buys and sells U.S. Treasury securities in the open market under direction of the FOMC -when treasuries are PURCHASED, money supply INCREASES b/c FOMC is purchasing securities from commercial banks causing the banks to have more $$ -when treasuries are SOLD, money supply REDUCES b/c funds are pulled out of the bank's reserves to pay for those securities *Most actively used Fed tool*

Fiscal Policy

Refers to government's use of spending and taxation to influence economic activity. -BALANCED when gov tax revenues = gov expenditures -SURPLUS when gov tax revenues > gov expenses -DEFICIT when gov tax revenues < gov expenses

Monetary Policy fundamentals

-Policy of the FRB -Discount rate (set by Fed) -Reserve requirement (most drastic) -Open market operations (most frequently used)

Prime Rate

-Rate of interest banks charge on short-term loans to their best customers -Each bank sets its own prime rate, w/ larger banks generally setting the rate that other banks follow -banks LOWER the prime rate when Fed eases the money supply -banks RAISE the prime rate when Fed contracts the money supply

Changes in the discount rate (Fed tool 2)

-The rate that the Fed charges member banks when lending them money -Higher rates= discourage borrowing -lower rates= encourage borrowing

tools of the Federal Reserve Board to affect money supply (3)

1. Changes in reserve requirements 2. Changes in the discount rate 3. Open-market operations

Causes of inflation

1. Excessive Demand 2. Monetary expansion (rapid increase in money stock that are in excess to the growth rate)

Causes of Deflation

1. when demand for goods is substantially below the supply, prices drift downward to encourage increased demand 2. severe shrinkage in money supply

Final approval of the annual operating budget for the United States is given by A) the Congress B) the Conference of Governors C) the Cabinet D) the president

A

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

A 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 curve.

Bottom-up analysis

A type of fundamental analysis involving a look at a particular company than move to the overall economy. micro to macro

Top Down Analysis

A type of fundamental analysis starting with overall economic trends and then moving down to industry sectors and particular companies macro to micro

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

B 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.

A free trade agreement is entered into between Country A and Country B. As time goes on, the value of Country A's currency decreases while that of Country B increases. The effect of this will likely be that A) Country A's imports from Country B will increase B) the free trade agreement will be abrogated C) Country B's imports from Country A will increase D) Country A's exports to Country B will decrease

C As a country's currency decreases in value, its exports become less expensive so they will rise. On the other hand, with a weaker currency, the country's citizens will have less buying power, and this will cause imports to decrease.

Core inflation is best described as an inflation rate A. for producer's raw materials B. the central bank views as acceptable C. that excludes certain volatile goods prices D. that represents a market basket of consumer items

C core inflation is measured using price index that excludes food and energy prices

Consumer Price Index (CPI)

Measure of general retail price level -Compares the current price of goods to what it has been in the past to get an indication of changes in cost of living -Most commonly used measurement of the rate of inflation

Classical & Supply-Side Economics

Classical economists: favor supply side economics and believe that LOWER taxes and LESS government regulation benefits consumers through a greater supply of goods and services at lower costs Supply Side Economics: supply creates demand by providing jobs and wages -Prices of goods of which there is excess supply will fall, and price of goods in demand will rise

Yield Spread

Compare the difference between yields on bonds with the same maturity but have different quality ratings to get a sense of the market -A common measurement is measuring the difference in yields between Treasuries and corporate bonds -Yield spread widens when recession is expected -Yield spread narrows when expansion is expected

Which of the following would probably NOT be an attractive investment during periods of rising inflation? A) Real estate B) Oil stocks C) Gold D) Corporate bonds

D Interest rates tend to increase with inflation. Rising interest rates cause the values of all fixed-income securities to decline. That is why bonds are not an attractive investment during periods of inflation. Values of real estate, gold, and natural resources tend to rise with inflation.

Difference between the Fed discount rate and the Fed funds rate

DISCOUNT RATE -Fed establishes this -a managed rate FEDERAL FUNDS RATE -market rate -determined by the demand for bank reserves

Inflation

General increase in prices measured by an index -Mild inflation= encourages economic growth because gradually increasing prices tend to stimulate business investments -High inflation= reduces a dollar's buying power, which can reduce demand for goods

Keynesian Economics

His strategy for recovery from a recession was for government to run deficits to stimulate demand and employment -LOWER levels of taxation -MORE government spending

If the U.S. dollar has fallen relative to foreign currencies, which of the following statements are TRUE? I. U.S. exports are likely to rise. II. U.S. exports are likely to fall. III. Foreign currencies buy fewer U.S. dollars. IV. Foreign currencies buy more U.S. dollars.

I and III

If the U.S. dollar is devalued relative to other world currencies, which of the following will occur with respect to the prices of goods? I. U.S. exports will be more price-competitive overseas. II. U.S. exports will be less price-competitive overseas. III. Foreign imported goods will be more price-competitive with ours. IV. Foreign imported goods will be less price-competitive with ours.

I and IV

Growth industries

Industry is in growth stage when they are growing faster than the economy as a whole -social media

Interest rates and bond prices

Inverse relationship -When interest rates are down, bond prices are up -vice versa

Federal Funds Rate

Rate that banks charge each other for overnight loans of $1 million or greater -very volatile

Inflation Inertia

The concept that the rate of inflation does not immediately react to unexpected changes in economic conditions. Rather, it takes a pronounced change in the reality before there is an effect. -lags behind for several quarters before there is an effect

countercyclical industries

Turn down as economy heats up and rise when economy turns down -gold mining

cyclical industries

industries with above-average sensitivity to the state of the economy -heavy machinery and automobiles

Balance of Trade

the difference between a country's total exports and total imports -Trade Deficit= imports > exports Over time, excessive deficit leads to the devaluation of a country's currency b/c the country will be converting or selling its currency to obtain foreign currency to pay for its increasing imports -when debits > credits = deficit -Trade Surplus= imports < exports Over time, excessive surplus leads to the strengthening of a country's currency -when credits > debits = surplus

GDP (Gross Domestic Product)

the total market value of all final goods and services produced annually in an economy -When GDP is negative, sign of deflation

Defensive Industries

those that are least affected by the stage of the business cycle and include things such as food, pharmaceuticals, tobacco, and energy -stocks in defensive industries decline less during recessions -However, with the less risk comes less reward