Analysis - Basic Tax Rules: Economic Analysis

During prolonged periods of economic expansion all of the following will occur EXCEPT: A. interest rates can be expected to rise B. the Federal Reserve will begin to tighten credit C. inflationary pressures will decrease D. business activity will increase

C. inflationary pressures will decrease (During prolonged periods of economic expansion, business activity is increasing, also increasing inflationary pressures. To stop inflation from accelerating, the Federal Reserve begins to tighten credit, raising interest rates to keep the economy from growing too fast.)

Fiscal policy is set by: A. Supreme Court decisions B. Congressional action C. Presidential edict D. Federal Reserve action

B. Congressional Action (Fiscal policy is set by Congress. Fiscal policy encompasses the tax code, government transfer payment levels, and government spending.)

Which economic theory postulates that production and economic growth are stimulated by lower interest rate levels, and can be managed by Federal Reserve actions? A. Supply Side Theory B. Monetarist Theory C. Keynesian Theory D. Demand Side Theory

B. 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.)

Which of the following is a lagging economic indicator? A. Index of Industrial Production B. Reported corporate profits C. Standard and Poor's 500 Index D. New consumer goods orders

B. Reported corporate profits (Reported corporate profits are a lagging indicator because they show activity for the prior quarter. The index of industrial production is a coincident indicator, showing output levels at that time. Both new consumer goods orders and the Standard and Poor's 500 Index are leading indicators.)

The economic theory that postulates that production and economic growth are stimulated by increased government spending and transfer payments is: A. Supply Side Theory B. Monetarist Theory C. Keynesian Theory D. Demand Side Theory

C. Keynesian Theory ( 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.)

The use of which tool of the Federal Reserve has the biggest impact on money supply levels? A. Open market operations B. Discount rate C. Reserve requirements D. Margin on securities

C. 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.

Inflation has been running at the annualized rate of 5%. You have just received a distribution from a mutual fund investment that has increased by 5%. Your purchasing power has: A. increased B. decreased C. stayed the same D. become more variable

C. Stayed the same ( If inflation is running at 5%; and that individual's income has risen by 5%; then that individual's purchasing power has stayed the same. Yes, the individual is earning 5% more, but it costs 5% more to live, so that individual's economic status has not improved (nor has it gotten worse).

Which tool would be used by the Federal Reserve to control inflation? A. Adjusting tax rates B. Adjusting the level of government spending C. Adjusting the balance of payments D. Adjusting the discount rate

D. Adjusting the discount rate (Fiscal policy is set by Congress. It includes setting the level of government spending, setting tax rates, and setting the level of transfer payments such as social security payments. The balance of payments (level of imports versus the level of exports) is also influenced by fiscal policy. The Federal Reserve sets monetary policy. Tools of the Fed include setting reserve requirements, open market operations, setting the discount rate, and setting margin rates. 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.)

Which of the following is a leading economic indicator? A. Personal Income B. Employment Duration C. Labor Cost Per Manufactured Unit D. Contracts for plant and equipment

D. Contracts for plant and equipment (Contracts for plant and equipment are a leading indicator, since these must be built or produced over the coming months. Personal income levels is a coincident indicator, showing current earnings for consumers. Both employment duration (how long the average person worked before being terminated) and labor cost per manufactured unit are lagging indicators, since they show what has already happened.)

Monetary policy is set by: A. Supreme Court decisions B. Congressional action C. Presidential edict D. Federal Reserve action

D. 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.)

The broadest monetary measure is: A. M-1 B. M-2 C. M-3 D. L

D. L (The measures of the money supply are: M-1 includes currency in circulation and demand deposits. M-2 includes M-1 plus time deposits of $100,000 or less. M-3 includes M-2 plus time deposits over $100,000. L is M-3 plus savings bonds and money market instruments, and is the broadest money supply measure. (Note that the Federal Reserve no longer computes M-3 or L, but these may still be tested.)

Fiscal policy encompasses all of the following EXCEPT: A. government spending B. social security payment levels C. tax policy D. monetary policy

D. Monetary policy (Fiscal policy is set through Government Actions (approved by Congress) that influence economic activity. Fiscal policy encompasses the tax code, government transfer payment levels, and government spending. Monetary policy is controlled by the Federal Reserve Board.)

The interest rate charged from commercial banks to their best customers is the: A. Discount Rate B. Federal Funds Rate C. Broker Loan Rate D. Prime Rate

D. 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.)

Which of the following interest rates is the highest? A. Discount Rate B. Federal Funds Rate C. Broker Loan Rate D. Prime Rate

D. 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 a period of inflation, the Federal Reserve would increase the: A. prime rate B. broker loan rate C. call loan rate D. discount rate

D. discount rate (If the Fed is worried about inflation and an economy that is expanding too rapidly, it needs to reduce the available money supply and reduce the level of loans being made. To do this, it could increase the Discount Rate, which is the rate at which the Fed lends directly to member banks at its "discount window." The prime rate is the rate at which banks lend to their best customers. The broker loan rate is the rate at which brokers lend to their clients using margin securities as collateral. Another name for this is a "call loan," because the loan can be called at any time.)

An increasing 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

I and III (An increasing index indicates that consumers are "confident," and thus are likely to spend money - resulting in increased future output. Conversely, if the index is falling, then consumer confidence is low and future spending will be reduced.)

In a period of deflation, which of the following statements about issuers of fixed income securities are TRUE? I Issuers are more likely to sell fixed income securities II Issuers are less likely to sell fixed income securities III Issuers are likely to sell non-callable issues IV Issuers are likely to sell callable issue

I and III (In a deflationary period, prices fall. Therefore, money buys "more" in real terms. As deflation occurs, interest rates will drop, causing long term debt prices to rise. Because interest rates will be lower, issuers are more likely to sell fixed income securities - it costs them less to finance. Issuers are likely to sell non-callable issues because interest rates are low, and there is no need to call in such issues when the financing rates are so favorable. Callable issues are generally sold in periods of high interest rates, so the issuer can call in the securities if interest rates fall subsequently.)

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.)

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 deflationary period, which of the following statements are TRUE? I Equity securities are a defensive investment II Equity securities are not a defensive investment III Fixed income securities are a defensive investment IV Fixed income securities are not a defensive investment

II and III (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. Equity securities' price movements will depend on the state of the economy at the time deflation occurs, and thus would not be defensive during deflationary periods.)

Which of the following statements are TRUE about the Federal Funds rate? I The Federal Funds rate is set by the Federal Reserve and is the rate at which member banks can borrow reserves from the Fed II Federal Reserve actions taken by the FOMC will influence the Federal Funds rate III The Federal Funds Rate is lower than the discount rate IV The "Effective" Federal Funds rate is the daily compounded rate of interest paid by borrowers

II and III only (The Federal Funds Rate is set by member banks, and is the rate on overnight loans of reserves from member to member. FOMC (Federal Open Market Committee) actions influence the Fed Funds Rate. If the FOMC directs the Federal Reserve trading desk to loosen credit, the trading desk will engage in repo's with banks, injecting reserves into the banking system. This should lower the Fed Funds Rate between banks since there are more reserves available. If the FOMC directs the Federal Reserve trading desk to tighten credit, the trading desk will engage in reverse repo's with banks, draining reserves from the banking system. This should raise the Fed Funds Rate between banks, since there are less reserves available. The Fed Funds Rate will be lower than the discount rate. Members of the Federal Reserve system can borrow from the Fed itself at the discount rate. The "effective" Federal Funds Rate is the average rate charged by selected banks across the country on a given day.)

If the rate of inflation as measured by the Consumer Price Index rises greatly, then which of the following is likely to happen? I Interest rates will fall II Interest rates will rise III Stocks become a more attractive investment IV Money market instruments become a more attractive investment

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.)

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

II and IV (If inventory levels are increasing, this is a sign that demand is falling off (more inventory is still on the shelves, not being sold), and therefore, economic conditions are deteriorating.)

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.)

What can the Federal Reserve do to stimulate the economy? A. Buy Treasury securities from banks B. Sell Treasury securities to banks C. Increase the reserve requirement D. Increase the margin requirement

A. Buy treasury securities from banks (If the Federal Reserve buys Treasury securities from banks, it is giving the banks cash to lend out. This will reduce interest rates, making borrowing more attractive and will stimulate growth. If the Federal Reserve sells Treasury securities to the banks, this drains cash out of the banks, which gives banks less money to lend, increasing interest rates and restraining growth. An increase in the reserve requirement makes banks keep a larger portion of each deposit in reserve, reducing the amount they can lend. An increase in the margin requirement will reduce the amount that can be borrowed when securities are used as collateral.)

If a country is exporting more, then than country's: A. GDP is increasing B. GDP is decreasing C. Inflation rate is increasing D. Inflation rate is decreasing

A. GDP is Increasing (GDP is Gross Domestic Product - the sum of all goods and services produced within a country. If a country exports more, it is producing more within that country and GDP increases. If a country imports more, it is producing less within that country and GDP decreases.)

Open market operations of the Federal Reserve Board cause direct changes in: A. M1 levels B. velocity of money C. dollar exchange rate D. short term interest rates

A. M1 Levels (Open market operations of the Federal Reserve Board are used to inject monetary reserves into banks via repurchase agreements or to drain monetary reserves from banks via reverse-repurchase agreements. Thus, open market operations cause direct changes in money supply levels. (M1 is the money supply measure that includes all currency in circulation and demand deposits). As the money supply expands or contracts, this influences interest rate levels in the economy, which can also influence the dollar exchange rate (the higher the level of interest rates, the higher the dollar). The velocity of money is not affected by open market operations. Velocity is affected mainly by bank clearing times for deposits.)

Which tool of the Federal Reserve is used most frequently? A. Open market operations B. Discount rate C. Reserve requirements D. Margin on securities

A. 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.)

What is subtracted to find the real interest rate? A. The inflation rate B. The deflation rate C. The discount rate D. The prime rate

A. The inflation rate ( The "real interest rate" is the nominal YTM of that security minus the inflation rate. So, if a 30-year T-Bond is yielding 3.50%, and the inflation rate is 1%, then the "real" interest rate on that security is 2.50%. It is the yield that is being earned, once inflation is stripped out of the equation.)

The Federal Reserve will lend funds at the discount rate to: A. savings and loans B. commercial banks C. investment banks D. insurance companies

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

The term "hawkish" monetary policy means that: A. the Federal Reserve is loosening credit by lowering interest rates B. the Federal Reserve is tightening credit by raising interest rates C. Congress is stimulating economic growth by increasing government spending D. Congress is curbing economic growth by decreasing government spending

B. the Federal Reserve is tightening credit by raising interest rates (If the Fed is worried about inflation and an economy that is expanding too rapidly, it needs to reduce the available money supply and reduce the level of loans being made. To do this, it would raise interest rates. This is commonly known as the Fed taking a "hawkish" tone - which comes from Federal Reserve leaders being "inflation hawks" on the watch-out for inflation, and raising rates to keep it in check. In contrast, if the Fed is taking a "dovish tone," then Fed policy makers are taking a looser monetary policy, keeping rates low to fuel growth.)

Gross Domestic Product (GDP) consists of all of the following EXCEPT: A. Consumer spending B. U.S. Government spending C. Foreign Government spending D. Fixed investment

C. 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.)

Which is considered to be a coincident economic indicator? A. Stock market prices B. Corporate profits C. Index of industrial production D. Orders for machinery

C. Index of industrial production ( Stock market prices are a leading indicator - as stock prices rise, people feel richer and will spend more; corporate profits show what happened in the preceding quarter so they are a lagging indicator; orders for machinery show production to come and are a leading indicator; the index of industrial production shows current production levels and is a coincident indicator.)

During which phase of the economic cycle would one most likely find monetary "deflation" starting to occur? A. Expansion B. Prosperity C. Recession D. Recovery

C. 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.)

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.)

Under Supply Side Theory, which of the following will stimulate the economy? I Increased government spending II Decreased government spending III Tax rate increases IV Tax rate reductions

II and IV (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.)

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.)