Chapter 1 Why Study Money, Banking, and Financial Markets?

1.1 Why Study Financial Markets?

1) Financial markets promote economic efficiency by channeling funds from savers to investors.
2) Financial markets promote greater economic efficiency by channeling funds from savers to borrowers
3) Well-functioning financial markets promote growth
4) A key factor in producing high economic growth is well-functioning financial markets.
5) Markets in which funds are transferred from those who have excess funds available to those who have a shortage of available funds
are called financial markets.
6) Financial markets transfer funds from people who have an excess of available funds to people who have a shortage.
7) Poorly performing financial markets can be the cause of poverty.
8) The bond markets are important because they are the markets where interest rates are determined.
9) The price paid for the rental of borrowed funds (usually expressed as a percentage of the rental of $100 per year) is commonly
referred to as the interest rate.
10) Compared to interest rates on long-term U.S. government bonds, interest rates on three-month Treasury bills fluctuate more and
are lower on average.
11) The interest rate on Baa (medium quality) corporate bonds is higher, on average, than other interest rates, and the spread between
it and other rates became larger in the 1970s.
12) Everything else held constant, a decline in interest rates will cause spending on housing to rise.
13) High interest rates might disencourage purchasing a house or car but at the same time high interest rates might encourage saving.
14) An increase in interest rates might encourage saving because more can be earned in interest income.
15) Everything else held constant, an increase in interest rates on student loans increases the cost of a college education.
16) High interest rates might cause a corporation to postpone building a new plant that would provide more jobs.
17) The stock market is important because it is the most widely followed financial market in the United States.
18) Stock prices are extremely volatile.
19) A rising stock market index due to higher share prices increases peopleʹs wealth and as a result may increase their willingness
to spend.
20) When stock prices fall an individualʹs wealth may decrease and their willingness to spend may decrease.
21) Changes in stock prices affect firmsʹ decisions to sell stock to finance investment spending.
23) Low stock market prices might decrease consumers willingness to spend and might decrease businesses willingness to undertake
investment projects.
24) Fear of a major recession causes stock prices to fall, everything else held constant, which in turn causes consumer spending to
decrease.
25) A share of common stock is a claim on a corporationʹs earnings and assets.
26) On ʺBlack Mondayʺ October 19, 1987, the market experienced its worst one-day drop in its entire history with the DIJA falling
by more than 500 points.
27) The decline in stock prices from 2000 through 2002 reduced individualsʹ willingness to spend.
28) The Dow reached a peak of over 11,000 before the collapse of the high-tech bubble in 2000.
29) What is a stock? How do stocks affect the economy?
Answer: A stock represents a share of ownership of a corporation, or a claim on a firmʹs earnings/assets. Stocks are part of
wealth, and changes in their value affect peopleʹs willingness to spend. Changes in stock prices affect a firmʹs ability to raise
funds, and thus their investment.
30) Why is it important to understand the bond market?
Answer: The bond market supports economic activity by enabling the government and corporations to borrow to undertake
their projects and it is the market where interest rates are determined.
1.2 Why Study Financial Institutions and Banking?
1) Channeling funds from individuals with surplus funds to those desiring funds when the saver does not purchase the borrowerʹs
security is known as financial intermediation.
2) A financial crisis is a major disruption in the financial markets.
3) Banks are important to the study of money and the economy because they have been a source of rapid financial innovation.
4) Financial intermediaries provide a channel for linking those who want to save with those who want to invest.
5) Banks, savings and loan associations, mutual savings banks, and credit unions have been adept at innovating in response to
changes in the regulatory environment.
6) Financial institutions search for higher profits has resulted in many financial innovations.
7) Banks and other financial institutions engage in financial intermediation, which can benefit economic performance.
8) Financial institutions that accept deposits and make loans are called banks.
9) The financial intermediaries that the average person interacts with most frequently are banks
10) Which of the following is not a financial institution?
A) a life insurance company C) a credit union
B) a pension fund D) a business college
11) The delivery of financial services electronically is called e-finance
12) What crucial role do financial intermediaries perform in an economy?
Answer: Financial intermediaries borrow funds from people who have saved and make loans to other individuals and businesses and
thus improve the efficiency of the economy.
1.3 Why Study Money and Monetary Policy?
1) Money is defined as anything that is generally accepted in payment for goods and services or in the repayment of debt.
2) The upward and downward movement of aggregate output produced in the economy is referred to as the business cycle
3) Sustained downward movements in the business cycle are referred to as recessions.
4) During a recession, output declines resulting in higher unemployment in the economy.
5) Prior to all recessions since 1900, there has been a drop in the growth rate of the money stock.
6) Evidence from business cycle fluctuations in the United States indicates that recessions have been preceded by a decline in the
growth rate of money.
7) Monetary theory relates changes in the quantity of money to changes in aggregate economic activity and the price level.
8) A sharp increase in the growth of the money supply is likely followed by an increase in the inflation rate.
9) It is true that inflation is a continually rising price level.
10) Which of the following is a true statement?
A) Money or the money supply is defined as Federal Reserve notes.
B) The average price of goods and services in an economy is called the aggregate price level.
C) The inflation rate is measured as the rate of change in the federal government budget deficit.
D) The aggregate price level is measured as the rate of change in the inflation rate.
11) If ten years ago the prices of the items bought last month by the average consumer would have been much higher, then one can
likely conclude that the aggregate price level has declined during this ten-year period.
12) From 1950-2008 the price level in the United States increased more than sixfold
13) Complete Milton Friedmanʹs famous statement, ʺInflation is always and everywhere a monetary phenomenon.ʺ
14) There is a positive; association between inflation and the growth rate of money supply
15) Evidence from the United States and other foreign countries indicates that there is a strong positive association between
inflation and growth rate of money over long periods of time.
16) Countries that experience very high rates of inflation may also have rapidly growing money supplies.
17) Between 1950 and 1980 in the U.S., interest rates trended upward. During this same time period, the rate of money growth
increased.
18) The management of money and interest rates is called monetary policy and is conducted by a nationʹs central bank.
19) The organization responsible for the conduct of monetary policy in the United States is the Federal Reserve System.
20) Fiscal policy involves decisions about government spending and taxation.
21) When tax revenues are greater than government expenditures, the government has a budget surplus
22) A budget deficit occurs when government expenditures exceed tax revenues for a particular time period.
23) Budgets deficits can be a concern because they might ultimately lead to higher inflation.
24) Budget deficits are important because deficits can result in higher rates of monetary growth.
25) What happens to economic growth and unemployment during a business cycle recession? What is the relationship between the
money growth rate and a business cycle recession?
Answer: During a recession, output declines and unemployment increases. Prior to every recession in the U.S. the money
growth rate has declined, however, not every decline is followed by a recession.
1.4 Why Study International Finance?
1) American companies can borrow funds in both U.S. and foreign financial markets.
2) The price of one countryʹs currency in terms of another countryʹs currency is called the exchange rate.
3) The market where one currency is converted into another currency is called the foreign exchange market.
4) Everything else constant, a stronger dollar will mean that vacationing in England becomes less expensive.
5) Which of the following is most likely to result from a stronger dollar? C) U.S. goods exported abroad will cost more in foreign
countries, and so foreigners will buy fewer of them.
6) Everything else held constant, a weaker dollar will likely hurt furniture importers in California.
7) Everything else held constant, a stronger dollar benefits American consumers and hurts American businesses.
8) From 1980 to early 1985 the dollar appreciated in value, thereby benefiting American consumers
9) From 1980 to 1985 the dollar appreciated relative to the British pound. Holding everything else
constant, one would expect that, when compared to 1980, fewer Britons traveled to the United States in 1985.
10) When in 1985 a British pound cost approximately $1.30, a Shetland sweater that cost 100 British pounds would have cost $130.
With a weaker dollar, the same Shetland sweater would have Cost more than $130.
11) Everything else held constant, a decrease in the value of the dollar relative to all foreign currencies means that the price of foreign
goods purchased by Americans increases.
12) American farmers who sell beef to Europe benefit most from an increase in the dollar price of euros.
13) If the price of a euro (the European currency) increases from $1.00 to $1.10, then, everything else held constant, a European
vacation becomes more expensive.
14) Everything else held constant, Americans who love French wine benefit most from a decrease in the dollar price of euros.
15) From 1980-1985, the dollar strengthened in value against other currencies. Who was helped and who was hurt by this strong
dollar? Answer: American consumers benefitted because imports were cheaper and consumers could purchase more.
American businesses and workers in those businesses were hurt as domestic and foreign sales of American products fell.
1.5 Appendix: Defining Aggregate Output, Income, the Price Level, and the Inflation Rate
1) The most comprehensive measure of aggregate output is gross domestic product.
2) The gross domestic product is the the market value of all final goods and services produced in an economy in a year.
3) Which of the following items are not counted in U.S. GDP? C) GMʹs purchase of tires for new cars
4) If an economy has aggregate output of $20 trillion, then aggregate income is $20 trillion.
5) When the total value of final goods and services is calculated using current prices, the resulting measure is referred nominal GDP.
6) Nominal GDP is output measured in current prices while real GDP is output measured in fixed prices.
7) GDP measured with constant prices is referred to as real GDP.
8) If your nominal income in 2002 was $50,000, and prices doubled between 2002 and 2008, to have the same real income, your
nominal income in 2008 must be $100,000.
9) If your nominal income in 1998 is $50,000, and prices increase by 50% between 1998 and 2008, then to have the same real income,
your nominal income in 2008 must be $75,000.
10) To convert a nominal GDP to a real GDP, you would use the GDP deflator.
11) If nominal GDP in 2001 is $9 trillion, and 2001 real GDP in 1996 prices is $6 trillion, the GDP deflator price index is 150.
12) When prices are measured in terms of fixed (base-year) prices they are called real prices.
13) The measure of the aggregate price level that is most frequently reported in the media is the consumer price index
14) To calculate the growth rate of a variable, you will calculate the percentage change from one time period to the next.
15) If real GDP grows from $10 trillion in 2002 to $10.5 trillion in 2003, the growth rate for real GDP is 5%
16) If real GDP in 2002 is $10 trillion, and in 2003 real GDP is $9.5 trillion, then real GDP growth from 2002 to 2003 is -5%
17) If the aggregate price level at time t is denoted by Pt, the inflation rate from time t - 1 to t is defined as πt = (Pt - Pt - 1)/Pt - 1.
18) If the price level increases from 200 in year 1 to 220 in year 2, the rate of inflation from year 1 to year 2 is 10%
19) If the CPI is 120 in 1996 and 180 in 2002, then between 1996 and 2002, prices have increased by 50%
20) If the CPI in 2004 is 200, and in 2005 the CPI is 180, the rate of inflation from 2004 to 2005 is -10%
CHAPTER 2 AN OVERVIEW OF THE FINANCIAL SYSTEM
2.1 Function of Financial Markets
1) Every financial market has the following characteristic: It channels funds from lenders-savers to borrowers-spenders.
2) Financial markets have the basic function of getting people with funds to lend together with people who want to borrow funds.
3) Financial markets improve economic welfare because they allow consumers to time their purchase better.
4) Well-functioning financial markets produce an efficient allocation of capital.
5) A breakdown of financial markets can result in political instability.
6) The principal lender-savers are households.
7) Which of the following can be described as direct finance?
A) You take out a mortgage from your local bank.
B) You borrow $2500 from a friend.
C) You buy shares of common stock in the secondary market.
D) You buy shares in a mutual fund.
8) Assume that you borrow $2000 at 10%3nual interest to finance a new business project. For this loan to be profitable, the minimum
amount this project must generate in annual earnings is $201.
9) You can borrow $5000 to finance a new business venture. This new venture will generate annual earnings of $251. The maximum
interest rate that you would pay on the borrowed funds and still increase your income is 5%.
10) Which of the following can be described as involving direct finance?
A) A corporation issues new shares of stock.
B) People buy shares in a mutual fund.
C) A pension fund manager buys a short-term corporate security in the secondary market.
D) An insurance company buys shares of common stock in the over-the-counter markets.
11) Which of the following can be described as involving direct finance?
A) A corporation takes out loans from a bank.
B) People buy shares in a mutual fund.
C) A corporation buys a short-term corporate security in a secondary market.
D) People buy shares of common stock in the primary markets.
12) Which of the following can be described as involving indirect finance?
A) You make a loan to your neighbor.
B) A corporation buys a share of common stock issued by another corporation in the primary market.
C) You buy a U.S. Treasury bill from the U.S. Treasury.
D) You make a deposit at a bank.
13) Which of the following can be described as involving indirect finance?
A) You make a loan to your neighbor.
 B) You buy shares in a mutual fund.
C) You buy a U.S. Treasury bill from the U.S. Treasury.
D) A corporation buys a short-term security issued by another corporation in the primary market.
14) Securities are assets; for the person who buys them, but are liabilities for the individual or firm that issues them.
15) With direct finance, borrowers obtain funds from lenders by selling them securities in the financial markets.
16) With direct finance funds are channeled through the financial market from the savers, directly to the spenders
17) Distinguish between direct finance and indirect finance. Which of these is the most important source of funds for corporations in
the United States?
Answer: With direct finance, funds flow directly from the lender/saver to the borrower. With indirect finance, funds flow
from the lender/saver to a financial intermediary who then channels the funds to the borrower/investor. Financial
intermediaries (indirect finance) are the major source of funds for corporations in the U.S.
2.2 Structure of Financial Markets
1) Which of the following statements about the characteristics of debt and equity is false?
A) They can both be long-term financial instruments.
B) They can both be short-term financial instruments.
C) They both involve a claim on the issuerʹs income.
D) They both enable a corporation to raise funds.
2) Which of the following statements about the characteristics of debt and equities is true?
A) They can both be long-term financial instruments.
B) Bond holders are residual claimants.
C) The income from bonds is typically more variable than that from equities.
D) Bonds pay dividends.
3) Which of the following statements about financial markets and securities is true?
A) A bond is a long-term security that promises to make periodic payments called dividends to the firmʹs residual claimants.
B) A debt instrument is intermediate term if its maturity is less than one year.
C) A debt instrument is intermediate term if its maturity is ten years or longer.
D) The maturity of a debt instrument is the number of years (term) to that instrumentʹs expiration date.
4) Which of the following is an example of an intermediate-term debt?
A) A thirty-year mortgage. C) A six month loan from a finance company.
B) A sixty-month car loan. D) A Treasury bond.
5) If the maturity of a debt instrument is less than one year, the debt is called short-term
6) Long-term debt has a maturity that is ten years or longer.
7) When I purchase stock, I own a portion of a firm and have the right to vote on issues important to the firm and to elect its directors.
8) Equity holders are a corporationʹs residual claimants. That means the corporation must pay all of its debt holders before it pays its
equity holders.
9) Which of the following benefit directly from any increase in the corporationʹs profitability?
A) a bond holder C) a shareholder
B) a commercial paper holder D) a T-bill holder
10) A financial market in which previously issued securities can be resold is called a secondary market.
11) An important financial institution that assists in the initial sale of securities in the primary market is the investment bank.
12) When an investment bank underwrites securities, it guarantees a price for a corporationʹs securities and then sells them to the
public.
13) Which of the following is not a secondary market?
A) foreign exchange market C) options market
B) futures market D) IPO market
14) Brokers work in the secondary markets matching buyers with sellers of securities.
15) A corporation acquires new funds only when its securities are sold in the primary market by an investment bank.
16) A corporation acquires new funds only when its securities are sold in the primary market by an investment bank.
17) An important function of secondary markets is to make it easier to sell financial instruments to raise funds.
18) Secondary markets make financial instruments more liquid.
19) A liquid asset is an asset that can easily and quickly be sold to raise cash.
20) The higher a securityʹs price in the secondary market the more funds a firm can raise by selling securities in the primary market.
21) When secondary market buyers and sellers of securities meet in one central location to conduct trades the market is called a(n)
exchange.
22) Forty or so dealers establish a ʺmarketʺ in these securities by standing ready to buy and sell them.
A) Secondary stocks C) U.S. government bonds
B) Surplus stocks D) Common stocks
23) Which of the following statements about financial markets and securities is true?
A) Many common stocks are traded over-the-counter, although the largest corporations usually have their shares
traded at organized stock exchanges such as the New York Stock Exchange.
B) As a corporation gets a share of the brokerʹs commission, a corporation acquires new funds whenever its securities are
 sold.
C) Capital market securities are usually more widely traded than shorter-term securities and so tend to be more liquid.
D) Because of their short-terms to maturity, the prices of money market instruments tend to fluctuate wildly.
24) A financial market in which only short-term debt instruments are traded is called the money market.
25) Equity instruments are traded in the capital market.
26) Corporations receive funds when their stock is sold in the primary market. Why do corporations pay attention to what is happening
to their stock in the secondary market?
Answer: The existence of the secondary market makes their stock more liquid and the price in the secondary market sets the
price that the corporation would receive if they choose to sell more stock in the primary market.
27) Describe the two methods of organizing a secondary market.
Answer: A secondary market can be organized as an exchange where buyers and sellers meet in one central location to
conduct trades. An example of an exchange is the New York Stock Exchange. A secondary market can also be organized as an
over-the-counter market. In this type of market, dealers in different locations buy and sell securities to anyone who comes to
them and is willing to accept their prices. An example of an over-the-counter market is the federal funds market.
2.3 Financial Market Instruments
1) Prices of money market instruments undergo the least price fluctuations because of the short terms to maturity for the securities.
2) U.S. Treasury bills pay no interest but are sold at a discount. That is, you will pay a lower purchase price than the amount you
receive at maturity.
3) U.S. Treasury bills are considered the safest of all money market instruments because there is no risk of default.
4) A debt instrument sold by a bank to its depositors that pays annual interest of a given amount and at maturity pays back the original
purchase price is called a negotiable certificate of deposit.
5) A short-term debt instrument issued by well-known corporations is called commercial paper.
6) Repurchase agreements are short-term loans in which Treasury bills serve as collateral.
7) Collateral is an asset the lender receives if the borrower does not pay back the loan.
8) Federal funds are loans made by banks to each other.
9) The British Bankerʹs Association average of interbank rates for dollar deposits in the London market is called the Libor rate.
10) Which of the following are short-term financial instruments?
A) A repurchase agreement. C) A Treasury note with a maturity of four years.
B) A share of Walt Disney Corporation stock. D) A residential mortgage.
11) Which of the following instruments are traded in a money market?
A) State and local government bonds. C) Corporate bonds.
B) U.S. Treasury bills. D) U.S. government agency securities.
12) Which of the following instruments are traded in a money market?
A) Bank commercial loans. C) State and local government bonds.
B) Commercial paper. D) Residential mortgage
13) Which of the following instruments is not traded in a money market?
A) Residential mortgages. C) Negotiable bank certificates of deposit.
B) U.S. Treasury Bills. D) Commercial paper.
14) Bonds issued by state and local governments are called municipal bonds.
15) Equity and debt instruments with maturities greater than one year are called capital market instruments.
16) Which of the following is a long-term financial instrument?
A) A negotiable certificate of deposit. C) A U.S. Treasury bond.
B) A repurchase agreement. D) A U.S. Treasury bill.
17) Which of the following instruments are traded in a capital market?
A) U.S. Government agency securities. C) Repurchase agreements.
B) Negotiable bank CDs. D) U.S. Treasury bills.
18) Which of the following instruments are traded in a capital market?
A) Corporate bonds. C) Negotiable bank CDs.
B) U.S. Treasury bills. D) Repurchase agreements.
19) Which of the following are not traded in a capital market?
A) U.S. government agency securities. C) Repurchase agreements.
B) State and local government bonds. D) Corporate bonds
2.4 Internationalization of Financial Markets
1) Equity of U.S. companies can be purchased by U.S. citizens and foreign citizens.
2) One reason for the extraordinary growth of foreign financial markets is increases in the pool of savings in foreign countries
3) Bonds that are sold in a foreign country and are denominated in the countryʹs currency in which they are sold are known as foreign
bonds.
4) Bonds that are sold in a foreign country and are denominated in a currency other than that of the country in which it is sold are
known as Eurobonds
5) If Microsoft sells a bond in London and it is denominated in dollars, the bond is a Eurobonds.
6) U.S. dollar deposits in foreign banks outside the U.S. or in foreign branches of U.S. banks are called Eurodollars
7) Distinguish between a foreign bond and a Eurobond.
Answer: A foreign bond is sold in a foreign country and priced in that countryʹs currency. A Eurobond is sold in a foreign
country and priced in a currency that is not that countryʹs currency.
2.5 Function of Financial Intermediaries: Indirect Finance
1) The process of indirect finance using financial intermediaries is called financial intermediation.
2) In the United States, loans from financial intermediaries are far more important for corporate finance than are securities markets.
3) The time and money spent in carrying out financial transactions are called transaction costs.
4) Economies of scale enable financial institutions to reduce transactions costs
5) An example of economies of scale in the provision of financial services is spreading the cost of writing a standardized contract
over many borrowers.
6) Financial intermediaries provide customers with liquidity services. Liquidity services make it easier for customers to conduct
transactions.
7) The process where financial intermediaries create and sell low-risk assets and use the proceeds to purchase riskier assets is known
as risk sharing.
8) The process of asset transformation refers to the conversion of risky assets into safer assets.
9) Reducing risk through the purchase of assets whose returns do not always move together is diversification.
10) The concept of diversification is captured by the statement donʹt put all your eggs in one basket.
11) Risk sharing is profitable for financial institutions due to low transactions costs.
12) Typically, borrowers have superior information relative to lenders about the potential returns and risks associated with an
investment project. The difference in information is called asymmetric information.
13) If bad credit risks are the ones who most actively seek loans and, therefore, receive them from financial intermediaries, then
financial intermediaries face the problem of adverse selection.
14) The problem created by asymmetric information before the transaction occurs is called adverse selection. , while the problem
created after the transaction occurs is called moral hazard
15) Adverse selection is a problem associated with equity and debt contracts arising from the lenderʹs relative lack of information
about the borrowerʹs potential returns and risks of his investment activities.
16) An example of the problem of moral hazard is when a corporation uses the funds raised from selling bonds to fund corporate
expansion to pay for Caribbean cruises for all of its employees and their families.
17) Studies of the major developed countries show that when businesses go looking for funds to finance their activities they usually
obtain these funds from financial intermediaries.
18) The countries that have made the least use of securities markets are Germany; Japan; in these two countries finance from
financial intermediaries has been almost ten times greater than that from securities markets.
19) Although the dominance of financial intermediaries over securities markets is clear in all countries, the relative importance of
bond versus stock markets differs widely.
20) Because there is an imbalance of information in a lending situation, we must deal with the problems of adverse selection and
moral hazard. Define these terms and explain how financial intermediaries can reduce these problems.
Answer: Adverse selection is the asymmetric information problem that exists before the transaction occurs. For lenders, it is
the difficulty in judging a good credit risk from a bad credit risk. Moral hazard is the asymmetric information problem that
exists after the transaction occurs. For lenders, it is the difficulty in making sure the borrower uses the funds appropriately.
Financial intermediaries can reduce adverse selection through intensive screening and can reduce moral hazard by monitoring
the borrower.
2.6 Types of Financial Intermediaries
1) Financial institutions that accept deposits and make loans are called depository institutions.
2) Thrift institutions include savings and loan associations, mutual savings banks, and credit unions.
3) Which of the following is a depository institution?
A) A life insurance company C) A pension fund
B) A credit union D) A mutual fund
4) Which of the following is a depository institution?
A) A life insurance company C) A pension fund
B) A mutual savings bank D) A finance company
5) Which of the following financial intermediaries is not a depository institution?
A) A savings and loan association C) A credit union
B) A commercial bank D) A finance company
6) The primary assets of credit unions are consumer loans.
7) The primary liabilities of a commercial bank are deposits.
8) The primary liabilities of depository institutions are deposits.
9) Contractual savings institutions are financial intermediaries that acquire funds at periodic intervals on a contractual basis.
10) Which of the following is a contractual savings institution?
A) A life insurance company B) A credit union
 C) A savings and loan association D) A mutual fund
11) Contractual savings institutions include life insurance companies.
12) Which of the following are not contractual savings institutions?
A) Life insurance companies C) Pension funds
B) Credit unions D) State and local government retirement funds
13) Which of the following is not a contractual savings institution?
A) A life insurance company C) A savings and loan association
B) A pension fund D) A fire and casualty insurance company
14) The primary assets of a pension fund are corporate bonds and stock.
15) Which of the following are investment intermediaries?
A) Life insurance companies C) Pension funds
B) Mutual funds D) State and local government retirement funds
16) An investment intermediary that lends funds to consumers is a finance company.
17) The primary assets of a finance company are consumer and business loans.
18) Mutual funds are financial intermediaries that acquire funds by selling shares to many individuals
and using the proceeds to purchase diversified portfolios of stocks and bonds.
19) Money market mutual fund shares function like checking accounts that pay interest.
20) An important feature of money market mutual fund shares is the ability to write checks against shareholdings.
21) The primary assets of money market mutual funds are money market instruments
22) An investment bank helps a corporation issue securities.
23) An investment bank purchases securities from a corporation at a predetermined price and then resells them in the market. This
process is called underwriting.
2.7 Regulation of the Financial System
1) Which of the following is not a goal of financial regulation?
A) Ensuring the soundness of the financial system C) Reducing adverse selection
B) Reducing moral hazard D) Ensuring that investors never suffer losses
2) Increasing the amount of information available to investors helps to reduce the problems of adverse selection & moral hazard in
the financial markets.
3) A goal of the Securities and Exchange Commission is to reduce problems arising from asymmetric information.
4) The purpose of the disclosure requirements of the Securities and Exchange Commission is to increase the information available
to investors.
5) Government regulations to reduce the possibility of financial panic include all of the following except transactions costs.
6) Which of the following do not provide charters?
A) The Office of the Comptroller of the Currency C) The National Credit Union Administration
B) The Federal Reserve System D) State banking and insurance commissions
7) A restriction on bank activities that was repealed in 1999 was separation of commercial banking from the securities industries.
8) In order to reduce risk and increase the safety of financial institutions, commercial banks and other depository institutions are
prohibited from owning common stock.
9) The primary purpose of deposit insurance is to prevent banking panics.
10) The agency that was created to protect depositors after the banking failures of 1930 -1933 is the Federal Deposit Insurance
Corporation.
11) Savings and loan associations are regulated by the Office of Thrift Supervision.
12) The regulatory agency that sets reserve requirements for all banks is the Federal Reserve System.
13) Asymmetric information is a universal problem. This would suggest that financial regulations in industrialized
nations are similar.
14) How do regulators help to ensure the soundness of financial intermediaries?
Answer: Regulators restrict who can set up a financial intermediary, conduct regular examinations, restrict assets, and provide
insurance to help ensure the soundness of financial intermediaries.

CHAPTER 4: UNDERSTANDING INTEREST RATES

4.1 Measuring Interest Rates
1) The concept of present value is based on the common-sense notion that a dollar paid to you in the future is less
valuable to you than a dollar today.
2) The present value of an expected future payment falls as the interest rate increases.
3) An increase in the time to the promised future payment decreases the present value of the payment.
4) With an interest rate of 6 percent, the present value of $100 next year is approximately $94
5) If a security pays $55 in one year and $133 in three years, its present value is $150 if the interest rate is 10 percent.
6) To claim that a lottery winner who is to receive $1 million per year for twenty years has won $20 million ignores the
process of discounting the future.
7) A credit market instrument that provides the borrower with an amount of funds that must be repaid at the maturity date
along with an interest payment is known as a simple loan.
8) A credit market instrument that requires the borrower to make the same payment every period until the maturity date is
known as a fixed-payment loan.
9) Which of the following are true of fixed payment loans? Installment loans and mortgages are frequently of the
fixed payment type.
10) A fully amortized loan is another name for a fixed-payment loan.
11) A credit market instrument that pays the owner a fixed coupon payment every year until the maturity date and then
repays the face value is called a coupon bond.
12) A coupon bond pays the owner a fixed coupon payment every year until the maturity date, when the face value is
repaid.
13) The face value is the final amount that will be paid to the holder of a coupon bond.
14) When talking about a coupon bond, face value and par value mean the same thing.
15) The dollar amount of the yearly coupon payment expressed as a percentage of the face value of the bond is called the
bondʹs coupon rate.
16) If a $5,000 coupon bond has a coupon rate of 13 percent, then the coupon payment every year is $650.
17) An $8,000 coupon bond with a $400 coupon payment every year has a coupon rate of 5 percent.
18) All of the following are examples of coupon bonds except U.S. Treasury bills
19) A bond that is bought at a price below its face value and the face value is repaid at a maturity date is called a discount
bond.
20) A discount bond is bought at a price below its face value, and the face value is repaid at the maturity date.
21) A discount bond pays the bondholder the face value at maturity.
22) Examples of discount bonds include U.S. Treasury bills.
23) Which of the following are true for discount bonds? The purchaser receives the face value of the bond at the
maturity date.
24) The interest rate that equates the present value of payments received from a debt instrument with its value today is the
yield to maturity.
25) Economists consider the yield to maturity. to be the most accurate measure of interest rates.
26) For simple loans, the simple interest rate is equal to the yield to maturity.
27) If the amount payable in two years is $2420 for a simple loan at 10 percent interest, the loan amount is $2000.
28) For a 3-year simple loan of $10,000 at 10 percent, the amount to be repaid is $13,310.
29) If $22,050 is the amount payable in two years for a $20,000 simple loan made today, the interest rate is 5 percent.
30) If a security pays $110 next year and $121 the year after that, what is its yield to maturity if it sells for $200? 10
percent
31) The present value of a fixed-payment loan is calculated as the sum of the present value of all cash flow payments.
32) Which of the following are true for a coupon bond? When the coupon bond is priced at its face value, the yield to
maturity equals the coupon rate.
33) The price of a coupon bond and the yield to maturity are negatively related; that is, as the yield to maturity rises, the
price of the bond falls.
34) The yield to maturity is greater than the coupon rate when the bond price is below its face value.
35) A $10,000 8 percent coupon bond that sells for $10,000 has a yield to maturity of 8 percent.
36) Which of the following $1,000 face-value securities has the highest yield to maturity?
A) A 5 percent coupon bond selling for $1,000 C) A 12 percent coupon bond selling for $1,000
B) A 10 percent coupon bond selling for D) A 12 percent coupon bond selling for $1,100
$1,000
37) Which of the following $5,000 face-value securities has the highest to maturity?
A) A 6 percent coupon bond selling for $5,000 C) A 10 percent coupon bond selling for $5,000
B) A 6 percent coupon bond selling for $5,500 D) A 12 percent coupon bond selling for $4,500
38) Which of the following $1,000 face-value securities has the highest yield to maturity?
A) A 5 percent coupon bond with a price of $600
B) A 5 percent coupon bond with a price of $800
C) A 5 percent coupon bond with a price of $1,000
D) A 5 percent coupon bond with a price of $1,200
39) Which of the following $1,000 face-value securities has the lowest yield to maturity?
A) A 5 percent coupon bond selling for $1,000
 B) A 10 percent coupon bond selling for $1,000
C) A 15 percent coupon bond selling for $1,000
D) A 15 percent coupon bond selling for $900
40) Which of the following bonds would you prefer to be buying?
A) A $10,000 face-value security with a 10 percent coupon selling for $9,000
B) A $10,000 face-value security with a 7 percent coupon selling for $10,000
C) A $10,000 face-value security with a 9 percent coupon selling for $10,000
D) A $10,000 face-value security with a 10 percent coupon selling for $10,000
41) A coupon bond that has no maturity date and no repayment of principal is called a consol.
42) The price of a consol equals the coupon payment divided by the interest rate.
43) The interest rate on a consol equals the coupon payment divided by the price.
44) A consol paying $20 annually when the interest rate is 5 percent has a price of $400.
45) If a perpetuity has a price of $500 and an annual interest payment of $25, the interest rate is 5 percent.
46) The yield to maturity for a perpetuity is a useful approximation for the yield to maturity on
long-term coupon bonds. It is called the current yield when approximating the yield for a coupon bond.
47) The yield to maturity for a one-year discount bond equals the increase in price over the year, divided by the initial
price.
48) If a $10,000 face-value discount bond maturing in one year is selling for $5,000, then its yield to maturity is 100
percent.
49) If a $5,000 face-value discount bond maturing in one year is selling for $5,000, then its yield to maturity is 0 percent.
50) A discount bond selling for $15,000 with a face value of $20,000 in one year has a yield to maturity of 33.3 percent.
51) The yield to maturity for a discount bond is negatively related to the current bond price.
52) In Japan in 1998 and in the U.S. in 2008, interest rates were negative for a short period of time because investors
found it convenient to hold six-month bills as a store of value because the bills were denominated in large amounts and
could be stored electronically.
53) If the interest rate is 5%, what is the present value of a security that pays you $1, 050 next year and $1,102.50 two
years from now? If this security sold for $2200, is the yield to maturity greater or less than 5%? Why?
PV = $1,050/(1. +.05) + $1,102.50/(1 + 0.5)2
PV = $2,000
If this security sold for $2200, the yield to maturity is less than 5%. The lower the interest rate the higher the present
value.
4.2 The Distinction Between Interest Rates and Returns
1) The rate of return is defined as the payments to the owner plus the change in a securityʹs value expressed as a fraction
of the securityʹs purchase price.
2) Which of the following are true concerning the distinction between interest rates and returns?
A) The rate of return on a bond will not necessarily equal the interest rate on that bond.
B) The return can be expressed as the difference between the current yield and the rate of capital gains.
C) The rate of return will be greater than the interest rate when the price of the bond falls between time t and time
t + 1.
D) The return can be expressed as the sum of the discount yield and the rate of capital gains.
3) The sum of the current yield and the rate of capital gain is called the rate of return.
4) What is the return on a 5 percent coupon bond that initially sells for $1,000 and sells for $1,200 next year? 25 percent
5) What is the return on a 5 percent coupon bond that initially sells for $1,000 and sells for $900 next year? -5 percent
6) The return on a 5 percent coupon bond that initially sells for $1,000 and sells for $950 next year is 0 percent.
7) Suppose you are holding a 5 percent coupon bond maturing in one year with a yield to maturity of 15 percent. If the
interest rate on one-year bonds rises from 15 percent to 20 percent over the course of the year, what is the yearly return on
the bond you are holding? 15 percent
8) If the interest rates on all bonds rise from 5 to 6 percent over the course of the year, which bond would you prefer to
have been holding? A bond with one year to maturity
9) An equal decrease in all bond interest rates increases the price of a ten-year bond more than the price of a five-year
bond.
10) An equal increase in all bond interest rates decreases long-term bond returns more than short-term bond returns.
11) Which of the following are generally true of bonds? The only bond whose return equals the initial yield to
maturity is one whose time to maturity is the same as the holding period.
12) Which of the following are generally true of all bonds?
 A) The longer a bondʹs maturity, the greater is the rate of return that occurs as a result of the increase in the
interest rate.
B) Even though a bond has a substantial initial interest rate, its return can turn out to be negative if
interest rates rise.
C) Prices and returns for short-term bonds are more volatile than those for longer term bonds.
D) A fall in interest rates results in capital losses for bonds whose terms to maturity are longer than the holding
period.
13) The riskiness of an assetʹs returns due to changes in interest rates is interest-rate risk.
14) Interest-rate risk is the riskiness of an assetʹs returns due to interest-rate changes.
15) Prices and returns for long-term bonds are more volatile than those for short-term bonds, everything else held
constant.
16) There is no interest-rate risk for any bond whose time to maturity matches the holding period.
17) Your favorite uncle advises you to purchase long-term bonds because their interest rate is 10%. Should you follow his
advice? It depends on where you think interest rates are headed in the future. If you think interest rates will be
going up, you should not follow your uncleʹs advice because you would then have to discount your bond if you
needed to sell it before the maturity date. Long-term bonds have a greater interest-rate risk.
4.3 The Distinction Between Real and Nominal Interest Rates
1) The ex ante real interest rate is adjusted for expected changes in the price level.
2) The real interest rate more accurately reflects the true cost of borrowing.
3) The nominal interest rate minus the expected rate of inflation defines the real interest rate.
4) When the real interest rate is low, there are greater incentives to borrow and fewer incentives to lend.
5) The interest rate that describes how well a lender has done in real terms after the fact is called the ex post real interest
rate.
6) The Fisher equation states that the nominal interest rate equals the real interest rate plus the expected rate of inflation.
7) If the nominal rate of interest is 2 percent, and the expected inflation rate is -10 percent, the real rate of interest is 12
percent.
8) In which of the following situations would you prefer to be the lender?
A) The interest rate is 9 percent and the expected inflation rate is 7 percent.
B) The interest rate is 4 percent and the expected inflation rate is 1 percent.
C) The interest rate is 13 percent and the expected inflation rate is 15 percent.
D) The interest rate is 25 percent and the expected inflation rate is 50 percent.
9) In which of the following situations would you prefer to be the borrower?
A) The interest rate is 9 percent and the expected inflation rate is 7 percent.
B) The interest rate is 4 percent and the expected inflation rate is 1 percent.
C) The interest rate is 13 percent and the expected inflation rate is 15 percent.
D) The interest rate is 25 percent and the expected inflation rate is 50 percent.
10) If you expect the inflation rate to be 15 percent next year and a one -year bond has a yield to maturity of 7 percent,
then the real interest rate on this bond is -8 percent.
11) If you expect the inflation rate to be 12 percent next year and a one -year bond has a yield to maturity of 7 percent,
then the real interest rate on this bond is -5 percent.
12) If you expect the inflation rate to be 4 percent next year and a one year bond has a yield to maturity of 7 percent, then
the real interest rate on this bond is 3 percent.
13) The interest rate on Treasury Inflation Protected Securities is a direct measure of the real interest rate.
14) Assuming the same coupon rate and maturity length, the difference between the yield on a Treasury Inflation
Protected Security and the yield on a nonindexed Treasury security provides insight into the expected inflation rate.
15) Assuming the same coupon rate and maturity length, when the interest rate on a Treasury Inflation Protected Security
is 3 percent, and the yield on a nonindexed Treasury bond is 8 percent, the expected rate of inflation is 5 percent.
16) Would it make sense to buy a house when mortgage rates are 14% and expected inflation is 15%? Explain your
answer. Even though the nominal rate for the mortgage appears high, the real cost of borrowing the funds is -1%.
Yes, under this circumstance it would be reasonable to make this purchase.
4.4 Web Appendix: Measuring Interest-Rate Risk: Duration
1) Duration is the average lifetime of a debt securityʹs stream of payments.
2) Comparing a discount bond and a coupon bond with the same maturity, the discount bond has the greater effective
maturity.
3) The duration of a coupon bond increases the longer is the bondʹs term to maturity.
4) All else equal, when interest rates rise, the duration of a coupon bond falls.
5) All else equal, the higher the coupon rate on a bond, the shorter the bondʹs duration.
6) If a financial institution has 50% of its portfolio in a bond with a five-year duration and 50% of its portfolio in a bond
with a seven-year duration, what is the duration of the portfolio? 6 years
7) An assetʹs interest rate risk decreases as the duration of the asset decreases.
CHAPTER 5: THE BEHAVIOR OF INTEREST RATES
5.1 Determinants of Asset Demand
1) Pieces of property that serve as a store of value are called assets.
2) Of the four factors that influence asset demand, which factor will cause the demand for all assets to increase when it
increases, everything else held constant? wealth
3) If wealth increases, the demand for stocks increases and that of long-term bonds increases, everything else holds
constant.
4) Everything else held constant, a decrease in wealth reduces the demand for silver.
5) An increase in an assetʹs expected return relative to that of an alternative asset, holding
everything else constant, increases the quantity demanded of the asset.
6) Everything else held constant, if the expected return on ABC stock rises from 5 to 10 percent and the expected return
on CBS stock is unchanged, then the expected return of holding CBS stock falls relative to ABC stock and the demand for
CBS stock falls.
7) Everything else held constant, if the expected return in the U.S. Treasury bonds fall from 10 to 5 percent and the
expected return on GE stock rises from 7 to 8 percent, then the expected return of holding GE stock rises relative to the
U.S. Treasury bonds and the demand for GE stock rises.
8) If housing prices are expected to increase, then, other things equal, the demand for houses will increase and that of
Treasury bills will decrease.
9) If stock prices are expected to drop dramatically, then, other things equal, the demand for stocks will decrease and that
of Treasury bills will increase
10) Everything else held constant, if the expected return on RST stock declines from 12 to 9 percent and the expected
return on XYZ stock declines from 8 to 7 percent, then the expected return of holding RST stock falls relative to XYZ
stock and demand for XYZ stock rises
11) Everything else held constant, if the expected return in the U.S. Treasury bonds falls from 8 to 7 percent and the
expected return on corporate bonds falls from 10 to 8 percent, then the expected return of corporate bonds falls relative to
the U.S. Treasury bonds and the demand for corporate bonds falls.
12) An increase in the expected rate of inflation will reduce the expected return on bonds relative to that on real assets,
everything else held constant.
13) If fluctuations in interest rates become smaller, then, other things equal, the demand for stocks decreases and the
demand for long-term bonds increases
14) If the price of gold becomes less volatile, then, other things equal, the demand for stocks will decrease and the
demand for antiques will decrease.
15) If brokerage commissions on bond sales decrease, then, other things equal, the demand for bonds will increase and
the demand for real estate will decrease
16) If gold becomes acceptable as a medium of exchange, the demand for gold will increase and the demand for bonds
will decrease, everything else held constant.
17) The demand for Picasso paintings rises (holding everything else equal) when Treasury securities become riskier.
18) The demand for silver decreases, other things equal, when the gold market is expected to boom.
19) You would be less willing to purchase U.S. Treasury bonds, other things equal, if
A) you inherit $1 million from your Uncle Harry. gold becomes more liquid.
20) You would be more willing to buy AT&T bonds (holding everything else constant) if the brokerage commissions on
bond sales become cheaper.
21) The demand for gold increases, other things equal, when interest rates are expected to rise.
22) Holding everything else constant, the more liquid asset A is, relative to alternative assets, the greater will be the
demand for asset A.
23) Holding all other factors constant, the quantity demanded of an asset is positively related to wealth.
24) Everything else held constant, would an increase in volatility of stock prices have any impact on the demand for rare
coins? Why or why not? Yes, it would cause the demand for rare coins to increase. The increased volatility of stock
prices means that there is relatively more risk in owning stock than there was previously and so the demand for an
alternative asset, rare coins, would increase.
5.2 Supply and Demand in the Bond Market
1) In the bond market, the bond demanders are the lenders and the bond suppliers are the
borrowers.
2) The demand curve for bonds has the usual downward slope, indicating that at lower prices of the bond, everything else
equal, the quantity demanded is higher.
3) The supply curve for bonds has the usual upward slope, indicating that as the price rises, ceteris paribus, the quantity
supplied increases.
4) In the bond market, the market equilibrium shows the market-clearing price and market-clearing interest rate.
5) When the price of a bond is above the equilibrium price, there is an excess supply of bonds and the price will fall.
6) When the price of a bond is below the equilibrium price, there is an excess demand for bonds and the price will rise.
7) When the interest rate on a bond is above the equilibrium interest rate, in the bond market there is excess demand and
the interest rate will fall.
8) When the interest rate on a bond is above the equilibrium interest rate, in the bond market there is excess demand and
the interest rate will fall
9) A situation in which the quantity of bonds supplied exceeds the quantity of bonds demanded is called a condition of
excess supply; because people want to sell more bonds than others want to buy, the price of bonds will fall
10) If the price of bonds is set below the equilibrium price, the quantity of bonds demanded exceeds the quantity of bonds
supplied, a condition called excess demand
5.3 Changes in Equilibrium Interest Rates
1) A movement along the bond demand or supply curve occurs when bond price changes.
2) When the price of a bond decreases, all else equal, the bond demand curve does not shift.
3) During business cycle expansions when income and wealth are rising, the demand for bonds rises and the demand
curve shifts to the right, everything else held constant.
4) Everything else held constant, when households save less, wealth and the demand for bonds decrease and the bond
demand curve shifts left
5) Everything else held constant, if interest rates are expected to fall in the future, the demand for long-term bonds today
rises and the demand curve shifts to the right
6) Holding the expected return on bonds constant, an increase in the expected return on common stocks would decrease
the demand for bonds, shifting the demand curve to the left
7) Everything else held constant, an increase in expected inflation, lowers the expected return on bonds compared to real
assets.
8) Everything else held constant, an increase in the riskiness of bonds relative to alternative assets causes the demand for
bonds to fall and the demand curve to shift to the left
9) Everything else held constant, when stock prices become less volatile, the demand curve for bonds shifts to the left and
the interest rate rises.
10) Everything else held constant, when stock prices become more volatile, the demand curve for bonds shifts to the right
and the interest rate falls
11) Everything else held constant, an increase in the liquidity of bonds results in a rise in demand for bonds and the
demand curve shifts to the right.
12) Everything else held constant, when bonds become less widely traded, and as a consequence the market becomes less
liquid, the demand curve for bonds shifts to the left and the interest rate rises.
13) The reduction of brokerage commissions for trading common stocks that occurred in 1975 caused the demand for
bonds to fall and the demand curve to shift to the left.
14) Factors that decrease the demand for bonds include a decrease in the riskiness of stocks.
15) During a recession, the supply of bonds decreases and the supply curve shifts to the left, everything else held
constant.
16) In a business cycle expansion, the supply of bonds increases and the supply curve shifts to the right as business
investments are expected to be more profitable.
17) When the expected inflation rate increases, the real cost of borrowing decreases and bond supply increases,
everything else held constant.
18) An increase in the expected inflation rate causes the supply of bonds to increase and the supply curve to shift to the
right, everything else held constant.
19) Higher government deficits increase the supply of bonds and shift the supply curve to the right, everything else held
constant.
20) Factors that can cause the supply curve for bonds to shift to the right include an expansion in overall economic
activity.
21) When the inflation rate is expected to increase, the demand for bonds falls, while the supply curve shifts to the right,
everything else held constant.
22) When the expected inflation rate increases, the demand for bonds decreases, the supply of bonds increases, and the
interest rate rises, everything else held constant.
23) Everything else held constant, when the inflation rate is expected to rise, interest rates will rise; this result has been
termed the Fisher effect
24) The economist Irving Fisher, after whom the Fisher effect is named, explained why interest rates rise as the expected
rate of inflation increases, everything else held constant.
25) Everything else held constant, during a business cycle expansion, the supply of bonds shifts to the right as businesses
perceive more profitable investment opportunities, while the demand for bonds shifts to the right as a result of the
increase in wealth generated by the economic expansion.
26) When the economy slips into a recession, normally the demand for bonds decreases, the supply of bonds decreases,
and the interest rate falls, everything else held constant.
27) When an economy grows out of a recession, normally the demand for bonds increases and the supply of bonds
increases, everything else held constant.
28) Deflation causes the demand for bonds to increase, the supply of bonds to decrease, and bond prices to increase,
everything else held constant.
29) In the 1990s Japan had the lowest interest rates in the world due to a combination of deflation and recession.
30) When the interest rate changes, it is because either the demand or the supply curve has shifted.
31) The interest rate falls when either the demand for bonds increases or the supply of bonds decreases.
32) When the government has a surplus, as occurred in the late 1990s, the supply curve of bonds shifts to the left,
everything else held constant.
33) A decrease in the brokerage commissions in the housing market from 6% to 5% of the sales price will shift the
demand curve for bonds to the left, everything else held constant.
34) When rare coin prices become volatile, the demand curve for bonds shifts to the right, everything else held constant.
35) If people expect real estate prices to increase significantly, the demand curve for bonds will shift to the left,
everything else held constant.
36) Everything else held constant, when prices in the art market become more uncertain, the demand curve for bonds
shifts to the right and the interest rate falls.
37) Everything else held constant, when real estate prices are expected to decrease the demand curve for bonds shifts to
the right and the interest rate falls.
38) Everything else held constant, when the government has higher budget deficits the supply curve for bonds shifts to
the right and the interest rate rises.
39) If stock prices are expected to climb next year, everything else held constant, the demand curve for bonds shifts left
and the interest rate rises
40) If prices in the bond market become more volatile, everything else held constant, the demand curve for bonds shifts
left and interest rates rise
41) If brokerage commissions on stocks fall, everything else held constant, the demand for bonds decreases, the price of
bonds decreases, and the interest rate increases.
42) If the expected return on bonds increases, all else equal, the demand for bonds increases, the price of bonds increases,
and the interest rate decreases
43) In the figure above, a factor that could cause the supply of bonds to shift to the right is: a business cycle expansion.
44) In the figure above, a factor that could cause the demand for bonds to decrease (shift to the left) is: a decrease in the
expected return on bonds relative to other assets.
45) In the figure above, the price of bonds would fall from P1 to P2 inflation is expected to increase in the future.
46) In the figure above, a factor that could cause the supply of bonds to increase (shift to the right) is: expectations of
more profitable investment opportunities.
47) In the figure above, a factor that could cause the demand for bonds to shift to the right is: expectations of lower
interest rates in the future.
48) In the figure above, the price of bonds would fall from P2 to P1 if there is a business cycle expansion.
49) What is the impact on interest rates when the Federal Reserve decreases the money supply by selling bonds to the
public? Bond supply increases and the bond supply curve shifts to the right. The new equilibrium bond price is
lower and thus interest rates will increase.
50) Use demand and supply analysis to explain why an expectation of Fed rate hikes would cause Treasury prices to fall.
The expected return on bonds would decrease relative to other assets resulting in a decrease in the demand for
bonds. The leftward shift of the bond demand curve results in a new lower equilibrium price for bonds.
5.4 Supply and Demand in the Market for Money: The Liquidity Preference
Framework
1) In Keynesʹs liquidity preference framework, individuals are assumed to hold their wealth in two forms: money and
bonds.
2) In Keynesʹs liquidity preference framework, an excess supply of bonds implies an excess demand for money.
3) In Keynesʹs liquidity preference framework, if there is excess demand for money, there is excess supply of bonds.
4) The bond supply and demand framework is easier to use when analyzing the effects of changes in expected inflation,
while the liquidity preference framework provides a simpler analysis of the effects from changes in income, the price
level, and the supply of money.
5) Keynes assumed that money has a zero rate of return.
6) In his Liquidity Preference Framework, Keynes assumed that money has a zero rate of return; thus, when interest
rates rise, the expected return on money falls relative to the expected return on bonds, causing the demand for
money to fall.
7) In Keynesʹs liquidity preference framework, as the expected return on bonds increases (holding everything else
unchanged), the expected return on money falls, causing the demand for money to fall.
8) The opportunity cost of holding money is the interest rate.
9) An increase in the interest rate decreases the quantity of money demanded.
10) If there is an excess supply of money, individuals buy bonds, causing interest rates to fall.
11) When the interest rate is above the equilibrium interest rate, there is an excess supply of money and the interest rate
will fall.
12) In the market for money, an interest rate below equilibrium results in an excess demand for money and the interest
rate will rise.
5.5 Changes in Equilibrium Interest Rates in the Liquidity Preference Framework
1) In the Keynesian liquidity preference framework, an increase in the interest rate causes the demand curve for money to
stay where it is, everything else held constant.
2) A lower level of income causes the demand for money to decrease and the interest rate to decrease, everything else
held constant.
3) When real income rises, the demand curve for money shifts to the right and the interest rate rises, everything else held
constant.
4) A business cycle expansion increases income, causing money demand to increase and interest rates to increase,
everything else held constant.
5) In the Keynesian liquidity preference framework, a rise in the price level causes the demand for money to increase and
the demand curve to shift to the right, everything else held constant.
6) When the price level rises, the demand curve for money shifts to the right and the interest rate rises, everything else
held constant.
7) A rise in the price level causes the demand for money to increase and the interest rate to increase, everything else held
constant.
8) When the price level falls, the demand curve for nominal money decreases, and interest rates fall, everything else held
constant.
9) A decline in the expected inflation rate causes the demand for money to decrease and the demand curve to shift to the
left, everything else held constant.
10) When the Fed decreases the money stock, the money supply curve shifts to the left and the interest rate rises,
everything else held constant.
11) When the Fed increases the money stock, the money supply curve shifts to the right and the interest rate falls,
everything else held constant.
12) A decrease in the money supply creates excess demand for money, causing interest rates to rise, everything else held
constant.
13) An increase in the money supply creates excess demand for bonds, causing interest rates to fall, everything else held
constant.
14) When the price level falls, the demand curve for nominal money decreases, and interest rates fall, everything else
held constant.
15) In the figure above, one factor not responsible for the decline in the demand for money is an increase in income.
16) In the figure above, the decrease in the interest rate from i1 to i2 can be explained by a decline in the expected price
level.
17) In the figure above, the factor responsible for the decline in the interest rate is an increase in the money supply.
18) In the figure above, the decrease in the interest rate from i1 to i2 can be explained by an increase in money growth.
19) Milton Friedman called the response of lower interest rates resulting from an increase in the money supply the
liquidity effect.
20) Of the four effects on interest rates from an increase in the money supply, the initial effect is, generally, the liquidity
effect.
21) In the liquidity preference framework, a one-time increase in the money supply results in a price level effect. The
maximum impact of the price level effect on interest rates occurs at the moment the price level hits its peak (stops rising)
because both the price level and
expected inflation effects are at work.
22) Of the four effects on interest rates from an increase in the money supply, the one that works in the opposite direction
of the other three is the liquidity effect.
23) It is possible that when the money supply rises, interest rates may rise if the liquidity effect is more than offset by
changes in income, the price level, and expected inflation.
24) When the growth rate of the money supply increases, interest rates end up being permanently lower if the liquidity
effect is larger than the other effects.
25) When the growth rate of the money supply is increased, interest rates will fall immediately if the liquidity effect is
larger than the other money supply effects and there is slow adjustment of expected inflation.
26) If the Fed wants to permanently lower interest rates, then it should raise the rate of money growth if the liquidity
effect is larger than the other effects.
27) If the liquidity effect is smaller than the other effects, and the adjustment to expected inflation is slow, then the
interest rate will initially fall but eventually climb above the initial level in response to an increase in money
growth.
28) If the liquidity effect is smaller than the other effects, and the adjustment to expected inflation is immediate, then the
interest rate will rise immediately above the initial level when the money supply grows.
29) In the figure above, illustrates the effect of an increased rate of money supply growth at time period 0. From the
figure, one can conclude that the liquidity effect is smaller than the expected inflation effect and interest rates adjust
quickly to changes in expected inflation.

30) In the figure above, illustrates the effect of an increased rate of money supply growth at time period 0. From the
figure, one can conclude that the liquidity effect is dominated by the Fisher effect and interest rates adjust quickly to
changes in expected inflation.
31) The figure above illustrates the effect of an increased rate of money supply growth at time period T0. From the figure,
one can conclude that the liquidity effect is larger than the expected inflation effect and interest rates adjust slowly
to changes in expected inflation.
32) The figure above illustrates the effect of an increased rate of money supply growth at time period T0. From the figure,
one can conclude that the Fisher effect is dominated by the liquidity effect and interest rates adjust slowly to changes
in expected inflation.

33) The figure above illustrates the effect of an increased rate of money supply growth at time period T0. From the figure,
one can conclude that the liquidity effect is smaller than the expected inflation effect and interest rates adjust slowly
to changes in expected inflation.
34) The figure above illustrates the effect of an increased rate of money supply growth at time period T0. From the figure,
one can conclude that the Fisher effect is dominated by the liquidity effect and interest rates adjust slowly to changes
in expected inflation.

35) Interest rates increased continuously during the 1970s. The most likely explanation is increasing expected rates of
inflation.
36) Using the liquidity preference framework, what will happen to interest rates if the Fed increases the money supply?
The Fedʹs actions shift the money supply curve to the right. The new equilibrium interest rate will be lower than it
was previously.
37) Using the liquidity preference framework, show what happens to interest rates during a
business cycle recession. During a business cycle recession, income will fall. This causes the money demand curve to
shift to the left. The resulting equilibrium will be at a lower interest rate.
5.6 Web Appendix 1: Models of Asset Pricing
1) The riskiness of an asset is measured by the standard deviation of its return.
2) Holding many risky assets and thus reducing the overall risk an investor faces is called diversification.
3) The less the returns on two securities move together, the less benefit there is from
diversification.
4) A higher beta means that an assetʹs return is more sensitive to changes in the value of the market portfolio.
5) The riskiness of an asset that is unique to the particular asset is nonsystematic risk.
6) The risk of a well-diversified portfolio depends only on the systematic risk of the assets in the portfolio.
7) Both the CAPM and APT suggest that an asset should be priced so that it has a higher expected return when it has a
greater systematic risk.
8) In contrast to the CAPM , the APT assumes that there can be several sources of systematic risk that cannot be
eliminated through diversification.
5.7 Web Appendix 2: Applying the Asset Market Approach to a Commodity Market: The Case of Gold
1) When stock prices become more volatile, the demand curve for gold shifts right and gold prices
increase, everything else held constant.
2) A return to the gold standard, that is, using gold for money will increase the demand for gold, increasing its price,
everything else held constant.
3) When gold prices become more volatile, the demand curve for gold shifts to the left; decreasing the price of gold.
4) Discovery of new gold in Alaska will increase the supply of gold, decreasing its price,
everything else held constant.
5) An increase in the expected inflation rate will increase the demand for gold, increasing its price, everything else held
constant.
6) The price of gold should be positively related to the expected inflation rate.
5.8 Web Appendix 3: Loanable Funds Framework
1) In the loanable funds framework, the demand curve of bonds is equivalent to the supply curve of loanable funds.
2) In the loanable funds framework, the interest rate is measured on the vertical axis.
Chapter 6: The Risk and Term Structure of Interest Rates
6.1 Risk Structure of Interest Rates
1) The risk structure of interest rates is the relationship among interest rates of different bonds with the same
maturity.
2) The risk that interest payments will not be made, or that the face value of a bond is not repaid when a bond matures is
default risk.
3) Bonds with no default risk are called default-free bonds.
4) Which of the following bonds are considered to be default-risk free? U.S. Treasury bonds
5) U.S. government bonds have no default risk because the federal government can increase taxes to pay its
obligations.
6) The spread between the interest rates on bonds with default risk and default-free bonds is called the risk premium.
7) If the probability of a bond default increases because corporations begin to suffer large losses, then the default risk on
corporate bonds will increase and the expected return on these bonds will decrease, everything else held constant.
8) A bond with default risk will always have a positive risk premium and an increase in its default risk will raise the risk
premium.
9) If a corporation begins to suffer large losses, then the default risk on the corporate bond will increase and the bondʹs
return will become more uncertain, meaning the expected return on the corporate bond will fall.
10) If the possibility of a default increases because corporations begin to suffer losses, then the default risk on corporate
bonds will increase, and the bondsʹ returns will become more uncertain, meaning that the expected return on these bonds
will decrease, everything else held constant.
11) Other things being equal, an increase in the default risk of corporate bonds shifts the demand curve for corporate
bonds to the left and the demand curve for Treasury bonds to the right.
12) An increase in the riskiness of corporate bonds will reduce the price of corporate bonds and increase the price of
Treasury bonds, everything else held constant.
13) An increase in the riskiness of corporate bonds will increase the yield on corporate bonds and reduce the yield on
Treasury securities, everything else held constant.
14) An increase in default risk on corporate bonds lowers the demand for these bonds, but increases the demand for
default-free bonds, everything else held constant.
15) As default risk increases, the expected return on corporate bonds decreases, and the return becomes more uncertain,
everything else held constant.
16) As their relative riskiness increases, the expected return on corporate bonds decreases relative to the expected return
on default-free bonds, everything else held constant.
17) Which of the following statements are true?
A) A decrease in default risk on corporate bonds lowers the demand for these bonds, but increases the demand for
default-free bonds.
B) The expected return on corporate bonds decreases as default risk increases.
C) A corporate bondʹs return becomes less uncertain as default risk increases.
 D) As their relative riskiness increases, the expected return on corporate bonds increases relative to the expected
return on default-free bonds.
18) Everything else held constant, if the federal government were to guarantee today that it will pay creditors if a
corporation goes bankrupt in the future, the interest rate on corporate bonds will decrease and the interest rate on
Treasury securities will increase.
19) Bonds with relatively high risk of default are called junk bonds.
20) Bonds with relatively low risk of default are called investment grade securities and have a rating of Baa (or BBB)
and above; bonds with ratings below Baa (or BBB) have a higher default risk and are called junk bonds.
21) Which of the following bonds would have the highest default risk? Junk bonds
22) Which of the following long-term bonds has the highest interest rate? Corporate Baa bonds
23) Which of the following securities has the lowest interest rate?
A) Junk bonds
B) U.S. Treasury bonds
C) Investment-grade bonds
D) Corporate Baa bonds
24) The spread between interest rates on low quality corporate bonds and U.S. government bonds widened significantly
during the Great Depression.
25) During the Great Depression years 1930-1933 there was a very high rate of business failures and defaults, we would
expect the risk premium for corporate Baa bonds to be very high.
26) Risk premiums on corporate bonds tend to decrease during business cycle expansions and increase during recessions,
everything else held constant.
27) The collapse of the subprime mortgage market increased the Baa-Aaa spread.
28) The collapse of the subprime mortgage market increased the spread between Baa and default-free U.S. Treasury
bonds. This is due to a flight to quality.
29) During a ʺflight to qualityʺ the spread between Treasury bonds and Baa bonds increases.
30) If you have a very low tolerance for risk, which of the following bonds would you be least likely to hold in your
portfolio? a corporate bond with a rating of Baa
31) Which of the following statements are true?
A) A liquid asset is one that can be quickly and cheaply converted into cash.
B) The demand for a bond declines when it becomes less liquid, decreasing the interest rate
spread between it and relatively more liquid bonds.
C) The differences in bond interest rates reflect differences in default risk only.
D) The corporate bond market is the most liquid bond market.
32) Corporate bonds are not as liquid as government bonds because fewer corporate bonds for any one corporation are
traded, making them more costly to sell.
33) When the Treasury bond market becomes more liquid, other things equal, the demand curve for corporate bonds shifts
to the left and the demand curve for Treasury bonds shifts to the right.
34) A decrease in the liquidity of corporate bonds, other things being equal, shifts the demand curve for corporate bonds
to the left and the demand curve for Treasury bonds shifts to the right.
35) An increase in the liquidity of corporate bonds will increase the price of corporate bonds and increase the yield of
Treasury bonds, everything else held constant.
36) The risk premium on corporate bonds reflects the fact that corporate bonds have a higher default risk and are less
liquid than U.S. Treasury bonds.
37) Which of the following statements is true?
A) State and local governments cannot default on their bonds.
B) Bonds issued by state and local governments are called municipal bonds.
C) All government issued bonds local, state, and federal are federal income tax exempt.
D) The coupon payment on municipal bonds is usually higher than the coupon payment on
Treasury bonds.
38) Everything else held constant, if the tax-exempt status of municipal bonds were eliminated, then the interest rate on
municipal bonds would exceed the rate on Treasury bonds.
39) Municipal bonds have default risk, yet their interest rates are lower than the rates on
default-free Treasury bonds. This suggests that the benefit from the tax-exempt status of municipal bonds exceeds
their default risk.
40) Everything else held constant, an increase in marginal tax rates would likely have the effect of increasing the demand
for municipal bonds, and decreasing the demand for U.S. government bonds.
41) Everything else held constant, the interest rate on municipal bonds rises relative to the interest rate on Treasury
securities when income tax rates are lowered.
42) Everything else held constant, if income tax rates were lowered, then the interest rate on municipal bonds would
rise.
43) Everything else held constant, abolishing all taxes will increase the interest rate on municipal bonds.
44) Which of the following statements are true?
A) An increase in tax rates will increase the demand for Treasury bonds, lowering their interest rates.
B) Because the tax-exempt status of municipal bonds was of little benefit to bond holders when tax rates
were low, they had higher interest rates than U.S. government bonds before World War II.
C) Interest rates on municipal bonds will be higher than comparable bonds without the tax exemption.
D) Because coupon payments on municipal bonds are exempt from federal income tax, the expected after-tax
return on them will be higher for individuals in lower income tax brackets.
45) The Bush tax cut reduced the top income tax bracket from 39% to 35% over a ten-year period. Supply and demand
analysis predicts the impact of this change was a higher interest rate on municipal bonds and a lower interest rate on
Treasury bonds.
46) Three factors explain the risk structure of interest rates: liquidity, default risk, and the income tax treatment of a
security.
47) The spread between the interest rates on Baa corporate bonds and U.S. government bonds was very large during the
Great Depression years 1930-1933. Explain this difference using the bond supply and demand analysis. During the Great
Depression many businesses failed. The default risk for the corporate bond increased compared to the default-free
Treasury bond. The demand for corporate bonds decreased while the demand for Treasury bonds increased
resulting in a larger risk premium.
48) If the federal government where to raise the income tax rates, would this have any impact on a stateʹs cost of
borrowing funds? Explain. Yes, if the federal government raises income tax rates, demand for municipal bonds
which are federal income tax exempt would increase. This would lower the interest rate on the municipal bonds
thus lowering the cost to the state of borrowing funds.
6.2 Term Structure of Interest Rates
1) The term structure of interest rates is the relationship among interest rates on bonds with different maturities.
2) A plot of the interest rates on default-free government bonds with different terms to maturity is called a yield curve.
3) Differences in time to maturity explain why interest rates on Treasury securities are not all the same.
4) Typically, yield curves are gently upward sloping.
5) When yield curves are steeply upward sloping, long-term interest rates are above short-term interest rates.
6) When yield curves are flat, short-term interest rates are about the same as long-term interest rates.
7) When yield curves are downward sloping, short-term interest rates are above long-term interest rates.
8) An inverted yield curve slopes down.
9) Economistsʹ attempts to explain the term structure of interest rates illustrate how economists modify theories to
improve them when they are inconsistent with the empirical evidence.
10) According to the expectations theory of the term structure, the interest rate on a long-term bond will equal the average
of the short-term interest rates that people expect to occur over the life of the long-term bond.
11) If bonds with different maturities are perfect substitutes, then the expected return on these bonds must be equal.
12) If the expected path of one-year interest rates over the next five years is 4 percent, 5 percent, 7 percent, 8 percent, and
6 percent, then the expectations theory predicts that todayʹs interest rate on the five-year bond is 6 percent.
13) If the expected path of 1-year interest rates over the next four years is 5 percent, 4 percent, 2 percent, and 1 percent,
then the expectations theory predicts that todayʹs interest rate on the four-year bond is 3 percent.
14) If the expected path of 1-year interest rates over the next five years is 1 percent, 2 percent, 3 percent, 4 percent, and 5
percent, the expectations theory predicts that the bond with the highest interest rate today is the one with a maturity of five
years.
15) If the expected path of 1-year interest rates over the next five years is 2 percent, 4 percent, 1 percent, 4 percent, and 3
percent, the expectations theory predicts that the bond with the lowest interest rate today is the one with a maturity of one
year.
16) Over the next three years, the expected path of 1-year interest rates is 4, 1, and 1 percent. The expectations theory of
the term structure predicts that the current interest rate on a 3-year bond is 2 percent.
17) According to the expectations theory of the term structure Interest rates on bonds of different maturities move
together over time.
18) According to the expectations theory of the term structure, yield curves should be equally likely to slope downward
as slope upward.
19) According to the segmented markets theory of the term structure the interest rate for each maturity bond is
determined by supply and demand for that maturity bond.
20) According to the segmented markets theory of the term structure, interest rates on bonds of different
maturities do not move together over time.
21) A key assumption in the segmented markets theory is that bonds of different maturities are not substitutes at all.
22) The segmented markets theory can explain why yield curves usually tend to slope upward.
23) According to the liquidity premium theory of the term structure the interest rate on long-term bonds will equal an
average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a term
premium.
24) According to the liquidity premium theory of the term structure if yield curves are downward sloping, then short-
term interest rates are expected to fall by so much that, even when the positive term premium is added, long-term
rates fall below short-term rates.
25) The additional incentive that the purchaser of a Treasury security requires to buy a long -term security rather than a
short-term security is called the term premium.
26) If 1-year interest rates for the next three years are expected to be 4, 2, and 3 percent, and the 3-year term premium is 1
percent, than the 3-year bond rate will be 4 percent.
27) If 1-year interest rates for the next five years are expected to be 4, 2, 5, 4, and 5 percent, and the 5-year term premium
is 1 percent, than the 5-year bond rate will be 5 percent.
28) According to the liquidity premium theory of the term structure, a steeply upward sloping yield curve indicates that
short-term interest rates are expected to rise in the future.
29) According to the liquidity premium theory of the term structure, a slightly upward sloping yield curve indicates that
short-term interest rates are expected to remain unchanged in the future.
30) According to the liquidity premium theory of the term structure, a flat yield curve indicates that short-term interest
rates are expected to decline moderately in the future
31) According to the liquidity premium theory of the term structure, a downward sloping yield curve indicates that short-
term interest rates are expected to decline sharply in the future.
32) According to the liquidity premium theory, a yield curve that is flat means that bond purchasers expect interest
rates to fall in the future.
33) If the yield curve is flat for short maturities and then slopes downward for longer maturities, the liquidity premium
theory (assuming a mild preference for shorter-term bonds) indicates that the market is predicting. a decline in short-
term interest rates in the near future and an even steeper decline further out in the future.
34) If the yield curve slope is flat for short maturities and then slopes steeply upward for longer maturities, the liquidity
premium theory (assuming a mild preference for shorter-term bonds) indicates that the market is predicting a decline in
short-term interest rates in the near future and a rise further out in the future.
35) If the yield curve has a mild upward slope, the liquidity premium theory (assuming a mild
preference for shorter-term bonds) indicates that the market is predicting constant short-term interest rates in the near
future and further out in the future.
36) The preferred habitat theory of the term structure is closely related to the liquidity premium theory of the term
structure.
37) The expectations theory and the segmented markets theory do not explain the facts very well, but they provide the
groundwork for the most widely accepted theory of the term structure of interest rates, liquidity premium theory.
38) The expectations theory of the term structure of interest rates states that the interest rate on a long -term bond will
equal the average of short-term interest rates that individuals expect to occur over the life of the long-term bond, and
investors have no preference for short-term bonds relative to long-term bonds.
39) According to this theory of the term structure, bonds of different maturities are not substitutes for one another.
Segmented markets theory
40) In actual practice, short-term interest rates and long-term interest rates usually move together; this is the major
shortcoming of the segmented markets theory.
41) The liquidity premium theory of the term structure states the following: the interest rate on a long-term bond will
equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a term premium
that responds to supply and demand conditions for that bond.
42) A particularly attractive feature of the liquidity premium theory is that it tells you what the market is predicting
about future short-term interest rates by just looking at the slope of the yield curve.
43) The steeply upward sloping yield curve in the figure above indicates that short-term interest rates are expected to
rise in the future.
44) The steeply upward sloping yield curve in the figure above indicates that short-term interest rates are expected to rise
in the future.
45) The U-shaped yield curve in the figure above indicates that short-term interest rates are expected to fall sharply in
the near-term and rise later on.
46) The U-shaped yield curve in the figure above indicates that the inflation rate is expected to fall sharply in the near-
term and rise later on.
47) The mound-shaped yield curve in the figure above indicates that short-term interest rates are expected to rise in the
near-term and fall later on.
48) The mound-shaped yield curve in the figure above indicates that the inflation rate is expected to rise moderately in
the near-term and fall later on.
49) An inverted yield curve predicts that short-term interest rates will fall in the future.
50) When short-term interest rates are expected to fall sharply in the future, the yield curve will be inverted.
51) If investors expect interest rates to fall significantly in the future, the yield curve will be
inverted. This means that the yield curve has a downward slope.
52) When the yield curve is flat or downward-sloping, it suggest that the economy is more likely to enter a recession.
53) A steeply upward sloping yield curve predicts a future increase in inflation.
54) If a higher inflation is expected, what would you expect to happen to the shape of the yield curve? Why? The yield
curve should have a steep upward slope. Nominal interest rates will increase if the inflation rate increases,
therefore, bond purchasers will require a higher term premium to hold the riskier long-term bond.
Chapter 7:
The Stock Market, Theory of Rational Expectations & Efficient Market Hypothesis
7.1 Computing the Price of Common Stock
1) A stockholderʹs ownership of a companyʹs stock gives her the right to vote and be the residual claimant of all cash flows.
2) Stockholders are residual claimants, meaning that they receive the remaining cash flow after all other claims are paid.
3) Periodic payments of net earnings to shareholders are known as dividends.
4) The value of any investment is found by computing the present value of all future cash flows.
5) In the one-period valuation model, the value of a share of stock today depends upon the present value of both dividends and the
expected sales price.
6) In the one-period valuation model, the current stock price increases if the expected sales price increases.
7) In the one-period valuation model, an increase in the required return on investments in equity reduces the current price of a stock.
8) Using the one-period valuation model, assuming a year-end dividend of $0.11, an expected sales price of $110, and a required rate
of return of 10%, the current price of the stock would be $100.10.
9) Using the one-period valuation model, assuming a year-end dividend of $1.00, an expected sales price of $100, and a required rate
of return of 5%, the current price of the stock would be $96.19.
10) In the generalized dividend model, if the expected sales price is in the distant future, it does not affect the current stock price.
11) In the generalized dividend model, a future sales price far in the future does not affect the current stock price because the present
value is almost zero.
12) In the generalized dividend model, the current stock price is the sum of the present value of the future dividend stream.
13) Using the Gordon growth model, a stockʹs price will increase if the dividend growth rate increases.
14) In the Gordon growth model, a decrease in the required rate of return on equity increases the current stock price.
15) Using the Gordon growth formula, if D1 is $2.00, ke is 12% or 0.12, and g is 10% or 0.10, then the current stock price is $100.
16) Using the Gordon growth formula, if D1 is $1.00, ke is 10% or 0.10, and g is 5% or 0.05, then the current stock price is $20.
17) One of the assumptions of the Gordon Growth Model is that dividends will continue growing at a constant rate.
18) In the Gordon Growth Model, the growth rate is assumed to be less than the required return on equity.
19) You believe that a corporationʹs dividends will grow 5% on average into the foreseeable future. If the companyʹs last dividend
payment was $5 what should be the current price of the stock assuming a 12% required return?
Answer: Use the Gordon Growth Model: $5(1 + .05)/(.12-.05) = $75
20) What rights does ownership interest give stockholders?
Answer: Stockholders have the right to vote on issues brought before the stockholders, be the residual claimant, that is, receive a
portion of any net earnings of the corporation, and the right to sell the stock.
7.2 How the Market Sets Stock Prices
1) In asset markets, an assetʹs price is set by the buyer willing to pay the highest price.
2) Information plays an important role in asset pricing because it allows the buyer to more accurately judge risk.
3) New information that might lead to a decrease in an assetʹs price might be an expected decrease in the level of future dividends.
4) A change in perceived risk of a stock changes the required rate of return.
5) A stockʹs price will fall if there is an increase in the required rate of return.
6) A monetary expansion increases stock prices due to a decrease in the required rate of return and an increase in the dividend
growth rate, everything else held constant.
7) The subprime financial crisis lead to a decline in stock prices because of a lowered expected dividend growth rate.
8) Increased uncertainty resulting from the subprime crisis raised the required return on investment in equity.
9) In October 2008, the stock market crashed, falling by over 40% from its peak value a year earlier.
7.3 The Theory of Rational Expectations
1) Economists have focused more attention on the formation of expectations in recent years. This increase in interest can probably best
be explained by the recognition that expectations influence the behavior of participants in the economy and thus have a major
impact on economic activity.
2) The view that expectations change relatively slowly over time in response to new information is known in economics as adaptive
expectations.
3) If expectations of the future inflation rate are formed solely on the basis of a weighted average of past inflation rates, then
economics would say that expectation formation is adaptive.
4) If expectations are formed adaptively, then people use only the information from past data on a single variable to form their
expectations of that variable.
5) If during the past decade the average rate of monetary growth has been 5% and the average inflation rate has been 5%, everything
else held constant, when the Federal Reserve announces that the new rate of monetary growth will be 10%, the adaptive expectation
forecast of the inflation rate is 5%.
6) The major criticism of the view that expectations are formed adaptively is that this view ignores that people use more information
than just past data to form their expectations.
7) In rational expectations theory, the term ʺoptimal forecastʺ is essentially synonymous with the best guess.
8) If a forecast is made using all available information, then economists say that the expectation formation is rational.
9) If a forecast made using all available information is not perfectly accurate, then it is still a rational expectation.
10) If additional information is not used when forming an optimal forecast because it is not available at that time, then expectations
are still considered to be formed rationally.
11) An expectation may fail to be rational if relevant information is available but ignored at the time the forecast is made.
12) According to rational expectations theory, forecast errors of expectations are unpredictable.
13) Rational expectations forecast errors will on average be zero and therefore cannot be predicted ahead of time.
14) People have a strong incentive to form rational expectations because it is costly not to do so.
15) If market participants notice that a variable behaves differently now than in the past, then, according to rational expectations
theory, we can expect market participants to change the way they form expectations about future values of the variable.
16) According to rational expectations, expectations will not differ from optimal forecasts using all available information.
17) Suppose Barbara looks out in the morning and sees a clear sky so decides that a picnic for lunch is a good idea. Last night the
weather forecast included a 100% chance of rain by midday but Barbara did not watch the local news program. Is Barbaraʹs prediction
of good weather at lunch time rational? Why or why not?
Answer: No, this prediction is not using rational expectations. Although Barbara based her guess on the information that was available
to her at the time, additional information was readily available that could have been used to improve her prediction.
7.4 The Efficient Market Hypothesis: Rational Expectations in Financial Markets
1) The theory of rational expectations, when applied to financial markets, is known as the efficient markets hypothesis.
2) According to the efficient markets hypothesis, the current price of a financial security fully reflects all available relevant
information.
3) If the optimal forecast of the return on a security exceeds the equilibrium return, then the market is inefficient.
4) Another way to state the efficient markets condition is: in an efficient market, unexploited profit opportunities will be quickly
eliminated.
5) Arbitrage occurs when market participants observe returns on a security that are larger than what is justified by the characteristics
of that security and take action to quickly eliminate the unexploited profit opportunity.
6) The efficient markets hypothesis suggests that if an unexploited profit opportunity arises in an efficient market, it will be quickly
eliminated.
7) Financial markets quickly eliminate unexploited profit opportunities through changes in asset prices.
8) The elimination of unexploited profit opportunities requires that a few market participants be well informed.
9) If in an efficient market all prices are correct and reflect market fundamentals, which of the following is a false statement?
A) A stock that has done poorly in the past is more likely to do well in the future.
B) One investment is as good as any other because the securitiesʹ prices are correct.
C) A securityʹs price reflects all available information about the intrinsic value of the security.
D) Security prices can be used by managers to assess their cost of capital accurately.
10) According to the efficient markets hypothesis, purchasing the reports of financial analysts is not likely to be an effective strategy
for increasing financial returns.
11) You have observed that the forecasts of an investment advisor consistently outperform the other reported forecasts. The efficient
markets hypothesis says that future forecasts by this advisor may or may not be better than the other forecasts. Past performance is
no guarantee of the future.
12) Which of the following types of information most likely allows the exploitation of a profit opportunity?
A) Financial analystsʹ published recommendations
B) Technical analysis
C) Hot tips from a stockbroker
D) Insider information
13) Sometimes one observes that the price of a companyʹs stock falls after the announcement of favorable earnings. This phenomenon
is consistent with the efficient markets hypothesis if the earnings were not as high as anticipated.
14) You read a story in the newspaper announcing the proposed merger of Dell Computer and Gateway. The merger is expected to
greatly increase Gatewayʹs profitability. If you decide to invest in Gateway stock, you can expect to earn a normal return since stock
prices adjust to reflect expected changes in profitability almost immediately.
15) The efficient markets hypothesis indicates that investors do better on average if they adopt a ʺbuy and holdʺ strategy.
16) The efficient markets hypothesis suggests that investors should purchase no-load mutual funds which have low management
fees.
17) The advantage of a ʺbuy-and-hold strategyʺ is that net profits will tend to be higher because there will be fewer brokerage
commissions.
18) For small investors, the best way to pursue a ʺbuy and holdʺ strategy is to buy no-load mutual funds with low management fees.
19) A situation when an asset price differs from its fundamental value is a bubble.
20) In a rational bubble, investors can have rational expectations that a bubble is occurring but continue to hold the asset anyway.
21) If a corporation announces that it expects quarterly earnings to increase by 25% and it actually sees an increase of 22%, what
should happen to the price of the corporationʹs stock if the efficient markets hypothesis holds, everything else held constant?
Answer: The stockʹs price should fall. The price had adjusted based on the statement of expected earnings. When the actual number
turned out to be lower than expected, the stock price changes to reflect the additional information.
22) Your best friend calls and gives you the latest stock market ʺhot tipʺ that he heard at the health club. Should you act on this
information? Why or why not?
Answer: No, if this information is readily available, it will already be reflected in the stock price.

7.5 Behavioral Finance

1) Behavioral finance is the field of study that applies concepts from social sciences such as psychology and sociology to help
understand the behavior of securities prices.
2) If a market participant believes that a stock price is irrationally high, they may try to borrow stock from brokers to sell in the market
and then make a profit by buying the stock back again after the stock falls in price. This practice is called short selling.
3) Loss aversion means people are more unhappy when they suffer losses than they are happy when they achieve gains.
4) Loss aversion can explain why very little short selling actually takes place in the securities market.
5) Psychologists have found that people tend to be overconfident in their own judgments.
6) Overconfidence and social contagion may provide an explanation for stock market bubbles.
7.6 Web Appendix: Evidence on the Efficient Market Hypothesis
1) If a mutual fund outperforms the market in one period, evidence suggests that this fund is not likely to consistently outperform the
market in subsequent periods.
2) Studies of mutual fund performance indicate that mutual funds that outperformed the market in one time period usually do not beat
the market in the next time period.
3) The number and availability of discount brokers has grown rapidly since the mid -1970s. The efficient markets hypothesis predicts
that people who use discount brokers will likely earn about the same as those who use full-service brokers, but will net more after
brokerage commissions.
4) When Happy Feet Corporation announces that their fourth quarter earnings are up 10%, their stock price falls. This is consistent
with the efficient markets hypothesis if earnings were not as high as expected.
5) To say that stock prices follow a ʺrandom walkʺ is to argue that stock prices cannot be predicted based on past trends.
6) The efficient markets hypothesis predicts that stock prices follow a ʺrandom walk.ʺ The implication of this hypothesis for investing
in stocks is a ʺbuy and hold strategyʺ of holding stocks to avoid brokerage commissions.
7) Rules used to predict movements in stock prices based on past patterns are, according to the efficient markets hypothesis, a waste
of time.
8) Tests used to rate the performance of rules developed in technical analysis conclude that technical analysis does not outperform the
overall market.
9) Which of the following accurately summarize the empirical evidence about technical analysis?
A) Technical analysts fare no better than other financial analysison average they do not outperform the market.
B) Technical analysts tend to outperform other financial analysis, but on average they nevertheless under-perform the market.
C) Technical analysts fare no better than other financial analysis, and like other financial analysts they outperform the market.
D) Technical analysts fare no better than other financial analysis, and like other financial analysts they under-perform the market.
10) The small-firm effect refers to the abnormally high returns earned by small firms.
11) The January effect refers to the fact that stock prices have historically experienced abnormal price increases in January.
12) When a corporation announces a major decline in earnings, the stock price may initially decline significantly and then rise back to
normal levels over the next few weeks. This impact is called market overreaction.
13) A phenomenon closely related to market overreaction is excessive volatility.
14) Excessive volatility refers to the fact that stock prices fluctuate more than is justified by dividend fluctuations.
15) Mean reversion refers to the fact that stocks that have had low returns in the past are more likely to do well in the future.
16) Evidence in support of the efficient markets hypothesis includes the failure of technical analysis to outperform the market.
17) Evidence against market efficiency includes the January effect.
Chapter 8: An Economic Analysis of Financial Structure
8.1 Basic Facts About Financial Structure Throughout the World
1) American businesses get their external funds primarily from loans from nonbank financial intermediaries.
2) Of the sources of external funds for nonfinancial businesses in the United States, loans from banks and other financial
intermediaries account for approximately 56% of the total.
3) Of the sources of external funds for nonfinancial businesses in the United States, corporate bonds and commercial paper account for
approximately 32% of the total.
4) Of the following sources of external finance for American nonfinancial businesses, the least important is stocks.
5) Of the sources of external funds for nonfinancial businesses in the United States, stocks account for approximately 11% of the total.
6) Which of the following statements concerning external sources of financing for nonfinancial businesses in the United States are
true?
A) Stocks are a far more important source of finance than are bonds.
B) Stocks and bonds, combined, supply less than one-half of the external funds.
C) Financial intermediaries are the least important source of external funds for businesses.
D) Since 1970, more than half of the new issues of stock have been sold to American households.
7) Which of the following statements concerning external sources of financing for nonfinancial businesses in the United States are
true?
A) Issuing marketable securities is the primary way that they finance their activities.
B) Bonds are the least important source of external funds to finance their activities.
C) Stocks are a relatively unimportant source of finance for their activities.
D) Selling bonds directly to the American household is a major source of funding for
American businesses.
8) With regard to external sources of financing for nonfinancial businesses in the United States, which of the following are accurate
statements?
A) Marketable securities account for a larger share of external business financing in the United States than in Germany and
Japan.
B) Since 1970, most of the newly issued corporate bonds and commercial paper have been sold directly to American households.
C) Direct finance accounts for more than 50 percent of the external financing of American businesses.
D) Smaller businesses almost always raise funds by issuing marketable securities.
9) Nonfinancial businesses in Germany, Japan, and Canada raise most of their funds from bank loans.
10) As a source of funds for nonfinancial businesses, stocks are relatively more important in Canada.
11) Direct finance involves the sale to households of marketable securities such as stocks and bonds.
12) Regulation of the financial system ensures the stability of the financial system.
13) One purpose of regulation of financial markets is to promote the provision of information to shareholders, depositors and the
public.
14) Property that is pledged to the lender in the event that a borrower cannot make his or her debt payment is called collateral.
15) Collateralized debt is also known as secured debt.
16) Credit card debt is unsecured debt.
17) The predominant form of household debt is collateralized debt.
18) If you default on your auto loan, your car will be repossessed because it has been pledged as collateral for the loan.
19) Commercial and farm mortgages, in which property is pledged as collateral, account for one-quarter of borrowing by
nonfinancial businesses.
20) A restrictive covenant is a provision that restricts or specifies certain activities that a borrower can engage in.
21) A clause in a mortgage loan contract requiring the borrower to purchase homeownerʹs
insurance is an example of a restrictive covenant.
22) Which of the following is not one of the eight basic puzzles about financial structure?
A) Stocks are the most important source of finance for American businesses.
B) Issuing marketable securities is not the primary way businesses finance their operations.
C) Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in
which businesses raise funds directly from lenders in financial markets.
D) Banks are the most important source of external funds to finance businesses.
23) Which of the following is not one of the eight basic puzzles about financial structure?
A) Debt contracts are typically extremely complicated legal documents that place substantial restrictions on the behavior of the
borrower.
B) Indirect finance, which involves the activities of financial intermediaries, is many times more important than direct finance, in
which businesses raise funds directly from lenders in financial markets.
C) Collateral is a prevalent feature of debt contracts for both households and business.
D) There is very little regulation of the financial system.
8.2 Transaction Costs
1) The current structure of financial markets can be best understood as the result of attempts by financial market participants to reduce
transaction costs.
2) The reduction in transactions costs per dollar of investment as the size of transactions increases is economies of scale.
3) Which of the following is not a benefit to an individual purchasing a mutual fund?
A) reduced risk
B) lower transactions costs
C) free-riding
D) diversification
4) Financial intermediaries develop expertise in things such as computer technology which allows them to lower transactions costs.
5) Financial intermediariesʹ low transaction costs allow them to provide liquidity services that make it easier for customers to conduct
transactions.
6) How does a mutual fund lower transactions costs through economies of scale?
Answer: The mutual fund takes the funds of the individuals who have purchased shares and uses them to purchase bonds or stocks.
Because the mutual fund will be purchasing large blocks of stocks or bonds they will be able to obtain them at lower transactions costs
than the individual purchases of smaller amounts could.
8.3 Asymmetric Information: Adverse Selection and Moral Hazard
1) A borrower who takes out a loan usually has better information about the potential returns and risk of the investment projects he
plans to undertake than does the lender. This inequality of information is called asymmetric information.
2) The presence of asymmetric information in financial markets leads to adverse selection and moral hazard problems that interfere
with the efficient functioning of financial markets.
3) The problem created by asymmetric information before the transaction occurs is called
adverse selection, while the problem created after the transaction occurs is called moral hazard.
4) If bad credit risks are the ones who most actively seek loans then financial intermediaries face the problem of adverse selection.
5) An example of the moral hazard problem would be if Brian borrowed money from Sean in order to purchase a used car and instead
took a trip to Atlantic City using those funds.
6) The analysis of how asymmetric information problems affect economic behavior is called agency theory.
8.4 The Lemons Problem: How Adverse Selection Influences Financial Structure
1) The ʺlemons problemʺ exists because of asymmetric information.
2) Because of the ʺlemons problemʺ the price a buyer of a used car pays is between the price of a lemon and a peach.
3) Adverse selection is a problem associated with equity and debt contracts arising from the lenderʹs relative lack of information
about the borrowerʹs potential returns and risks of his investment activities.
4) The free-rider problem helps to explain why the private production and sale of information cannot eliminate adverse selection.
5) The free-rider problem occurs because people who do not pay for information use it.
6) In the United States, the government agency requiring that firms that sell securities in public markets adhere to standard accounting
principles and disclose information about their sales, assets, and earnings is the Securities and Exchange Commission.
7) Government regulations require publicly traded firms to provide information, reducing the adverse selection problem.
8) A lesson of the Enron collapse is that government regulation can reduce but not eliminate asymmetric information.
9) That most used cars are sold by intermediaries (i.e., used car dealers) provides evidence that these intermediaries are able to
prevent potential competitors from free-riding off the information that they provide.
10) Analysis of adverse selection indicates that financial intermediaries, especially banks, have advantages in overcoming the free-
rider problem, helping to explain why indirect finance is a more important source of business finance than is direct finance.
11) The concept of adverse selection helps to explain all of the following except why direct finance is more important than indirect
finance as a source of business finance.
12) As information technology improves, the lending role of financial institutions such as banks should decrease.
13) That only large, well-established corporations have access to securities markets explains why indirect finance is such an
important source of external funds for businesses.
14) Because of the adverse selection problem, lenders are reluctant to make loans that are not secured by collateral.
15) Net worth can perform a similar role to collateral.
16) The problem of adverse selection helps to explain why firms are more likely to obtain funds from banks and other financial
intermediaries, rather than from securities markets.
17) The concept of adverse selection helps to explain why financial markets are among the most heavily regulated sectors of the
economy.
18) How does collateral help to reduce the adverse selection problem in credit market?
Answer: Collateral is property that is promised to the lender if the borrower defaults thus
reducing the lenderʹs losses. Lenders are more willing to make loans when there is collateral that can be sold if the borrower defaults.
8.5 How Moral Hazard Affects the Choice Between Debt and Equity Contracts
1) Equity contracts are claims to a share in the profits and assets of a business.
2) A problem for equity contracts is a particular type of moral hazard called the principal-agent problem.
3) Moral hazard in equity contracts is known as the principal-agent problem because the manager of the firm has fewer incentives to
maximize profits than the stockholders might ideally prefer.
4) Managers (agents) may act in their own interest rather than in the interest of the
stockholder-owners (principals) because the managers have less incentive to maximize profits than the stockholder-owners do.
5) The principal-agent problem would not arise if the owners of the firm had complete information about the activities of the
managers.
6) The recent Enron and Tyco scandals are an example of the principal-agent problem.
7) The name economists give the process by which stockholders gather information by frequent monitoring of the firmʹs activities is
costly state verification.
8) Because information is scarce, monitoring managers gives rise to costly state verification.
9) Government regulations designed to reduce the moral hazard problem include laws that force firms to adhere to standard
accounting principles.
10) One financial intermediary in our financial structure that helps to reduce the moral hazard from arising from the principal-agent
problem is the venture capital firm.
11) A venture capital firm protects its equity investment from moral hazard through which of the following means?
A) It places people on the board of directors to better monitor the borrowing firmʹs activities.
B) It writes contracts that prohibit the sale of an equity investment to the venture capital firm.
C) It prohibits the borrowing firm from replacing its management.
D) It requires a 50% stake in the company.
12) Equity contracts account for a small fraction of external funds raised by American businesses because costly state verification
makes the equity contract less desirable than the debt contract.
13) Debt contracts are agreements by the borrowers to pay the lenders fixed dollar amounts at periodic intervals.
14) Since they require less monitoring of firms, debt contracts are used more frequently than equity contracts to raise capital.
15) Explain the principal-agent problem as it pertains to equity contracts.
Answer: The principals are the stockholders who own most of the equity. The agents are the managers of the firm who generally own
only a small portion of the firm. The problem occurs because the agents may not have as much incentive to profit maximize as the
stockholders.
8.6 How Moral Hazard Influences Financial Structure in Debt Markets
1) Although debt contracts require less monitoring than equity contracts, debt contracts are still subject to moral hazard since
borrowers have an incentive to take on more risk than the lender would like.
2) A debt contract is incentive compatible if the borrower has the incentive to behave in the way that the lender expects and desires,
since doing otherwise jeopardizes the borrowerʹs net worth in the business.
3) High net worth helps to diminish the problem of moral hazard problem by making the debt contract incentive compatible.
4) One way of describing the solution that high net worth provides to the moral hazard problem is to say that it makes the debt
contract incentive compatible.
5) A clause in a debt contract requiring that the borrower purchase insurance against loss of the asset financed with the loan is called a
restrictive covenant.
6) Professional athletes often have contract clauses prohibiting risky activities such as skiing and motorcycle riding. These clauses are
restrictive covenants.
7) For restrictive covenants to help reduce the moral hazard problem they must be monitored and enforced by the lender.
8) Although restrictive covenants can potentially reduce moral hazard, a problem with restrictive covenants is that borrowers may
find loopholes that make the covenants ineffective.
9) Solutions to the moral hazard problem include monitoring and enforcement of restrictive covenants.
10) A key finding of the economic analysis of financial structure is that the existence of the free-rider problem for traded securities
helps to explain why banks play a predominant role in financing the activities of businesses.
11) One reason financial systems in developing and transition countries are underdeveloped is the legal system may be poor making it
difficult to enforce restrictive covenants.
12) One reason China has been able to grow so rapidly even though its financial development is still in its early stages is the high
savings rate of around 40%.
13) Why does the free-rider problem occur in the debt market?
Answer: Restrictive covenants can reduce moral hazard but they must be monitored and enforced to be effective. If bondholders know
that other bondholders are monitoring and
enforcing the restrictive covenants, they can free ride. Other bondholders will follow suit
resulting in not enough resources devoted to monitoring and enforcing restrictive covenants.
8.7 Conflicts of Interest
1) The presence of economies of scope may benefit financial institutions but may create potential costs from conflicts of interest.
2) Because conflicts of interest increase asymmetric information problems, the economy will not operate as efficiently.
3) Investment banks research companies issuing securities and underwrite these securities by selling them to the public on behalf of
the issuing companies.
4) A conflict of interest arises in investment banking because the banks are attempting to
simultaneously serve two client groups the security-issuing firms and the security-buying investors.
5) The practice of spinning is allocating initially underpriced initial public offerings to executives in companies the investment bank
hopes to do underwriting business with in the future.
6) A conflict of interest can occur for accounting firms when the firms both provide auditing services and nonaudit consulting
services.
7) Credit-rating agencies may face a conflict of interest because they both advise clients on how to structure debt issues and
determine the creditworthiness of the debt issues.
8) The fact that the credit-rating agencies both advised clients on how to structure the financial instruments that paid out cash flows
from subprime mortgages and also rated these financial instruments contributed to the subprime financial crisis that began in 2007.
9) All of the following are credit-rating agency reforms proposed by the SEC in 2008 except prohibit credit-rating agencies from
structuring the same products that they rate.
10) The Sarbanes-Oxley Act of 2002 increased supervisory oversight by increasing the SECʹs budget to supervise securities
markets.
11) While Sarbanes-Oxley is designed to reduce the problems caused by conflicts of interest critics say that it might diminish
economies of scope and reduce information in financial markets.
12) The Global Legal Settlement of 2002 required investment banks to separate research and securities underwriting.
13) What three types of financial service activities have led to serious conflict of interest problems in financial markets in recent
years?
Answer: Serious conflict of interest problems have resulted from both underwriting and research activities by investment banks, both
auditing and consulting by accounting firms, and both credit assessment and consulting by credit-rating agencies.
Chapter 9 Banking and the Management of Financial Institutions
10.1 The Bank Balance Sheet
1) Which of the following statements are true?
A) A bankʹs assets are its sources of funds.
B) A bankʹs liabilities are its uses of funds.
C) A bankʹs balance sheet shows that total assets equal total liabilities plus equity capital.
D) A bankʹs balance sheet indicates whether or not the bank is profitable.
2) Which of the following statements is false?
A) A bankʹs assets are its uses of funds.
B) A bank issues liabilities to acquire funds.
C) The bankʹs assets provide the bank with income.
D) Bank capital is recorded as an asset on the bank balance sheet.
3) Which of the following are reported as liabilities on a bankʹs balance sheet?
A) Reserves C) Loans
B) Checkable deposits D) Deposits with other banks
4) Which of the following are reported as liabilities on a bankʹs balance sheet?
A) Discount loans C) U.S. Treasury securities
B) Reserves D) Loans
5) The share of checkable deposits in total bank liabilities has shrunk over time.
6) Which of the following statements is false?
A) Checkable deposits are usually the lowest cost source of bank funds.
B) Checkable deposits are the primary source of bank funds.
C) Checkable deposits are payable on demand.
D) Checkable deposits include NOW accounts.
7) In recent years the interest paid on checkable and time deposits has accounted for around _____25%___ of total bank operating
expenses, while the costs involved in servicing accounts have been approximately ____50%____ of operating expenses.
8) Which of the following statements are true?
A) Checkable deposits are payable on demand.
B) Checkable deposits do not include NOW accounts.
C) Checkable deposits are the primary source of bank funds.
D) Demand deposits are checkable deposits that pay interest.
9) Because checking accounts are __more__ liquid for the depositor than passbook savings, they earn __lower__ interest rates.
10) Which of the following are transaction deposits?
A) Savings accounts B) Small-denomination time deposits
 C) Negotiable order of withdraw accounts D) Certificates of deposit
11) Which of the following is not a nontransaction deposit?
A) Savings accounts C) Negotiable order of withdrawal accounts
B) Small-denomination time deposits D) Certificate of deposit
12) Large-denomination CDs are negotiable, so that like a bond they can be resold in a __secondary__market before they mature.
13) Because __passbook savings___ are less liquid for the depositor than __checkable deposits__, they earn higher interest rates.
14) Because ___time deposits_____ are less liquid for the depositor than ____passbook savings____, they earn higher interest rates.
15) Banks acquire the funds that they use to purchase income-earning assets from such sources as savings accounts.
16) Bank loans from the Federal Reserve are called ___discount loans_____ and represent a ____source____ of funds.
17) Which of the following is not a source of borrowings for a bank?
A) Federal funds C) Transaction deposits
B) Eurodollars D) Discount loans
18) Bank capital is equal to total assets minus total liabilities
19) Bank capital is listed on the liability side of the bankʹs balance sheet because it represents a source of funds.
20) Bank reserves include vault cash and deposits at the Fed.
21) The fraction of checkable deposits that banks are required by regulation to hold are B) required reserves.
22) Which of the following are reported as assets on a bankʹs balance sheet?
A) Borrowings C) Savings deposits
B) Reserves D) Bank capital
23) Which of the following are not reported as assets on a bankʹs balance sheet?
A) Cash items in the process of collection C) U.S. Treasury securities
B) Deposits with other banks D) Checkable deposits
24) Through correspondent banking, large banks provide services to small banks, including B) foreign exchange transactions.
25) The largest percentage of banksʹ holdings of securities consist of A) Treasury and government agency securities.
26) Which of the following bank assets is the most liquid?
A) Consumer loans C) Cash items in process of collection
B) Reserves D) U.S. government securities
27) Secondary reserves include C) short-term Treasury securities.
28) Because of their ________ liquidity, ________ U.S. government securities are called secondary reserves. C) high; short-term
29) Secondary reserves are so called because they can be converted into cash with low transactions costs.
30) Banksʹ asset portfolios include state and local government securities because their interest payments are tax deductible for
federal income taxes.
31) Bankʹs make their profits primarily by issuing loans
32) The most important category of assets on a bankʹs balance sheet is loans.
33) Which of the following are bank assets?
A) the building owned by the bank C) a negotiable CD
B) a discount loan D) a customerʹs checking account
10.2 Basic Banking
1) Banks earn profits by selling ________ with attractive combinations of liquidity, risk, and return, and using the proceeds to buy
________ with a different set of characteristics. C) liabilities; asset
2) In general, banks make profits by selling short-term liabilities and buying longer-term assets.
3) Asset transformation can be described as borrowing short and lending long.
4) When a new depositor opens a checking account at the First National Bank, the bankʹs assets increase and its liabilities increase.
5) When Jane Brown writes a $100 check to her nephew (who lives in another state), Ms. Brownʹs bank ________ assets of $100 and
________ liabilities of $100. loses; loses
6) When you deposit a $50 bill in the Security Pacific National Bank, its assets increase by $50.
7) When you deposit $50 in currency at Old National Bank, its liabilities increase by $50.
8) Holding all else constant, when a bank receives the funds for a deposited check, cash items in the process of collection fall by the
amount of the check.
9) When a $10 check written on the First National Bank of Chicago is deposited in an account at Citibank, then C) the liabilities of
Citibank increase by $10.
10) When a $10 check written on the First National Bank of Chicago is deposited in an account at Citibank, then A) the liabilities of
the First National Bank decrease by $10.
11) When you deposit $50 in your account at First National Bank and a $100 check you have written on this account is cashed at
Chemical Bank, then C) the reserves at First National fall by $50.
12) When $1 million is deposited at a bank, the required reserve ratio is 20 percent, and the bank chooses not to hold any excess
reserves but makes loans instead, then, in the bankʹs final balance Sheet, B) the liabilities of the bank increase by $1,000,000.
13) When $1 million is deposited at a bank, the required reserve ratio is 20 percent, and the bank chooses not to make any loans but to
hold excess reserves instead, then, in the bankʹs final balance sheet, A) the assets at the bank increase by $1 million.
14) With a 10% reserve requirement ratio, a $100 deposit into New Bank means that the maximum amount New Bank could lend is A)
$90.
15) Using T-accounts show what happens to reserves at Security National Bank if one individual deposits $1000 in cash into her
checking account and another individual withdraws $750 in cash from her checking account.
Answer: Security National Bank
Assets Liabilities
Reserves +$250 Checkable deposits +$250
10.3 General Principles of Bank Management
1) Which of the following are primary concerns of the bank manager? A) Maintaining sufficient reserves to minimize the cost to the
bank of deposit outflows
2) If a bank has $100,000 of checkable deposits, a required reserve ratio of 20 percent, and it holds $40,000 in reserves, then the
maximum deposit outflow it can sustain without altering its balance sheet is B) $25,000.
3) If a bank has $200,000 of checkable deposits, a required reserve ratio of 20 percent, and it holds $80,000 in reserves, then the
maximum deposit outflow it can sustain without altering its balance sheet is A) $50,000.
4) If a bank has $10 million of checkable deposits, a required reserve ratio of 10 percent, and it holds $2 million in reserves, then it will
not have enough reserves to support a deposit outflow Of A) $1.2 million.
5) If a bank has excess reserves greater than the amount of a deposit outflow, the outflow will result in equal reductions in A) deposits
and reserves.
6) A $5 million deposit outflow from a bank has the immediate effect of A) reducing deposits and reserves by $5 million.
7) Bankersʹ concerns regarding the optimal mix of excess reserves, secondary reserves, borrowings from the Fed, and borrowings from
other banks to deal with deposit outflows is an example of B) liquidity management.
8) If, after a deposit outflow, a bank needs an additional $3 million to meet its reserve requirements, the bank can C) sell $3 million of
securities.
9) A bank with insufficient reserves can increase its reserves by B) calling in loans.
10) Of the following, which would be the first choice for a bank facing a reserve deficiency D) Borrow from other banks
11) In general, banks would prefer to acquire funds quickly by borrowing from the Fed rather than reducing loans
12) Calling in loans may antagonize customers and thus can be a very costly way of acquiring funds to meet an unexpected deposit
outflow.
13) Banks hold excess and secondary reserves to B) provide for deposit outflows.
14) Which of the following statements most accurately describes the task of bank asset management?
A) Banks seek the highest returns possible subject to minimizing risk and making adequate
15) The goals of bank asset management include D) purchasing securities with high returns and low risk.
16) Banks that suffered significant losses in the 1980s made the mistake of failing to diversify their loan portfolio.
17) A bank will want to hold more excess reserves (everything else equal) when brokerage commissions on selling bonds increase.
18) As the costs associated with deposit outflows ________, the banks willingness to hold excess reserves will ________. C) increase;
increase
19) Which of the following would a bank not hold as insurance against the highest cost of deposit outflow-bank failure?
A) Excess reserves C) Bank capital
B) Secondary reserves D) Mortgages
20) Which of the following has not resulted from more active liability management on the part of banks?
A) Increased bank holdings of cash items C) Increased use of negotiable CDs to raise funds
B) Aggressive targeting of goals for asset growth D) An increased proportion of bank assets held in
by banks loans
21) Banks that actively manage liabilities will most likely meet a reserve shortfall by B) borrowing federal funds.
22) Modern liability management has resulted in A) increased sales of certificates of deposits to raise funds.
23) A bank failure occurs whenever a bank cannot satisfy its obligations to pay its depositors and have enough reserves to meet its
reserve requirements.
24) A bank is insolvent when its liabilities exceed its assets.
25) Holding large amounts of bank capital helps prevent bank failures because C) it can be used to absorb the losses resulting from
bad loans.
26) Net profit after taxes per dollar of assets is a basic measure of bank profitability called A) return on assets.
27) Net profit after taxes per dollar of equity capital is a basic measure of bank profitability called C) return on equity.
28) The amount of assets per dollar of equity capital is called the C) equity multiplier.
29) For a given return on assets, the lower is bank capital, the higher is the return for the owners of the bank.
30) Bank capital has both benefits and costs for the bank owners. Higher bank capital ________ the likelihood of bankruptcy, but
higher bank capital ________ the return on equity for a given return on assets. reduces; reduces
31) In the absence of regulation, banks would probably hold too little capital.
32)Conditions that likely contributed to a credit crunch in 2008 include: capital shortfalls caused in part by falling real estate prices.
33) Which of the following would not be a way to increase the return on equity?
A) Buy back bank stock
B) Pay higher dividends
C) Acquire new funds by selling negotiable CDs and increase assets with them
D) Sell more bank stock
34) If a bank needs to raise the amount of capital relative to assets, a bank manager might choose to shrink the size of the bank.
35) Your bank has the following balance sheet:
Assets Liabilities
Reserves $ 50 million Checkable deposits $200 million
Securities 50 million
Loans 150 million Bank capital 50 million
If the required reserve ratio is 10%, what actions should the bank manager take if there is an unexpected deposit outflow of $50m?
Answer: After the deposit outflow, the bank will have a reserve shortfall of $15 million. The bank manager could try to borrow in the
Federal Funds market, take out a discount loan from the Federal Reserve, sell $15 million of the securities the bank owns, sell off $15
million of the loans the bank owns , or lastly call-in $15 million of loans. All of the actions will be costly to the bank. The bank
manager should try to acquire the funds with the least costly method.
10.4 Managing Credit Risk
1) Banks face the problem of adverse selection in loan markets because bad credit risks are the ones most likely to seek bank loans.
2) If borrowers with the most risky investment projects seek bank loans in higher proportion to
those borrowers with the safest investment projects, banks are said to face the problem of adverse selection.
3) Because borrowers, once they have a loan, are more likely to invest in high-risk investment projects, banks face the D) moral
hazard problem.
4) In order to reduce the adverse selection problem in loan markets, bankers collect information from prospective borrowers to screen
out the bad credit risks from the good ones.
5) In one sense ________ appears surprising since it means that the bank is not ________ its portfolio of loans and thus is exposing
itself to more risk. specialization in lending; diversifying
6) From the standpoint of ________, specialization in lending is surprising but makes perfect sense when one considers the ________
problem diversification; adverse selection
7) Provisions in loan contracts that prohibit borrowers from engaging in specified risky activities are called B) restrictive covenants.
8) To reduce moral hazard problems, banks include restrictive covenants in loan contracts. In order for these restrictive covenants to be
effective, banks must also A) monitor and enforce them.
9) Long-term customer relationships ________ the cost of information collection and make it easier to ________ credit risks. reduce;
screen
10) Unanticipated moral hazard contingencies can be reduced by B) long-term customer relationships.
11) A bankʹs commitment to provide a firm with loans up to pre-specified limit at an interest rate that is tied to a market interest rate is
called loan commitment.
12) Property promised to the lender as compensation if the borrower defaults is called collateral
13) A bank that wants to monitor the check payment practices of its commercial borrowers, so that moral hazard can be prevented, will
require borrowers to keep compensating balances in a checking account at the bank.
14) Of the following methods that banks might use to reduce moral hazard problems, the one not legally permitted in the United States
is the B) requirement that firms place on their board of directors an officer from the bank.
15) When a lender refuses to make a loan, although borrowers are willing to pay the stated interest rate or even a higher rate, the bank
is said to engage in C) credit rationing.
16) When banks offer borrowers smaller loans than they have requested, banks are said to D) ration credit.
17) Credit risk management tools include B) collateral.
18) How can specializing in lending help to reduce the adverse selection problem in lending?
Answer: Reducing the adverse selection problem requires the banks to acquire information to screen bad credit risks from good credit
risks. It is easier for banks to obtain information about local businesses. Also if the bank lends to firms in a few specific industries they
will become more knowledgeable about those industries and a better judge of creditworthiness in those industries.
10.5 Managing Interest-Rate Risk
1) Risk that is related to the uncertainty about interest rate movements is called interest-rate risk.
2) All else the same, if a bankʹs liabilities are more sensitive to interest rate fluctuations than are its assets, then ________ in interest
rates will ________ bank profits. an increase; reduce
3) If a bank has ________ rate-sensitive assets than liabilities, then ________ in interest rates will increase bank profits. more; an
increase
4) If a bank has ________ rate-sensitive assets than liabilities, a ________ in interest rates will reduce bank profits, while a ________
in interest rates will raise bank profits. more; decline; rise
5) If a bankʹs liabilities are more sensitive to interest rate movements than are its assets, then
A) an increase in interest rates will reduce bank profits.
6) The difference of rate-sensitive liabilities and rate-sensitive assets is known as the gap.
7) If the First National Bank has a gap equal to a negative $30 million, then a 5 percentage point increase in interest rates will cause
profits to decline by $1.5 million.
8) Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap times the change in the interest rate is
called B) basic gap analysis.
9) Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap for several maturity subintervals times
the change in the interest rate is called the maturity bucket approach to gap analysis.
First National Bank
Assets Liabilities
Rate-sensitive $20 million $50 million
Fixed-rate $80 million $50 million
10) If interest rates rise by 5 percentage points, say, from 10 to 15%, bank profits (measured using gap analysis) will decline by $1.5
million.
11) Assuming that the average duration of its assets is five years, while the average duration of its liabilities is three years, then a 5
percentage point increase in interest rates will cause the net worth of First National to decline by 10 percent of the total original asset
value.
12) If interest rates rise by 5 percentage points, say from 10 to 15%, bank profits (measured using gap analysis) will decline by $0.5m
13) Assuming that the average duration of its assets is four years, while the average duration of its liabilities is three years, then a 5
percentage point increase in interest rates will cause the net worth of First National to decline by 5 percent of the total original asset
value.
14) Duration analysis involves comparing the average duration of the bankʹs assets to the average duration of its liabilities
15) Because of an expected rise in interest rates in the future, a banker will likely buy short-term rather than long-term bonds.
16) If a banker expects interest rates to fall in the future, her best strategy for the present is to increase the duration of the bankʹs
assets.
17) Bruce the Bank Manager can reduce interest rate risk by ________ the duration of the bankʹs
assets to increase their rate sensitivity or, alternatively, ________ the duration of the bankʹs liabilities. A) shortening; lengthening
18) Your bank has the following balance sheet
Assets Liabilities
Rate-sensitive $100 million Rate-sensitive $75 million
Fixed-rate 100 million Fixed-rate 125 million
What would happen to bank profits if the interest rates in the economy go down? Is there anything that you could do to keep your bank
from being so vulnerable to interest rate movements?
Answer: The bankʹs profits would go down because it has more interest-rate sensitive assets than liabilities. In order to reduce interest-
rate sensitivity, the bank manager could use financial derivatives such as interest-rate swaps, options, or futures. The bank manager
could also try to adjust the balance sheet so that the bankʹs profits are not vulnerable to the movement of the interest rate.
10.6 Off-Balance-Sheet Activities
1) Examples of off-balance-sheet activities include A) loan sales.
2) All of the following are examples of off-balance sheet activities that generate fee income for banks except D) selling negotiable
CDs.
3) Which of the following is not an example of a backup line of credit?D) mortgages
4) Off-balance sheet activities involving guarantees of securities and back-up credit lines C) increase the risk a bank faces.
5) When banks involved in trading activities attempt to outguess markets, they are C) speculating
6) Traders working for banks are subject to the A) principal-agent problem.
7) A reason why rogue traders have bankrupt their banks is due to D) a failure to maintain proper internal controls.
8) One way for banks to reduce the principal-agent problems associated with trading activities is to A) set limits on the total amount
of a tradersʹ transactions.
9) The principal-agent problem that exists for bank trading activities can be reduced through B) creation of internal controls that
separate trading activities from bookkeeping.
10) Banks develop statistical models to calculate their maximum loss over a given time period. This approach is known as the B)
value-at-risk approach.
11) When banks calculate the losses the institution would incur if an unusual combination of bad events happened, the bank is using the
________ approach. A) stress-test
10.7 Web Appendix 1: Duration Gap Analysis
1) Assume a bank has $200 million of assets with a duration of 2.5, and $190 million of liabilities with a duration of 1.05. If interest
rates increase from 5 percent to 6 percent, the net worth of the bank falls by D) $4.8 million.
2) Assume a bank has $200 million of assets with a duration of 2.5, and $190 million of liabilitieswith a duration of 1.05. The duration
gap for this bank is C) 1.5 years.
3) If interest rates increase from 9 percent to 10 percent, a bank with a duration gap of 2 years would experience a decrease in its net
worth of 1.8 percent of its assets.
4) One of the problems in conducting a duration gap analysis is that the duration gap is calculated assuming that interest rates for all
maturities are the same. That means that the yield curve is A) flat.
10.8 Web Appendix 2: Measuring Bank Performance
1) Most of a bankʹs operating income results from A) interest on assets
2) All of the following are operating expenses for a bank except A) service charges on deposit accounts.
3) When a bank suspects that a $1 million loan might prove to be bad debt that will have to be written off in the future the bank A) can
set aside $1 million of its earnings in its loan loss reserves account
4) For banks, C) return on equity exceeds return on assets.
5) The quantity interest income minus interest expenses divided by assets is a measure of bank performance known as B) net interest
margin.
6) Looking at the Net Interest Margin indicates that the poor bank performance in the late 1980s A) was not the result of interest-rate
movements.
Chapter 10 Economic Analysis of Financial Regulation
11.1 Asymmetric Information and Financial Regulation
1) Depositors lack of information about the quality of bank assets can lead to A) bank panics
2) The fact that banks operate on a ʺsequential service constraintʺ means that C) depositors arriving first have the best chance of
withdrawing their funds
3) Depositors have a strong incentive to show up first to withdraw their funds during a bank crisis because banks operate on B)
sequential service constraint.
4) Because of asymmetric information, the failure of one bank can lead to runs on other banks. This is the D) contagion effect.
5) The contagion effect refers to the fact that D) the failure of one bank can hasten the failure of other banks.
6) During the boom years of the 1920s, bank failures were quite C) common, averaging about 600 per year.
7) To prevent bank runs and the consequent bank failures, the United States established the___ A) FDIC_____ in 1934 to provide
deposit insurance.
8) The primary difference between the ʺpayoffʺ and the ʺpurchase and assumptionʺ methods of handling failed banks is B) that the
FDIC guarantees all deposits when it uses the ʺpurchase and assumptionʺ method.
9) Deposit insurance has not worked well in countries with A) a weak institutional environment.
10) When one party to a transaction has incentives to engage in activities detrimental to the other party, there exists a problem of A)
moral hazard.
11) Moral hazard is an important concern of insurance arrangements because the existence of insurance A) provides increased
incentives for risk taking.
12) When bad drivers line up to purchase collision insurance, automobile insurers are subject to the B) adverse selection problem.
13) Deposit insurance is only one type of government safety net. All of the following are types of government support for troubled
financial institutions except A) forgiving tax debt.
14) Although the FDIC was created to prevent bank failures, its existence encourages banks to A) take too much risk.
15) A system of deposit insurance attracts risk-taking entrepreneurs into the banking industry.
16) The government safety net creates __A) an adverse selection______ problem because risk -loving entrepreneurs might find
banking an attractive industry.
17) Since depositors, like any lender, only receive fixed payments while the bank keeps any surplus profits, they face the ________
problem that banks may take on too ________ risk.
D) moral hazard; much
18) Acquiring information on a bankʹs activities in order to determine a bankʹs risk is difficult for depositors and is another argument
for government _A) regulation
19) The existence of deposit insurance can increase the likelihood that depositors will need deposit protection, as banks with deposit
insurance A) are likely to take on greater risks than they otherwise would.
20) In May 1991, the FDIC announced that it would sell the governmentʹs final 26% stake in Continental Illinois, ending government
ownership of the bank that it had rescued in 1984. The FDIC took control of the bank, rather than liquidate it, because it believed that
Continental Illinois C) was too big to fail.
21) If the FDIC decides that a bank is too big to fail, it will use the ________ method, effectively ensuring that ________ depositors
will suffer losses.
D) purchase and assumption; no
22) Federal deposit insurance covers deposits up to $100,000, but as part of a doctrine called ʺtoo-big-to-failʺ the FDIC sometimes ends
up covering all deposits to avoid disrupting the financial system. When the FDIC does this, it uses the
B) ʺpurchase and assumptionʺ method.
23) The result of the too-big-to-fail policy is that ________ banks will take on ________ risks, making bank failures more likely.
D) big; greater
24) A problem with the too-big-to-fail policy is that it ________ the incentives for ________ by big banks.
A) increases; moral hazard
25) The too-big-to-fail policy C) treats large depositors of small banks inequitably when compared to depositors of large banks.
26) Regulators attempt to reduce the riskiness of banksʹ asset portfolios by A) limiting the amount of loans in particular categories
or to individual borrowers.
27) A well-capitalized financial institution has ________ to lose if it fails and thus is ________ likely to pursue risky activities.
B) more; less
28) A bank failure is less likely to occur when D) a bank has more bank capital.
29) The leverage ratio is the ratio of a bankʹs C) capital divided by its total assets.
30) To be considered well capitalized, a bankʹs leverage ratio must exceed ________.C) 5%
31) Off-balance-sheet activities C) generate fee income but increase a bankʹs risk.
32) The Basel Accord, an international agreement, requires banks to hold capital based on risk-weighted assets.
33) The Basel Accord requires banks to hold as capital an amount that is at least __8%______ of their risk-weighted assets.
34) Under the Basel Accord, assets and off-balance sheet activities were sorted according tov 4 categories with each category assigned
a different weight to reflect the amount of credit risk
35) The practice of keeping high-risk assets on a bankʹs books while removing low-risk assets withthe same capital requirement is
know as regulatory arbitrage.
36) Banks engage in regulatory arbitrage by keeping high-risk assets on their books while removing low-risk assets with the same
capital requirement.
37) Because banks engage in regulatory arbitrage, the Basel Accord on risk-based capital requirements may result in D) increased risk
taking by banks.
38) One of the criticisms of Basel 2 is that it is procyclical. That means that banks may be required to hold more capital during
times when capital is short.
39) Overseeing who operates banks and how they are operated is called prudential supervision
40) The chartering process is especially designed to deal with the adverse selection problem, and regular bank examinations help to
reduce the moral hazard problem
41) The chartering process is similar to screening potential borrowers and the restriction of risk assets by regulators is similar to
restrictive covenants in private financial markets.
42) Banks will be examined at least once a year and given a CAMELS rating by examiners. The L stands for liquidity
43) The federal agencies that examine banks include A) the Federal Reserve System.
44) Banks are required to file ___A) call reports_____ usually quarterly that list information on the bankʹs assets and liabilities,
income and dividends, and so forth.
45) Regular bank examinations and restrictions on asset holdings help to indirectly reduce the___B) adverse selection_____ problem
because, given fewer opportunities to take on risk, risk-prone entrepreneurs will be discouraged from entering the banking industry.
46) The current supervisory practice toward risk management evaluates the soundness of a bankʹs risk-management process.
47) Regulations designed to provide information to the marketplace so that investors can make informed decisions are called disclosure
requirements.
48) With __A) mark-to-market accounting______, firms value assets on their balance sheet at what they would sell for in the market.
49) During times of financial crisis, mark-to-market accounting
A) requires that a financial firmsʹ assets be marked down in value which can worsen the lending crisis.
50) Consumer protection legislation includes legislation to A) reduce discrimination in credit markets.
51) An important factor in producing the subprime mortgage crisis was A) lax consumer protection regulation.
52) Competition between banks A) encourages greater risk taking.
53) Regulations that reduced competition between banks included A) branching restrictions.
54) The the Glass-Steagall Act that required separation of commercial and investment banking was repealed in 1999.
55) Which of the following is not a reason financial regulation and supervision is difficult in real life?
D) Financial institutions are not required to follow the rules.
56) Who has regulatory responsibility when a bank operates branches in many countries?A) It is not always clear.
57) The collapse of the Bank of Credit and Commerce International, BCCI, showed the difficulty of international banking regulation.
BCCI operated in more than 70 countries and was supervised by the small country of Luxembourg
58) Agreements such as the __A) Basel Accord______ are attempts to standardize international banking regulations.
59) The Basel Committee ruled that regulators in other countries can ___A) restrict_____ the operations of a foreign bank if they
believe that it lacks effective oversight.
60) The government safety net creates both an adverse selection problem and a moral hazard problem. Explain.
Answer: The adverse selection problem occurs because risk-loving individuals might view the banking system as a wonderful
opportunity to use other peoplesʹ funds knowing that those funds are protected. The moral hazard problem comes about
because depositors will not impose discipline on the banks since their funds are protected and the banks knowing this will be
tempted to take on more risk than they would otherwise.
11.2 The 1980ʹs Savings and Loan and Banking Crisis
1) In the ten year period 1981-1990, 1202 commercial banks were closed, with a peak of 206 failures in 1989. This rate of failures was
approximately ____D) ten____ times greater than that in the period from 1934 to 1980.
2) During the 1960s, 1970s, and early 1980s, traditional bank profitability declined because of A) financial innovation that increased
competition from new financial institutions.
3) Moral hazard problems increased in prominence in the 1980s B) following a burst of financial innovation in the 1970s and early
1980s that produced new
4) The Depository Institutions Deregulation and Monetary Control Act of 1980 D) increased deposit insurance from $40,000 to
$100,000.
5) How did the increase in the interest rates in the early 80s contribute to the S&L crisis?
Answer: The S&Ls suffered from an interest-rate risk problem. They had many fixed-ratemortgages with low interest rates. As interest
rates in the economy began to climb, S&Ls began to lose profitability. Because of deregulation and financial innovation, it became
possible for the S&Ls to undertake more risky ventures to try to regain their profitability. Many of them lacked expertise in judging
credit risk in the new loan areas resulting in large losses.
11.3 Banking Crises Throughout the World
1) The evidence from banking crises in other countries indicates that D) deregulation combined with poor regulatory supervision
raises moral hazard incentives.
2) A common element in all of the banking crisis episodes in different countries is A) the existence of a government safety net.
3) Banking crises have occurred throughout the world. What similarities do we find when we look at the different countries?
Answer: Financial deregulation with inadequate supervision can lead to increased moral hazard as banks take on more risk. Although
deposit insurance was not necessarily a major factor in every countryʹs bank crisis, there was always some kind of government safety
net. The presence of the government safety net also leads to increased risk-taking from the banks.
11.4 Whither Financial Regulation After the Subprime Financial Crisis?
1) All of the following would reduce the agency problems of the originate-to-distribute model except encouraging more complex
mortgage products.
2) Higher capital requirements will reduce the problems incurred when troubled ______A) structured investment vehicles (SIVs)__
which had been off-balance sheet activities come back on the balance sheet.
3) Currently, Fannie Mae and Freddie Mac are A) privately owned government-sponsored enterprises.
4) Investment banks that are part of _A) bank holding companies_______ are regulated and supervised like banks.
5) The inaccurate ratings provided by credit-rating agencies
A) meant that investors did not have the information they needed to make informed choices about their investments.
6) The subprime financial crisis showed the need for increased financial regulation, however, too much or poorly designed regulation
could A) choke off financial innovation.
11.5 Web Appendix 1: The Savings and Loan Crisis and Its Aftermath
1) Moral hazard and adverse selection problems increased in prominence in the 1980s B) following a burst of financial innovation in
the 1970s and early 1980s that produced new financial instruments and markets, thereby widening the scope for risk taking.
2) The Depository Institutions Deregulation and Monetary Control Act of 1980 D) increased deposit insurance from $40,000 to
$100,000.
3) One of the problems experienced by the savings and loan industry during the 1980s was A) managers lack of expertise to manage
risk in new lines of business.
4) In the early stages of the 1980s banking crisis, financial institutions were especially harmed by B) the severe recession in 1981-82.
5) When regulators chose to allow insolvent S&Ls to continue to operate rather than to close them, they were pursuing a policy of A)
regulatory forbearance
6) Savings and loan regulators allowed S&Ls to include in their capital calculations a high value for intangible capital called A)
goodwill.
7) Reasons regulators chose to follow regulatory forbearance rather than to close the insolvent S&Ls include all of the following except
D) they did not have the authority to close the insolvent S&Ls.
8) The policy of regulatory forbearance exacerbated moral hazard problems as savings and loans took on increasingly huge levels
of risk on the slim chance of returning to solvency.
9) Regulatory forbearance A) meant delaying the closing of ʺzombie S&Lsʺ as their losses mounted during the 1980s.
10) The major provisions of the Competitive Equality Banking Act of 1987 include.C) directing the Federal Home Loan Bank
Board to continue to pursue regulatory forbearance.
11) The S&L Crisis can be analyzed as a principal-agent problem. The agents in this case, the________, did not have the same
incentive to minimize cost to the economy as the principals, the________.
A) politicians/regulators; taxpayers
12) ʺBureaucratic gamblingʺ refers to C) the strategy adopted by thrift regulators of lowering capital requirements and pursuing
regulatory forbearance in the 1980s in the hope that conditions in the S&L industry would improve.
13) That several hundred S&Ls were not even examined once in the period January 1984 through June 1986 can be explained by A)
Congressʹs unwillingness to allocate the necessary funds to thrift regulators.
14) The bailout of the savings and loan industry was much delayed and, therefore, much more costly to taxpayers because A) of
regulatorsʹ initial attempts to downplay the seriousness of problems within the thrift industry.
15) An analysis of the political economy of the savings and loan crisis helps one to understand C) why thrift regulators willingly
acceded to pressures placed upon them by members of Congress.
16) Taxpayers were served poorly by thrift regulators in the 1980s. This poor performance cannot be explained by Congressʹs dogged
determination to protect taxpayers from the unsound banking practices of managers at many of the nations savings and loans.
17) The Federal Home Loan Bank Board and the FSLIC, both of which failed in their regulatory tasks, were abolished by the
B) Financial Institutions Reform, Recovery and Enforcement Act of 1989.
18) The Resolution Trust Corporation was created by the FIRREA in order to A) manage and resolve insolvent S&Ls.
19) FIRREA increased the core-capital leverage requirement for thrift institutions from 3% to A) 8%.
20) The Federal Deposit Insurance Corporation Improvement Act of 1991 A) increased the FDICʹs ability to borrow from the
Treasury to deal with failed banks.
21) The ability to use the too-big-to-fail policy was curtailed by the passage of the FDICIA. To use this action today, the FDIC must get
approval of a two-thirds majority of both the Board ofGovernors of the Federal Reserve and the directors of the FDIC and also the
approval of the A) Secretary of the Treasury
22) The directive of prompt corrective action means that A) the FDIC will intervene earlier and more vigorously when a bank gets
into trouble.
23) FDICIA ________ incentives for banks to hold capital and ________ incentives to take on excessive risk.
A) increased; decreased
11.6 Web Appendix 2: Banking Crises Throughout the World
1) As in the United States, an important factor in the banking crises in Norway, Sweden, and Finland was the
A) financial liberalization that occurred in the 1980s.
2) As in the United States, an important factor in the banking crises in Latin America was the A) financial liberalization that
occurred in the 1980s.
3) The Argentine banking crisis of 2001 resulted from Argentinaʹs banks being required to A) purchase large amounts of government
debt.
4) When comparing the banking crisis in the United States to the crises in Latin America, cost to the taxpayers of the government
bailouts was A) higher in Latin American than in the United States.
5) The Japanese banking system went through a cycle of ____A) regulatory forbearance____ in the 1990s similar to the one that
occurred in the U.S. in the 1980s.
6) China is trying to move its banking system from being strictly ______A) state,owned by having them issue shares overseas.
7) The evidence from banking crises in other countries indicates that D) deregulation combined with poor regulatory supervision
raises moral hazard incentives.
8) Banking crises have occurred throughout the world. What similarities do we find when we look at the different countries?
Answer: Financial deregulation with inadequate supervision can lead to increased moral hazard as banks take on more risk.
Although deposit insurance was not necessarily a major factor in every countryʹs bank crisis, there was always some kind of
government safety net. The presence of the government safety net also leads to increased risk-taking from the banks.
CHAPTER 11:
BANKING INDUSTRY: STRUCTURE AND COMPETITION
11.1 Historical Development of the Banking System
1) The modern commercial banking system began in America when the Bank of North America was chartered in Philadelphia in
1782.
2) A major controversy involving the banking industry in its early years was whether the federal government or the states should
charter banks.
3) The government institution that has responsibility for the amount of money and credit supplied in the economy as a whole is the
central bank.
4) Because of the abuses by state banks and the clear need for a central bank to help the federal government raise funds during the
War of 1812, Congress created the Second Bank of the United States in 1816.
5) The Second Bank of the United States was denied a new charter by President Andrew Jackson.
6) Currency circulated by banks that could be redeemed for gold was called banknotes
7) To eliminate the abuses of the state-chartered banks, the National Bank Act of 1863 created a new banking
system of federally chartered banks, supervised by the Office of the Comptroller of the Currency
8) The belief that bank failures were regularly caused by fraud or the lack of sufficient bank capital explains, in part, the passage of
the National Bank Act of 1863.
9) Before 1863, banks acquired funds by issuing bank notes.
10) Although the National Bank Act of 1863 was designed to eliminate state -chartered banks by imposing a prohibitive tax on
banknotes, these banks have been able to stay in business by acquiring funds through deposits.
11) The National Bank Act of 1863, and subsequent amendments to it, established the Office of the Comptroller of the Currency.
12) Which regulatory body charters national banks?
A) The Federal Reserve C) The Comptroller of the Currency
B) The FDIC D) The U.S. Treasury
13) The regulatory system that has evolved in the United States whereby banks are regulated at the state level, the national level, or
both, is known as a dual banking system.
14) Today the United States has a dual banking system in which banks supervised by the federal government; and by the states
operate side by side.
15) The U.S. banking system is considered to be a dual system because it is regulated by both state and federal governments.
16) The Federal Reserve Act of 1913 required that national banks join the Federal Reserve System.
17) The Federal Reserve Act required all national; banks to become members of the Federal Reserve System, while state banks could
choose to become members of the system.
18) Probably the most significant factor explaining the drastic drop in the number of bank failures since the Great Depression has been
the creation of the FDIC.
19) With the creation of the Federal Deposit Insurance Corporation, member banks of the Federal Reserve System were required to
purchase FDIC insurance for their depositors, while non-member commercial banks could choose to buy deposit insurance.
20) With the creation of the Federal Deposit Insurance Corporation, member banks of the Federal Reserve System were required
to purchase FDIC insurance for their depositors, while non-member commercial banks could choose to buy deposit insurance.
21) The Glass-Steagall Act, before its repeal in 1999, prohibited commercial banks from engaging in underwriting and dealing of
corporate securities.
22) The legislation that separated investment banking from commercial banking until its repeal in 1999 is known as the: Glass-
Steagall Act.
23) Which of the following statements concerning bank regulation in the United States are true?
A) The Office of the Comptroller of the Currency has the primary responsibility for state banks that are members of the
Federal Reserve System.
B) The Federal Reserve and the state banking authorities jointly have responsibility for the 900 state banks that are
members of the Federal Reserve System.
C) The Office of the Comptroller of the Currency has sole regulatory responsibility over bank holding companies.
D) The state banking authorities have sole regulatory responsibility for all state banks.
24) Which bank regulatory agency has the sole regulatory authority over bank holding companies?
A) The FDIC C) The FHLBS
B) The Comptroller of the Currency D) The Federal Reserve System
25) State banks that are not members of the Federal Reserve System are most likely to be examined by the FDIC.
26) State banking authorities have sole jurisdiction over state banks without FDIC insurance.
11.2 Financial Innovation and the Growth of the ʺShadow Banking Systemʺ
1) Financial innovations occur because of financial institutions search for profits
2) Financial engineering is the process of researching and developing profitable new products and services by financial institutions.
3) The most significant change in the economic environment that changed the demand for financial products in recent years has been
the dramatic increase in the volatility of interest rates.
4) In the 1950s the interest rate on three-month Treasury bills fluctuated between 1 percent and 3.5 percent; in the 1980s it fluctuated
between FIVE percent and FIFTEEN percent.
5) Uncertainty about interest-rate movements and returns is called interest-rate risk
6) Rising interest-rate risk increased the demand for financial innovation.
7) Adjustable rate mortgages benefit homeowners when interest rates are falling.
8) The agreement to provide a standardized commodity to a buyer on a specific date at a specific future price is a futures contract.
9) An instrument developed to help investors and institutions hedge interest-rate risk is a financial derivative.
10) Financial instruments whose payoffs are linked to previously issued securities are called financial derivatives
11) Both adjustable-rate mortgages and financial derivatives were financial innovations that occurred because of interest rate risk
volatility.
12) The most important source of the changes in supply conditions that stimulate financial innovation has been the improvement in
computer and telecommunications technology.
13) New computer technology has reduced the cost of financial innovation.
14) Credit cards date back to prior to the second World War.
15) A firm issuing credit cards earns income from loans it makes to credit card holders.
16) The entry of AT&T and GM into the credit card business is an indication of the rising profitability of credit card operations.
17) A debit card differs from a credit card in that a credit card is a loan while for a debit card purchase, payment is made
immediately.
18) Automated teller machines cost less than human tellers, so banks may encourage their use by charging less for using
ATMs.
19) The declining cost of computer technology has made virtual banking a reality.
20) Bank customers perceive Internet banks as being prone to many more technical problems.
21) A disadvantage of virtual banks (clicks) is that customers worry about the security of on-line transactions.
22) So-called fallen angels differ from junk bonds in that junk bonds refer to newly issued bonds with low credit ratings, whereas
fallen angels refer to previously bonds that have had their credit ratings fall below Baa.
23) Newly-issued high-yield bonds rated below investment grade by the bond-rating agencies are frequently referred to as junk
bonds.
24) In 1977, Michael Milken pioneered the concept of selling new public issues of junk bonds for companies that had not yet
achieved investment-grade status.
25) One factor contributing to the rapid growth of the commercial paper market since 1970 is improved information technology
making it easier to screen credit risks.
26) The development of money market mutual funds contributed to the growth of the commercial paper market since the money
market mutual funds need to hold liquid, high-quality, short-terms assets.
27) The process of transforming otherwise illiquid financial assets into marketable capital market instruments is know as
securitization.
28) Securitization. is creating a marketable capital market instrument by bundling a portfolio of mortgage or auto loans.
29) The driving force behind the securitization of mortgages and automobile loans has been the improvement in computer
technology.
30) According to Edward Kane, because the banking industry is one of the most regulated industries in America, it is an industry in
which loophole mining is especially likely to occur.
31) Loophole mining refers to financial innovation designed to get around regulations.
32) Prior to 2008, bank managers looked on reserve requirements as a tax on deposits.
33) Prior to 2008, the bankʹs cost of holding reserves equaled the interest earned on loans times the amount on reserves.
34) Prior to 1980, the Fed set an interest rate ceiling that is a maximum limit on the interest rate
that could be paid on time deposits.
35) The process in which people take their funds out of the banking system seeking higher-yielding securities is called
disintermediation.
36) Money market mutual funds function as interest-earning checking accounts.
37) In September 2008, the Reserve Primary Fund, a money market mutual fund, found itself in the situation know as ʺbreaking the
buck.ʺ This means that they could no longer afford to redeem shares at the par value of $1
38) In this type of arrangement, any balances above a certain amount in a corporationʹs checking account at the end of the business
day are ʺremovedʺ and invested in overnight securities that pay the corporation interest. This innovation is referred to as a sweep
account.
39) Sweep accounts which were created to avoid reserve requirements became possible because of a change in supply conditions
40) Sweep accounts have made reserve requirements nonbonding for many banks.
41) Since 1974, commercial banks importance as a source of funds for nonfinancial borrowers has shrunk dramatically, from
around 40 percent of total credit advanced to below 30 percent by 2005.
42) Thrift institutions importance as a source of funds for borrowers has shrunk from over 20 percent of total credit advanced in
the late 1970s to below 6 percent by 2005.
43) Since 1980 banks have offset the decline in profits from traditional activities with increased income from off-balance-sheet
activities.
44) Financial innovation has caused banks to suffer a simultaneous decline of cost and income advantages.
45) Disintermediation resulted from interest rate ceilings combine with inflation-driven increases in interest rates.
46) The experience of disintermediation in the banking industry illustrates that markets invent alternatives to costly regulations.
47) Banks responded to disintermediation by supporting the elimination of interest rate regulations, enabling them to better
compete for funds.
48) One factor contributing to the decline in cost advantages that banks once had is the decline in the importance of checkable
deposits from over 60 percent of banksʹ liabilities to under 10 percent today.
49) The most important developments that have reduced banks cost advantages in the past thirty years include: the competition from
money market mutual funds.
50) The most important developments that have reduced banks income advantages in the past thirty years include: the growth of
securitization.
51) Banks have attempted to maintain adequate profit levels by pursuing new off-balance-sheet activities.
52) The decline in traditional banking internationally can be attributed to improved information technology.
53) Why did the interest rate volatibility of the 1970s spur financial innovation?
Answer: Banks were very vulnerable to interest-rate risk in the mortgage loans. To protect themselves, banks began to issue
adjustable-rate mortgages whose interest rate will increase along with market interest rates. Additionally financial derivatives
were developed to help hedge against interest-rate risk.
11.3 Structure of the U.S. Commercial Banking Industry
1) The presence of so many commercial banks in the United States is most likely the result of prior regulations that restrict the
ability of these financial institutions to open branches.
2) The McFadden Act of 1927 effectively prohibited banks from branching across state lines.
3) The legislation that effectively prohibited banks from branching across state lines and forced all national banks to conform to the
branching regulations in the state in which they reside is the McFadden Act.
4) The large number of banks in the United States is an indication of lack of competition within the banking industry.
5) Lack of competition in the United States banking industry can be attributed to nineteenth-century populist sentiment.
6) Which of the following is a true statement concerning bank holding companies?
A) Bank holding companies own a few large banks.
B) Bank holding companies have experienced dramatic growth in the past three decades.
C) The McFadden Act has prevented bank holding companies from establishing branch banks.
D) Bank holding companies can own only banks.
7) A financial innovation that developed as a result of banks avoidance of bank branching restrictions was bank holding companies
8) ATMs were developed because of breakthroughs in technology and as a means of avoiding restrictive branching regulations.
9) What financial innovations helped banks to get around the bank branching restrictions of the McFadden Act?
Answer: The introduction of the automated teller machine allowed a bankʹs customers to have access to funds from various
locations not just the bank building and was not subject to the branching restrictions. Bank holding companies could own
controlling interest in several banks and other companies related to banking.
11.4 Bank Consolidation and Nationwide Banking
1) The primary reason for the recent reduction in the number of banks is mergers and acquisitions.
2) Bank holding companies that rival money center banks in size, but are not located in money center cities are superregional banks.
3) The ability to use one resource to provide different products and services is economies of scope.
4) The business term for economies of scope is synergies.
5) The legislation that overturned the prohibition on interstate banking is the Riegle-Neal Act
6) Although it has a population about half that of the United States, Japan has fewer than 100 commercial banks.
7) Experts predict that the future structure of the U.S. banking industry will have several thousand banks.
8) Bank consolidation will likely result in increased competition.
9) Critics of nationwide banking fear an elimination of community banks.
10) One of the concerns of increased bank consolidation is the reduction in community banks which could result in less lending to
small businesses.
11) Nationwide banking might reduce bank failures due to diversification of loan portfolios across state lines.
12) As the banking system in the United States evolves, it is expected that the number and importance of large banks will increase.
11.5 Separation of the Banking and Other Financial Service Industries
1) The legislation overturning the Glass-Steagall Act is the Gramm-Leach-Bliley Act.
2) Under the Gramm-Leach-Bliley Act states retain regulatory authority over insurance activities
3) As a result of the subprime financial crisis several of the large, free-standing investment banking firms chose to become bank
holding companies. This means that they will now be regulated by the Federal Reserve.
4) In a universal banking system, commercial banks provide a full range of banking, securities, and insurance services, all within a
single legal entity.
5) In a British-style universal banking system, commercial banks engage in securities underwriting, but legal subsidiaries conduct the
different activities. Also, banking and insurance are not typically undertaken together in this system.
6) A major difference between the United States and Japanese banking systems is that Japanese banks are allowed to hold
substantial equity stakes in commercial firms, whereas American banks cannot.
11.6 Thrift Industry: Regulation and Structure
1) Like the dual banking system for commercial banks, thrifts can have either state or federal charters.
2) The regulatory agency responsible for supervising savings and loans institutions is the Office of Thrift Supervision.
3) Unlike banks, federally-chartered S&Ls have been allowed to branch statewide since 1980.
4) Thrift institutions include mutual savings banks.
5) Mutual savings banks are owned by depositors
6) An essential characteristic of credit unions is that they are organized for individuals with a common bond.
7) Credit unions are the only depository institutions that are tax-exempt.
11.7 International Banking
1) The spectacular growth in international banking can be explained by the rapid growth in international trade.
2) What country is given credit for the birth of the Eurodollar market?
A) The United States C) The Soviet Union
B) England D) Japan
3) Deposits in European banks denominated in dollars for the purpose of international transactions are known as Eurodollars.
4) The main center of the Eurodollar market is London.
5) Eurodollars are dollar-denominated deposits held in banks outside the United States.
6) Reasons for holding Eurodollars include the fact that dollars are widely used to conduct international transactions.
7) An advantage to American banks from operating foreign branches is that Eurodollar deposits in offshore branches are not subject
to reserve requirements.
8) U.S. banks have most of their branches in Latin America, the Far East, the Caribbean, and London.
9) A Edge Act corporation is a subsidiary of a U.S. bank that is engaged primarily in international banking.
10) International Banking Facilities within the U.S. can make loans to foreigners but cannot make loans to domestic residents.
11) An agency office of a foreign bank operates in the U.S. but cannot accept deposits from domestic residents.
12) If a foreign bank operates a subsidiary bank in the U.S., the subsidiary bank is subject to the same regulations as a U.S. owned
bank.
13) Since the passage of the International Banking Act of 1978, the competitive advantage enjoyed by foreign banks in the U.S. has
been reduced.
14) Discuss three ways in which U.S. banks can become involved in international banking.
Answer: United States banks could open a foreign branch of their bank. A U.S. bank holding company could purchase
controlling interest in a foreign bank in a foreign country. A U.S. bank could open a Edge Act Corporation. A U.S. bank could
open an International Banking Facility in the U.S. which accepts time deposits from foreigners and makes loans to foreigners
in the U.S.
 CHAPTER 12+13:
FINANCIAL CRISES AND THE SUBPRIME MELTDOWN
12.1 Factors Causing Financial Crises
1) A major disruption in financial markets characterized by sharp declines in asset prices and firm failures is called a financial crisis.
2) A financial crisis occurs when an increase in asymmetric information from a disruption in the financial system causes severe
adverse selection and moral hazard problems that make financial markets incapable of channeling funds efficiently.
3) A serious consequence of a financial crisis is a contraction in economic activity.
4) A sharp decline in the stock market means that the _ net worth_ of corporations has fallen making lenders _less_ willing to lend.
5) A sharp stock market decline increases moral hazard incentives since borrowing firms have less to lose if their investments fail.
6) An unanticipated decline in the price level increases the burden of debt on borrowing firms but does not raise the real value of
borrowing firmsʹ assets. The result is that net worth in real terms declines.
7) If debt contracts are denominated in foreign currency, then an unanticipated decline in the value of the domestic currency results in
a decline in a firmʹs net worth.
8) Factors that lead to worsening conditions in financial markets include: the deterioration (giảm giá trị) in banksʹ balance sheets
9) In a bank panic, the source of contagion is the asymmetric information problem.
10) A bank panic can lead to a severe contraction in economic activity due to a decline in lending for productive investment.
11) In addition to having a direct effect on increasing adverse selection problems, increases in interest rates also promote financial
crises by ___increasing_____ firmsʹ and householdsʹ interest payments, thereby ___decreasing_____ their cash flow.
12) In emerging economies, government fiscal imbalances may cause fears of default on government debt.
13) How can asymmetric information lead to a bank panic?
Answer: Depositors cannot judge the quality of their banksʹ loan portfolios. So, when they hear about a failed financial
institution, they may worry about the safety of their deposits and begin to withdraw their funds from their bank. Even healthy
institutions can go under if enough deposits are withdrawn quickly.
12.2 Dynamics of the Past U.S. Financial Crises
1) When financial institutions go on a lending spree and expand their lending at a rapid pace they are participating in a credit boom.
2) When the value of loans begins to drop, the net worth of financial institutions falls causing them to cut back on lending in a process
called deleveraging. (pg 314)
3) When financial intermediaries deleverage, firms cannot fund investment opportunities resulting in a contraction of economic
activity.
4) A credit boom can lead to a(n) ___asset-price bubble__ such as we saw in the tech stock market in the late 1990s.
5) Many 19th century U.S. financial crises were started by spikes in interest rates.
6) Most U.S. financial crises have started during periods of __high uncertainty_ either after the start of a recession or a stock market
crash.
7) If uncertainty about banksʹ health causes depositors to begin to withdraw their funds from banks, the country experiences a(n)
banking crisis.
8) Debt deflation occurs when an economic downturn causes the price level to fall and a deterioration in firmsʹ net worth
because of the increased burden of indebtedness.
9) A substantial decrease in the aggregate price level that reduces firmsʹ net worth may stall a recovery from a recession. This process
is called debt deflation.
10) A possible sequence for the three stages of a financial crisis in the U.S. might be _asset price declines_ leads to _banking crises_
leads to _unanticipated decline in price level_.
11) The economy recovers quickly from most recessions, but the increase in adverse selection and moral hazard problems in the credit
markets caused by _debt deflation_ led to the severe economic contraction known as The Great Depression.
12) Typically, the economy recovers fairly quickly from a recession. Why did this not happen in the United States during the Great
Depression?
Answer: The 25% decline in the price level from 1930-1933 triggered a debt deflation. The loss of net worth increased adverse
selection and moral hazard problems in the credit markets and increased and prolonged the economic contraction.
12.3 The Subprime Financial Crisis of 2007-2008
1) Financial innovations that emerged after 2000 in the mortgage markets included all of the following except adjustable-rate
mortgages.
2) __Securitization__ is a process of bundling together smaller loans (like mortgages) into standard debt securities.
3) A ____Collateralized debt obligation (CDO)____ pays out cash flows from subprime mortgage-backed securities in different
tranches, with the highest-rated tranch paying out first, while lower ones paid out less if there were losses on the mortgage-backed
securities.
4) The growth of the subprime mortgage market led to increased demand for houses and helped fuel the boom in housing prices.
5) The originate-to-distribute business model has a serious _principal-agent_ problem since the mortgage broker has little incentive
to make sure that the mortgagee is a good credit risk.
6) Mortgage brokers often did not make a strong effort to evaluate whether the borrower could pay off the loan. This created a severe
adverse selection problem.
7) Agency problems in the subprime mortgage market included all of the following except homeowners could refinance their
houses with larger loans when their homes appreciated in value.
8) When housing prices began to decline after their peak in 2006, many subprime borrowers found that their mortgages were
ʺunderwater.ʺ This meant that the value of the house fell below the amount of the mortgage.
9) Although the subprime mortgage market problem began in the United States, the first indication of the seriousness of the crisis
began in Europe.
10) Like a CDO, a structured investment vehicle pays off cash flows from pools of assets, however, rather than long-term debt the
structured investment vehicle backs commercial paper.
11) Which investment bank filed for bankruptcy on September 15, 2008 making it the largest bankruptcy filing in U.S. history?
Lehman Brothers
12) The largest bank failure in U.S. history was __Washington Mutual which went into receivership by the FDIC on September 25,
2008.
13) Credit market problems of adverse selection and moral hazard increased as a result of all of the following except increase in
housing market prices.
14) The Economic Recovery Act of 2008 had several provisions to promote recovery from the subprime financial crisis. These
provisions included all of the following except guaranteed all the deposits of the commercial banks.
15) The government bailout of troubled financial institutions occurred in the U.S. and many other countries. Which country saw their
banking system collapse requiring the government to take over its three largest banks? Iceland
13.1 Dynamics of Financial Crises in Emerging Market Economies
1) Financial crises generally develop along two basic paths: mismanagement of financial liberalization/globalization and severe
fiscal imbalances.
2) In emerging market countries, the deterioration in bankʹs balance sheets has more __negative__effects on lending and economic
activity than in advanced countries.
3) The mismanagement of financial liberalization in emerging market countries can be understood as a severe __principal/agent
problem
4) Factors likely to cause a financial crisis in emerging market countries include fiscal imbalances.
5) The two key factors that trigger speculative attacks on emerging market currencies are deterioration in bank balance sheets and
severe fiscal imbalances.
6) Severe fiscal imbalances can directly trigger a currency crisis since investors fear that the government may not be able to pay
back the debt and so begin to sell domestic currency.
7) In emerging market countries, many firms have debt denominated in foreign currency like the dollar or yen. A depreciation of the
domestic currency results in increases in the firmʹs indebtedness in domestic currency terms, even though the value of their
assets remains unchanged.
8) A sharp depreciation of the domestic currency after a currency crisis leads to higher inflation.
9) The key factor leading to the financial crises in Mexico and the East Asian countries was a deterioration in banksʹ balance sheets
because of increasing loan losses.
10) Factors that led to worsening conditions in Mexicoʹs 1994-1995 financial markets include increased uncertainty from political
shocks.
11) Factors that led to worsening financial market conditions in East Asia in 1997-1998 include weak supervision by bank
regulators.
12) Factors that led to worsening conditions in Mexicoʹs 1994-1995 financial markets, but did not lead to worsening financial market
conditions in East Asia in 1997-1998 include rise in interest rates abroad.
13) Argentinaʹs financial crisis was due to fiscal imbalances.
14) A feature of debt markets in emerging-market countries is that debt contracts are typically__very short term______.
15) The economic hardship resulting from a financial crises is severe, however, there are also social consequences such as increased
crime.
16) Before the South Korean financial crisis, sales by the top five chaebols (family-owned conglomerates) were nearly 50% of GDP.
17) The chaebols encouraged the Korean government to open up Korean financial markets to foreign capital. The Korean government
responded by allowing unlimited short-term foreign borrowing but maintained quantity restrictions on long-term foreign
borrowing by financial institutions.
18) At the time of the South Korean financial crisis, the government allowed many chaebol owned finance companies to convert to
merchant banks. Finance companies __were not__ allowed to borrow abroad and merchant banks _ could borrow abroad___.
19) At the time of the South Korean financial crisis, the merchant banks were almost virtually unregulated.
20) What two key factors trigger speculative attacks leading to currency cries in emerging market countries?
Answer: The deterioration in bank balance sheets and severe fiscal imbalances are the key factors. To counter a speculative
attack, a country might try to raise interest rates. Raising interest rates, however, would worsen the problem of banks that are
already in trouble. Speculators recognize this and seize the opportunity. When there are severe fiscal imbalances, there is
concern that government debt will not be paid back. Funds are pulled out of the country and domestic currency is sold leading
to a decline in the value of the domestic currency. Speculators will once again seize the opportunity .
 CHAPTER 14: THE MONEY SUPPLY PROCESS
14.1 Three Players in the Money Supply Process
1) The government agency that oversees the banking system and is responsible for the conduct of monetary policy in the United States
is the Federal Reserve System.
2) Individuals that lend funds to a bank by opening a checking account are called depositors.
3) The three players in the money supply process include banks, depositors, and the central bank.
4) Of the three players in the money supply process, most observers agree that the most important player is the Federal Reserve
System.
14.2 The Fedʹs Balance Sheet
1) Both government securities and discount loans are Federal Reserve assets.
2) The monetary liabilities of the Federal Reserve include currency in circulation and reserves.
3) Both currency in circulation and reserves are monetary liabilities of the Fed.
4) The sum of the Fedʹs monetary liabilities and the U.S. Treasuryʹs monetary liabilities is called the monetary base.
5) The monetary base consists of currency in circulation and reserves.
6) Total reserves minus bank deposits with the Fed equals vault cash.
7) Reserves are equal to the sum of required reserves and excess reserves.
8) Total reserves are the sum of excess reserves and required reserves.
9) Excess reserves are equal to vault cash plus deposits with Federal Reserve banks minus required reserves.
10) Total Reserves minus vault cash equals bank deposits with the Fed.
11) The amount of deposits that banks must hold in reserve is required reserves.
12) The percentage of deposits that banks must hold in reserve is the required reserve ratio.
13) Suppose that from a new checkable deposit, First National Bank holds two million dollars in vault cash, eight million dollars on
deposit with the Federal Reserve, and one million dollars in required reserves. Given this information, we can say First National Bank
has NINE million dollars in excess reserves.
14) Suppose that from a new checkable deposit, First National Bank holds two million dollars in vault cash, eight million dollars on
deposit with the Federal Reserve, and one million dollars in required reserves. Given this information, we can say First National Bank
faces a required reserve ratio of TEN percent.
15) Suppose that from a new checkable deposit, First National Bank holds two million dollars in vault cash, eight million dollars on
deposit with the Federal Reserve, and nine million dollars in excess reserves. Given this information, we can say First National Bank
has ONE million dollars in required reserves.
16) Suppose that from a new checkable deposit, First National Bank holds two million dollars in vault cash, eight million dollars on
deposit with the Federal Reserve, and nine million dollars in excess reserves. Given this information, we can say First National Bank
faces a required reserve ratio of TEN percent.
17) Suppose that from a new checkable deposit, First National Bank holds eight million dollars on deposit with the Federal Reserve,
one million dollars in required reserves, and faces a required reserve ratio of ten percent. Given this information, we can say First
National Bank has NINE million dollars in excess reserves.
18) Suppose that from a new checkable deposit, First National Bank holds eight million dollars on deposit with the Federal Reserve,
one million dollars in required reserves, and faces a required reserve ratio of ten percent. Given this information, we can say First
National Bank has TWO million dollars in vault cash.
19) Suppose that from a new checkable deposit, First National Bank holds two million dollars in vault cash, nine million dollars in
excess reserves, and faces a required reserve ratio of ten percent. Given this information, we can say First National Bank has ONE
million dollars in required reserves.
20) Suppose that from a new checkable deposit, First National Bank holds two million dollars in vault cash, nine million dollars in
excess reserves, and faces a required reserve ratio of ten percent. Given this information, we can say First National Bank has EIGHT
million dollars on deposit with the Federal Reserve.
21) Suppose that from a new checkable deposit, First National Bank holds two million dollars in vault cash, one million dollars in
required reserves, and faces a required reserve ratio of ten percent. Given this information, we can say First National Bank has NINE
million dollars in excess reserves.
22) Suppose that from a new checkable deposit, First National Bank holds two million dollars in vault cash, one million dollars in
required reserves, and faces a required reserve ratio of ten percent. Given this information, we can say First National Bank has
EIGHT million dollars on deposit with the Federal Reserve.
23) Suppose that from a new checkable deposit, First National Bank holds eight million dollars on deposit with the Federal Reserve,
nine million dollars in excess reserves, and faces a required reserve ratio of ten percent. Given this information, we can say First
National Bank has ONE million dollars in required reserves.
24) Suppose that from a new checkable deposit, First National Bank holds eight million dollars on deposit with the Federal Reserve,
nine million dollars in excess reserves, and faces a required reserve ratio of ten percent. Given this information, we can say First
National Bank has TWO million dollars in vault cash.
25) The interest rate the Fed charges banks borrowing from the Fed is the discount rate.
26) When banks borrow money from the Federal Reserve, these funds are called discount loans.
14.3 Control of the Monetary Base
1) The monetary base minus currency in circulation equals reserves.
2) The monetary base minus reserves equals currency in circulation.
3) High-powered money minus reserves equals currency in circulation.
4) High-powered money minus currency in circulation equals reserves.
5) Purchases and sales of government securities by the Federal Reserve are called open market operations.
6) When the Federal Reserve purchases a government bond from a bank, reserves in the banking system increase and the monetary
base increase, everything else held constant.
7) When the Federal Reserve sells a government bond to a bank, reserves in the banking system decrease and the monetary base
decreases, everything else held constant.
8) When a bank sells a government bond to the Federal Reserve, reserves in the banking system increase and the monetary base
increases, everything else held constant.
9) When a bank buys a government bond from the Federal Reserve, reserves in the banking system decrease and the monetary base
decreases, everything else held constant.
10) When the Fed buys $100 worth of bonds from First National Bank, reserves in the banking system increase by $100.
11) When the Fed sells $100 worth of bonds to First National Bank, reserves in the banking system decrease by $100.
12) If a person selling bonds to the Fed cashes the Fedʹs check, then reserves remain unchanged and currency in circulation
increases, everything else held constant.
13) The effect of an open market purchase on reserves differs depending on how the seller of the bonds keeps the proceeds. If the
proceeds are kept in currency, the open market purchase has no effect on reserves; if the proceeds are kept as deposits, reserves
increase by the amount of the open market purchase.
14) The effect of an open market purchase on reserves differs depending on how the seller of the bonds keeps the proceeds. If th
proceeds are kept in currency, the open market purchase has no effect on reserves; if the proceeds are kept as deposits, the opeN
market purchase increases reserves.
15) When an individual sells a $100 bond to the Fed, she may either deposit the check she receives or cash it for currency. In both
cases high-powered money increases.
16) If a member of the nonbank public sells a government bond to the Federal Reserve in exchange for currency, the monetary base
will rise, but reserves will remain unchanged
17) If a member of the nonbank public purchases a government bond from the Federal Reserve in exchange for currency, the monetary
base will fall, but reserves will remain unchanged.
18) For which of the following is the change in reserves necessarily different from the change in the monetary base? Open market
purchases from an individual who cashes the check
19) When a member of the nonbank public withdraws currency from her bank account, bank reserves fall, but the monetary base
remains unchanged.
20) When a member of the nonbank public deposits currency into her bank account, bank reserves rise, but the monetary base
remains unchanged.
21) When the Fed extends a $100 discount loan to the First National Bank, reserves in the banking system increase by $100.
22) All else the same, when the Fed calls in a $100 discount loan previously extended to the First National Bank, reserves in the
banking system decrease by $100.
23) When the Federal Reserve extends a discount loan to a bank, the monetary base increases and reserves increase.
24) When the Federal Reserve calls in a discount loan from a bank, the monetary base decreases and reserves decrease.
25) If the Fed decides to reduce bank reserves, it can sell government bonds.
26) There are two ways in which the Fed can provide additional reserves to the banking system: it can purchase government bonds or
it can extend discount loans to commercial banks.
27) A decrease in float leads to an equal decrease in the monetary base in the short run.
28) The monetary base declines when the Fed sells securities.
29) An increase in float leads to an equal increase in the monetary base in the short run.
30) A decrease in securities leads to an equal decrease in the monetary base in the long run.
31) An increase in securities leads to an equal increase in the monetary base in the long run.
32) Suppose a person cashes his payroll check and holds all the funds in the form of currency. Everything else held constant, total
reserves in the banking system decrease and the monetary base remains unchanged.
33) Suppose your payroll check is directly deposited to your checking account. Everything else held constant, total reserves in the
banking system remain unchanged and the monetary base remain unchanged.
34) The Fed does not tightly control the monetary base because it does not completely control borrowed reserves.
35) Subtracting borrowed reserves from the monetary base obtains the nonborrowed monetary base.
36) The relationship between borrowed reserves, the nonborrowed monetary base, and the monetary base is BR = MB - MBn.
37) Explain two ways by which the Federal Reserve System can increase the monetary base. Why is the effect of Federal Reserve
actions on bank reserves less exact than the effect on the monetary base?
Answer: The Fed can increase the monetary base by purchasing government bonds and by extending discount loans. If the
person selling the security chooses to keep the proceeds in currency, bank reserves do not increase. Because the Fed cannot
control the distribution of the monetary base between reserves and currency, it has less control over reserves than the base.
14.4 Multiple Deposit Creation: A Simple Model
1) When the Fed supplies the banking system with an extra dollar of reserves, deposits increase by more than one dollara process
called multiple deposit creation.
2) When the Fed supplies the banking system with an extra dollar of reserves, deposits increase by more than one dollara process
called multiple deposit creation.
3) If the required reserve ratio is equal to 10 percent, a single bank can increase its loans up to a maximum amount equal to its excess
reserves.
4) In the simple deposit expansion model, if the Fed purchases $100 worth of bonds from a bank that previously had no excess
reserves, the bank can now increase its loans by $100.
5) In the simple deposit expansion model, if the Fed purchases $100 worth of bonds from a bank that previously had no excess
reserves, deposits in the banking system can potentially increase by $100 times the reciprocal of the required reserve ratio.
6) In the simple deposit expansion model, if the Fed extends a $100 discount loan to a bank that previously had no excess reserves, the
bank can now increase its loans by $100.
7) In the simple deposit expansion model, if the Fed extends a $100 discount loan to a bank that previously had no excess reserves,
deposits in the banking system can potentially increase by $100 times the reciprocal of the required reserve ratio.
8) The formula for the simple deposit multiplier can be expressed as △D = 1 r × △R
9) In the simple model of multiple deposit creation in which banks do not hold excess reserves, the increase in checkable deposits
equals the product of the change in excess reserves and the simple deposit expansion multiplier.
10) The simple deposit multiplier can be expressed as the ratio of the change in deposits divided by the change in reserves in the
banking system.
11) If reserves in the banking system increase by $100, then checkable deposits will increase by $1000 in the simple model of deposit
creation when the required reserve ratio is 0.10.
12) If reserves in the banking system increase by $100, then checkable deposits will increase by $500 in the simple model of deposit
creation when the required reserve ratio is 0.20
13) If the required reserve ratio is 10 percent, the simple deposit multiplier is 10.0
14) If the required reserve ratio is 15 percent, the simple deposit multiplier is 6.67.
15) If the required reserve ratio is 20 percent, the simple deposit multiplier is 5.0.
16) If the required reserve ratio is 25 percent, the simple deposit multiplier is 4.0.
17) A simple deposit multiplier equal to one implies a required reserve ratio equal to 100 percent.
18) A simple deposit multiplier equal to two implies a required reserve ratio equal to 50 percent.
19) A simple deposit multiplier equal to four implies a required reserve ratio equal to 25 percent.
20) In the simple deposit expansion model, if the banking system has excess reserves of $75, and the required reserve ratio is 20%, the
potential expansion of checkable deposits is $375.
21) In the simple deposit expansion model, if the required reserve ratio is 20 percent and the Fed increases reserves by $100,
checkable deposits can potentially expand by $500.
22) In the simple deposit expansion model, if the required reserve ratio is 10 percent and the Fed
increases reserves by $100, checkable deposits can potentially expand by $1,000.
23) In the simple deposit expansion model, an expansion in checkable deposits of $1,000 when the required reserve ratio is equal to 20
percent implies that the Fed purchased $200 in government bonds.
24) In the simple deposit expansion model, an expansion in checkable deposits of $1,000 when the required reserve ratio is equal to 10
percent implies that the Fed purchased $100 in government bonds.
25) In the simple deposit expansion model, a decline in checkable deposits of $1,000 when the required reserve ratio is equal to 20
percent implies that the Fed sold $200 in government bonds.
26) In the simple deposit expansion model, a decline in checkable deposits of $1,000 when the required reserve ratio is equal to 10
percent implies that the Fed sold $100 in government bonds.
27) In the simple deposit expansion model, a decline in checkable deposits of $500 when the required reserve ratio is equal to 10
percent implies that the Fed sold $50 in government bonds.
28) In the simple deposit expansion model, a decline in checkable deposits of $500 when the required reserve ratio is equal to 20
percent implies that the Fed sold $100 in government bonds.
29) If reserves in the banking system increase by $100, then checkable deposits will increase by $400 in the simple model of deposit
creation when the required reserve ratio is 0.25.
30) If reserves in the banking system increase by $100, then checkable deposits will increase by $667 in the simple model of deposit
creation when the required reserve ratio is 0.15.
31) If reserves in the banking system increase by $100, then checkable deposits will increase by $100 in the simple model of deposit
creation when the required reserve ratio is 1.00.
32) If reserves in the banking system increase by $100, then checkable deposits will increase by $2,000 in the simple model of deposit
creation when the required reserve ratio is 0.05.
33) If reserves in the banking system increase by $200, then checkable deposits will increase by $500 in the simple model of deposit
creation when the required reserve ratio is 0.40.
34) If a bank has excess reserves of $10,000 and demand deposit liabilities of $80,000, and if thereserve requirement is 20 percent,
then the bank has actual reserves of $26,000.
35) If a bank has excess reserves of $20,000 and demand deposit liabilities of $80,000, and if the reserve requirement is 20 percent,
then the bank has total reserves of $36,000.
36) If a bank has excess reserves of $5,000 and demand deposit liabilities of $80,000, and if the reserve requirement is 20 percent,
then the bank has actual reserves of $21,000.
37) If a bank has excess reserves of $15,000 and demand deposit liabilities of $80,000, and if thereserve requirement is 20 percent,
then the bank has total reserves of $31,000.
38) If a bank has excess reserves of $4,000 and demand deposit liabilities of $100,000, and if the reserve requirement is 15 percent,
then the bank has actual reserves of $19,000.
39) If a bank has excess reserves of $4,000 and demand deposit liabilities of $100,000, and if the reserve requirement is 10 percent,
then the bank has actual reserves of $14,000.
40) If a bank has excess reserves of $7,000 and demand deposit liabilities of $100,000, and if the reserve requirement is 15 percent,
then the bank has actual reserves of $22,000.
41) If a bank has excess reserves of $7,000 and demand deposit liabilities of $100,000, and if the reserve requirement is 10 percent,
then the bank has actual reserves of $17,000.
42) A bank has excess reserves of $6,000 and demand deposit liabilities of $100,000 when the required reserve ratio is 20 percent. If
the reserve ratio is raised to 25 percent, the bankʹs excess reserves will be $1,000
43) A bank has excess reserves of $4,000 and demand deposit liabilities of $100,000 when the required reserve ratio is 20 percent. If
the reserve ratio is raised to 25 percent, the bankʹs excess reserves will be -$1,000.
44) A bank has excess reserves of $10,000 and demand deposit liabilities of $100,000 when the required reserve ratio is 20 percent. If
the reserve ratio is raised to 25 percent, the bankʹs excess reserves will be $5,000.
45) A bank has no excess reserves and demand deposit liabilities of $100,000 when the required reserve ratio is 20 percent. If the
reserve ratio is raised to 25 percent, the bankʹs excess reserves will now be -$5,000.
46) A bank has excess reserves of $1,000 and demand deposit liabilities of $80,000 when the reserve requirement is 20 percent. If the
reserve requirement is lowered to 10 percent, the bankʹs excess reserves will be $9,000.
47) A bank has excess reserves of $1,000 and demand deposit liabilities of $80,000 when the reserve requirement is 25 percent. If the
reserve requirement is lowered to 20 percent, the bankʹs excess reserves will be $5,000.
48) Decisions by depositors to increase their holdings of currency, or of banks to hold excess reserves will result in a smaller
expansion of deposits than the simple model predicts.
49) Decisions by depositors to increase their holdings of currency, or of banks to hold excess reserves will result in a smaller
expansion of deposits than the simple model predicts.
50) Decisions by depositors about their holdings of currency and by banks about their holdings of excess reserves affect the money
supply.
51) Assume that no banks hold excess reserves, and the public holds no currency. If a bank sells a $100 security to the Fed, explain
what happens to this bank and two additional steps in the deposit expansion process, assuming a 10% reserve requirement. How much
do deposits and loans increase for the banking system when the process is completed?
Answer: Bank A first changes a security for reserves, and then lends the reserves, creating loans. It receives $100 in reserves
from the sale of securities. Since all of these reserve will be excess reserves (there was no change in checkable deposits), the
bank will loan out all $100. The $100 will then be deposited into Bank B. This bank now has a change in reserves of $100, of
which $90 is excess reserves. Bank B will loan out this $90, which will be deposited into Bank C. Bank C now has an increase
in reserves of $90, $81 of which is excess reserves. Bank C will loan out this $81 dollars and the process will continue until
there are no more excess reserves in the banking system. For the banking system, both loans and deposits increase by $1000.
52) Explain two reasons why the Fed does not have complete control over the level of bank deposits and loans. Explain how a change
in either factor affects the deposit expansion process.
Answer: The Fed does not completely control the level of bank deposits and loans because bankscan hold excess reserves and
the public can change its currency holdings. A change ineither factor changes the deposit expansion process. An increase in
either excess reserves or currency reduces the amount by which deposits and loans are increased.
53) Explain why the simple deposit multiplier overstates the true deposit multiplier.
Answer: The simple model ignores the role banks and their customers play in the creation process. The bankʹs customers can
decide to hold currency and the bank can decide to hold excess reserves. Both of these will restrict the banking systemʹs ability
to create deposits. Thus, the true multiplier is less than the prediction of the simple deposit multiplier.
14.5 Factors That Determine the Money Supply
1) An increase in the nonborrowed monetary base, everything else held constant, will cause the money supply to rise.
2) The money supply is positively related to the nonborrowed monetary base, and positively related to the level of borrowed reserves.
3) The amount of borrowed reserves is negatively related to the discount rate, and is positively related to the market interest rate.
4) A rise in market interest rates relative to the discount rate will cause discount borrowing to increase.
5) Everything else held constant, an increase in currency holdings will cause the money supply to fall.
6) Everything else held constant, a decrease in holdings of excess reserves will mean an increase in the money supply.
14.6 Overview of the Money Supply Process
1) In the model of the money supply process, the Federal Reserveʹs role in influencing the money supply is represented by the
required reserve ratio, nonborrowed reserves, borrowed reserves, and the market interest rate.
2) In the model of the money supply process, the depositorʹs role in influencing the money supply is represented by the currency
ratio, excess reserve ratio, and the market interest rate.
3) In the model of the money supply process, the bankʹs role in influencing the money supply process is represented by both the
excess reserve ratio and the market interest rate.
14.7 The Money Multiplier
1) Models describing the determination of the money supply and the Fedʹs role in this process normally focus on the monetary base
rather than reserves, since Fed actions have a more predictable effect on the former.
2) The Fed can exert more precise control over high-powered money than it can over reserves.
3) The ratio that relates the change in the money supply to a given change in the monetary base is called the money multiplier.
4) The formula linking the money supply to the monetary base is M = m × MB.
5) The variable that reflects the effect on the money supply of changes in factors other than the monetary base is the money
multiplier
6) An assumption in the model of the money supply process is that the desired levels of currency and excess reserves grow
proportionally with checkable deposits.
7) The total amount of reserves in the banking system is equal to the sum of required reserves and excess reserves.
8) The total amount of required reserves in the banking system is equal to the product of the required reserve ratio and checkable
deposits.
9) Since the Federal Reserve sets the required reserve ratio to less than one, one dollar of reserves can support more than one dollar
of checkable deposits.
10) The equation that shows the amount of the monetary base needed to support existing levels of checkable deposits, excess reserves,
and currency is MB = (r × D) + ER + C.
11) An increase in the monetary base that goes into currency is not multiplied, while an increase that goes into deposits is multiplied
12) An increase in the monetary base that goes into currency is not multiplied, while an increase that goes into deposits is
multiplied.
13) If the Fed injects reserves into the banking system and they are held as excess reserves, then the money supply does not change.
14) If the Fed injects reserves into the banking system and they are held as excess reserves, then themonetary base increases and the
money supply remains unchanged
15) The formula that links checkable deposits to the monetary base is D = 1 r + e + c × MB.
16) The formula that links checkable deposits to the money supply is D = 1 1 + c × M.
17) The formula for the M1 money multiplier is m = (1 + c)/(r + e + c).
18) If the required reserve ratio is 10 percent, currency in circulation is $400 billion, checkable deposits are $800 billion, and excess
reserves total $0.8 billion, then the money supply is $1200 billion.
19) If the required reserve ratio is 10 percent, currency in circulation is $400 billion, checkable deposits are $800 billion, and excess
reserves total $0.8 billion, then the M1 money multiplier is 2.5.
20) If the required reserve ratio is 10 percent, currency in circulation is $400 billion, checkable deposits are $800 billion, and excess
reserves total $0.8 billion, then the currency ratio is 0.5
21) If the required reserve ratio is 10 percent, currency in circulation is $400 billion, checkable deposits are $800 billion, and excess
reserves total $0.8 billion, then the excess reserves-checkable deposit ratio is 0.001.
22) If the required reserve ratio is 10 percent, currency in circulation is $400 billion, checkable deposits are $800 billion, and excess
reserves total $0.8 billion, then the monetary base is $480.8 billion.
23) If the required reserve ratio is 15 percent, currency in circulation is $400 billion, checkable deposits are $800 billion, and excess
reserves total $0.8 billion, then the M1 money multiplier is 2.3.
24) If the required reserve ratio is 5 percent, currency in circulation is $400 billion, checkable deposits are $800 billion, and excess
reserves total $0.8 billion, then the M1 money multiplier is 2.72.
25) If the required reserve ratio is 10 percent, currency in circulation is $400 billion, checkable deposits are $1000 billion, and excess
reserves total $1 billion, then the money supply is $1400 billion
26) If the required reserve ratio is 10 percent, currency in circulation is $400 billion, checkable deposits are $1000 billion, and excess
reserves total $1 billion, then the M1 money multiplier is 2.8.
27) If the required reserve ratio is 10 percent, currency in circulation is $400 billion, checkable deposits are $1000 billion, and excess
reserves total $1 billion, then the currency ratio is 0.40.
28) If the required reserve ratio is 10 percent, currency in circulation is $400 billion, checkable deposits are $1000 billion, and excess
reserves total $1 billion, then the excess reserves-checkable deposit ratio is 0.001.
29) If the required reserve ratio is 10 percent, currency in circulation is $400 billion, checkable deposits are $1000 billion, and excess
reserves total $1 billion, then the monetary base is $501 billion.
30) If the required reserve ratio is 15 percent, currency in circulation is $400 billion, checkable deposits are $1000 billion, and excess
reserves total $1 billion, then the M1 money multiplier is 2.54.
31) If the required reserve ratio is one-third, currency in circulation is $300 billion, and checkable deposits are $900 billion, then the
money supply is $1200 billion.
32) If the required reserve ratio is one-third, currency in circulation is $300 billion, and checkable deposits are $900 billion, then the
M1 money multiplier is 2.0.
33) If the required reserve ratio is one-third, currency in circulation is $300 billion, and checkable deposits are $900 billion, then the
currency ratio is 0.33.
34) If the required reserve ratio is one-third, currency in circulation is $300 billion, and checkable deposits are $900 billion, then the
level of excess reserves in the banking system is 0
35) If the required reserve ratio is one-third, currency in circulation is $300 billion, and checkable deposits are $900 billion, then the
monetary base is $600 billion.
36) Everything else held constant, an increase in the required reserve ratio on checkable deposits will cause the money supply to fall.
37) Everything else held constant, a decrease in the required reserve ratio on checkable deposits will mean an increase in the money
supply.
38) Everything else hed constant, an increase in the required reserve ratio on checkable deposits causes the M1 money multiplier to
decrease and the money supply to decrease.
39) Everything else held constant, a decrease in the required reserve ratio on checkable deposits causes the M1 money multiplier to
increase and the money supply to increase.
40) Assuming initially that r = 10%, c = 40%, and e = 0, an increase in r to 15% causes the M1 money multiplier to decrease from 2.8
to 2.55, everything else held constant.
41) Assuming initially that r = 10%, c = 40%, and e = 0, a decrease in r to 5% causes the M1 money multiplier to increase from 2.8 to
3.11, everything else held constant.
42) Everything else held constant, an increase in the currency-checkable deposit ratio will mean a decrease in the money supply.
43) Everything else held constant, a decrease in the currency-checkable deposit ratio will mean an increase in money supply.
44) Everything else held constant, an increase in the currency ratio causes the M1 money multiplier to decrease and the money supply
to decrease.
45) Everything else held constant, a decrease in the currency ratio causes the M1 money multiplier to increase and the money supply
to increase.
46) Assuming initially that r = 10%, c = 40%, and e = 0, an increase in c to 50% causes the M1 money
multiplier to decrease from 2.8 to 2.5, everything else held constant.
47) Assuming initially that r = 10%, c = 40%, and e = 0, an decrease in c to 30% causes the M1 money multiplier to increase from
2.8 to 3.25, everything else held constant.
48) Every thing else held constant, a decrease in the excess reserves ratio causes the M1 money multiplier to increase and the money
supply to increase.
49) Everything else held constant, an increase in the excess reserves ratio causes the M1 money multiplier to decrease and the money
supply to decrease.
50) Assuming initially that r = 15%, c = 40%, and e = 5%, a decrease in e to 0% causes the M1 money multiplier to increase from
2.33 to 2.55, everything else held constant.
51) Assuming initially that r = 15%, c = 40%, and e = 5%, an increase in e to 10% causes the M1 money multiplier to decrease from
2.33 to 2.15, everything else held constant.
52) The excess reserves ratio is positively related to expected deposit outflows, and is negatively related to the market interest rate.
53) The money supply is negatively related to expected deposit outflows, and is positively related to the market interest rate.
54) The money multiplier is negatively related to the required reserve ratio.
55) Recognizing the distinction between borrowed reserves and the nonborrowed monetary base, the money supply model is specified
as M = m × (MBn + BR).
56) During the bank panics of the Great Depression the currency ratio increased sharply.
57) During the bank panics of the Great Depression the excess reserve ratio increased sharply.
58) In the early 1930s, the currency ratio rose, as did the level of excess reserves. Money supply analysis predicts that, everything else
held constant, the money supply should have fallen.
59) Explain the complete formula for the M1 money supply, and explain how changes in required reserves, excess reserves, the
currency ratio, the nonborrowed base, and borrowed reserves affect the money supply.
Answer: The formula is M = 1 + c r + c + e × (MBn + BR). The formula indicates that the money supply is the product of the
multiplier times the base. Increases in any of the multiplier components, required reserves, r; excess reserves, e; or the
currency ratio, c; reduce the multiplier and the money supply. Increases in the nonborrowed base and borrowed reserves both
increase the base and the money supply.
60) The monetary base increased by 20% during the contraction of 1929-1933, but the money supply fell by 25%. Explain why this
occurred. How can the money supply fall when the base increases?
Answer: The banking crisis caused the public to fear for the safety of their deposits, increasing both the currency ratio and
bank holdings of excess reserves in anticipation of deposit outflows. Both of these changes reduce the money multiplier and the
money supply. In this case, the fall in the multiplier due to increases of currency and excess reserves more than offset the
increase in the base, causing the money supply to fall.
14.8 APPENDIX: The Fedʹs Balance Sheet and the Monetary Base
1) Which is the most important category of Fed assets? Securities
2) The two most important categories of assets on the Fedʹs balance sheet are securities and discount loans because they earn interest.
3) The Fedʹs holdings of securities consist primarily of Treasury securities, but also in the past have included bankersʹ acceptances.
4) The volume of loans that the Fed makes to banks is affected by the Fedʹs setting of the interest rate on these loans, called the
discount rate.
5) Special Drawing Rights (SDRs) are issued to governments by the International Monetary Fund to settle international debts and
have replaced gold in international transactions.
6) When the Treasury acquires gold or SDRs, it issues certificates to the Federal Reserve System, which are claims on the gold or
SDRs, and in turn is credited with deposit balances at the Fed.
7) Which of the following are not assets on the Fedʹs balance sheet?
A) Discount loans C) Cash items in the process of collection
B) U.S. Treasury deposits D) U.S. Treasury bills
8) Which of the following are not assets on the Fedʹs balance sheet?
A) Securities C) Cash items in the process of collection
B) Discount loans D) Deferred availability cash items
9) Which of the following are not liabilities on the Fedʹs balance sheet?
A) Discount loans C) Deferred availability cash items
B) Bank deposits D) U.S. Treasury deposits
10) When the Fed purchases artwork to decorate the conference room at the Federal Reserve Bank of Kansas City, the monetary base
rises.
11) A Fed purchase of gold, SDRs, a deposit denominated in a foreign currency or any other asset is just an open market purchase of
these assets, raising the monetary base.
12) An increase in Treasury deposits at the Fed causes the monetary base to decrease.
13) An increase in U.S. Treasury deposits at the Fed reduces both reserves and the monetary base.
14) U.S. Treasury deposits at the Fed are a liability for the Fed but an asset for the Treasury. Thus an increase in U.S. Treasury
deposits decreases the monetary base.
15) An increase in which of the following leads to a decline in the monetary base? Foreign deposits at the Fed
16) Suppose, while cleaning out its closets, a worker at the Federal Reserve bank branch in Memphis discovers a painting of Elvis
(medium: acrylic on velvet) that used to grace the walls of the conference room. Suppose further that, at a public auction, the bank
sells the painting for $19.95. This sale will cause a decrease of $19.95 in the monetary base, everything else held constant.
17) Suppose the Bank of China permanently decreases its purchases of U.S. government bonds and, instead, holds more dollars on
deposit at the Federal Reserve. Everything else held constant, a open market purchase would be the appropriate monetary policy
action for the Fed to take to offset the expected decrease in the monetary base in the United States.
14.9 APPENDIX: The M2 Money Multiplier
1) The equation that represents M2 in the model of the money supply process is M2 = C + D + T + MMF.
2) In the model of the money supply process for M2, the relationship between checkable deposits and the M2 money supply is
represented by D = 1 1 + c + t + mm × M2.
3) The M2 money supply is represented by M2 = 1 + c + t + mm r + e + c × MB.
4) The M2 money multiplier is positively related to the time deposit ratio.
5) Everything else held constant, an increase in the currency ratio will mean a decrease in the M2 money multiplier and a decrease in
the M2 money supply.
6) Everything else held constant, a decrease in the currency ratio will mean an increase in the M1 money multiplier and an increase
in the M2 money multiplier.
7) Everything else held constant, an increase in the required reserve ratio will mean a decrease in the M2 money multiplier and a
decrease in the M2 money supply.
8) Everything else held constant, an increase in the required reserve ratio will result in a decrease in M1 and a decrease in M2..
9) Everything else held constant, an increase in the time deposit ratio will mean an increase in the M2 money multiplier and an
increase in the M2 money supply.
10) Everything else held constant, an increase in the time deposit ratio will result in no change in the M1 money multiplier and an
increase in the M2 money multiplier.
11) Everything else held constant, an increase in the money market fund ratio will mean an increase in the M2 money multiplier and
an increase in the M2 money supply.
12) Everything else held constant, an increase in the money market fund ratio will result in no change in the M1 money multiplier and
an increase in the M2 money multiplier.
13) Everything else held constant, an increase in the excess reserve ratio will mean a decrease in the M2 money multiplier and a
decrease in the M2 money supply.
14) Everything else held constant, an increase in the excess reserve ratio will mean a decrease in the M1 money multiplier and a
decrease in the M2 money multiplier.
14.10 APPENDIX: Explaining the Behavior of the Currency Ratio
1) Factors causing an increase in currency holdings include an increase in illegal activity.
2) Part of the increase in currency holdings in the 1960s and 1970s can be attributed to bracket creep due to inflation and
progressive income taxes.
3) Everything else held constant, an increase in wealth will cause the holdings of checkable deposits to the holdings of currency to
increase and the currency ratio will decrease.
4) Everything else held constant, an increase in the interest rate paid on checkable deposits will cause an increase in the amount of
checkable deposits held relative to currency holdings andba decrease in the currency ratio.
5) The increase in the availability of ATMʹs has caused the cost of acquiring currency to decrease which will cause the currency ratio
to increase, everything else held constant.
6) The steepest increase in the currency ratio since 1892 occurred during the Great Depression.
7) The factor accounting for the steepest rise in the currency ratio since 1892 is bank panics.
8) The increase in the currency ratio during World War II was due to high taxes and illegal activities.
CHAPTER 15: TOOLS FOR MONETARY POLICY
15.1 The Market for Reserve and the Federal Funds Rate
1) The Fed uses three policy tools to manipulate the money supply: open market operations, which affect reserves and the monetary
base; changes in borrowed reserves, which affect the monetary base; and changes in reserve requirements, which affect the money
multiplier.
2) The Fed uses three policy tools to manipulate the money supply: open market operations, which affect the monetary base; changes
in borrowed reserves, which affect the monetary base; and changes in reserve requirements, which affect the money multiplier.
3) The interest rate charged on overnight loans of reserves between banks is the federal funds rate
4) The primary indicator of the Fedʹs stance on monetary policy is the federal funds rate.
5) The quantity of reserves demanded equals required reserves plus excess reserves.
6) Everything else held constant, when the federal funds rate is above the interest rate paid on reserves, the quantity of reserves
demanded rises when the federal funds rate falls.
7) The opportunity cost of holding excess reserves is the federal funds rate minus the interest rate paid on excess reserves.
8) In the market for reserves, when the federal funds rate is above the interest rate paid on excess reserves, the demand curve for
reserves is negatively sloped.
9) When the federal funds rate equals the interest rate paid on excess reserves the demand curve for reserves is horizontal.
10) Which of the following is NOT an argument for the Federal Reserve paying interest on excess reserve holdings?
A) Paying interest reduces the effective tax on deposits.
B) Paying interest will help in the implementation of monetary policy.
C) Paying interest will help the Federal Reserve have more control of the amount of discount loans.
D) Paying interest increases the capacity of the Fedʹs balance sheet which will make it easier to address financial crises.
11) The quantity of reserves supplied equals nonborrowed reserves plus borrowed reserves.
12) In the market for reserves, when the federal funds interest rate is below the discount rate, the supply curve of reserves is vertical.
13) When the federal funds rate equals the discount rate the supply curve of reserves is horizontal.
14) In the market for reserves, if the federal funds rate is above the interest rate paid on excess reserves, then an open market sale
decreases the supply of reserves, raising the federal funds interest
15) In the market for reserves, if the federal funds rate is above the interest rate paid on excess reserves, an open market purchase
increases the supply of reserves which causes the federal funds rate to fall, everything else held constant.
16) Suppose on any given day there is an excess demand of reserves in the federal funds market. If the Federal Reserve wishes to keep
the federal funds rate at its current level, then the appropriate action for the Federal Reserve to take is a defensive open market
purchase, everything else held constant.
17) In the market for reserves, if the federal funds rate is above the interest rate paid on excess reserves, an open market purchase
increases the supply of reserves and causes the federal funds interest rate to fall, everything else held constant.
18) Suppose on any given day the prevailing equilibrium federal funds rate is above the Federal Reserveʹs federal funds target rate. If
the Federal Reserve wishes for the federal funds rate to be at their target level, then the appropriate action for the Federal Reserve to
take is a dynamic open market purchase, everything else held constant.
19) In the market for reserves, if the federal funds rate is above the interest rate paid on excess reserves, an open market sale
decreases the supply of reserves causing the federal funds rate to increase, everything else held constant.
20) Suppose on any given day there is an excess supply of reserves in the federal funds market. If the Federal Reserve wishes to keep
the federal funds rate at its current level, then the appropriate action for the Federal Reserve to take is a defensive open market sale,
everything else held constant.
21) Suppose on any given day the prevailing equilibrium federal funds rate is below the Federal Reserveʹs federal funds target rate. If
the Federal Reserve wishes for the federal funds rate to be at their target level, then the appropriate action for the Federal Reserve to
take is a dynamic open market sale, everything else held constant.
22) In the market for reserves, if the federal funds rate is above the interest rate paid on excess reserves, an open market sale
decreases the supply of reserves, causing the federal funds rate to increase, everything else held constant.
23) In the market for reserves, a lower discount rate shortens the vertical section of the supply curve of reserves.
24) In the market for reserves, a lower interest rate paid on excess reserves decreases the effective floor for the federal funds rate.
25) Everything else held constant, in the market for reserves, when the federal funds rate is 3%, lowering the discount rate from 5% to
4% has no effect on the federal funds rate.
26) Everything else held constant, in the market for reserves, when the federal funds rate is 3%, increasing the interest rate paid on
excess reserves from 1% to 2% has no effect on the federal funds rate.
27) Everything else held constant, in the market for reserves, when the federal funds rate is 5%, lowering the discount rate from 5% to
4% lowers the federal funds rate.
28) Everything else held constant, in the market for reserves, when the federal funds rate is 1%, increasing the interest rate paid on
excess reserves from 1% to 2% raises the federal funds rate.
29) Everything else held constant, in the market for reserves, when the federal funds rate is 3%, raising the discount rate from 5% to
6% has no effect on the federal funds rate.
30) Everything else held constant, in the market for reserves, when the federal funds rate is 3%, lowering the interest rate paid on
excess reserves rate from 2% to 1% has no effect on the federal funds rate.
31) Everything else held constant, in the market for reserves, when the federal funds rate equals the discount rate, lowering the
discount rate lowers the federal funds rate.
32) Everything else held constant, in the market for reserves, when the federal funds rate equals the interest rate paid on excess
reserves, raising the interest rate paid on excess reserves increases the federal funds rate.
33) Everything else held constant, in the market for reserves, when the demand for federal funds intersects the reserve supply curve
along the horizontal section, increasing the discount rate increases the federal funds rate.
34) Everything else held constant, in the market for reserves, when the supply for federal funds intersects the reserve demand curve
along the horizontal section, lowering the interest rate paid on excess reserves increases the federal funds rate.
35) Everything else held constant, in the market for reserves, when the demand for federal funds intersects the reserve supply curve on
the vertical section, increasing the discount rate has no effect on the federal funds rate.
36) Everything else held constant, in the market for reserves, when the supply for federal funds intersects the reserve demand curve on
the downward sloping section, decreasing the interest rate paid on excess reserves has no effect on the federal funds rate.
37) Everything else held constant, in the market for reserves, increases in the discount rate affect the federal funds rate when the
funds rate equals the discount rate.
38) Everything else held constant, in the market for reserves, decreases in the interest rate paid on excess reserves affect the federal
funds rate when the funds rate equals the interest rate paid on excess reserves.
39) The Federal Reserve usually keeps the discount rate above the target federal funds rate.
40) Everything else held constant, the vertical section of the supply curve of reserves is shortened when the discount rate decreases.
41) Everything else held constant, the vertical section of the supply curve of reserves is lengthened when the discount rate increases.
42) In the market for reserves, if the federal funds rate is between the discount rate and the interest rate paid on excess reserves, an
increase in the reserve requirement increases the demand for reserves, raising the federal funds rate, everything else held constant.
43) In the market for reserves, if the federal funds rate is between the discount rate and the interest rate paid on excess reserves, a rise
in the reserve requirement increases the demand for reserves, raising the federal funds interest rate, everything else held constant.
44) In the market for reserves, if the federal funds rate is between the discount rate and the interest rate paid on excess reserves, a rise
in the reserve requirement increases the demand for reserves, raising the federal funds interest rate, everything else held constant.
45) In the market for reserves, if the federal funds rate is between the discount rate and the interest rate paid on excess reserves, a
increase in the reserve requirement increases the demand of reserves and causes the federal funds interest rate to rise, everything else
held constant.
46) In the market for reserves, if the federal funds rate is between the discount rate and the interest rate paid on excess reserves, an
increase in the reserve requirement increases the demand for reserves and causes the federal funds interest rate to rise, everything
else held constant.
47) In the market for reserves, if the federal funds rate is between the discount rate and the interest rate paid on excess reserves, a
decline in the reserve requirement decreases the demand for reserves, lowering the federal funds interest rate, everything else held
constant.
48) In the market for reserves, if the federal funds rate is between the discount rate and the interest rate paid on excess reserves, a
decline in the reserve requirement decreases the demand for reserves, lowering the federal funds interest rate, everything else held
constant.
49) In the market for reserves, if the federal funds rate is between the discount rate and the interest rate paid on excess reserves, a
decline in the reserve requirement decreases the demand curve of reserves and causes the federal funds interest rate to fall,
everything else held constant.
50) In the market for reserves, if the federal funds rate is between the discount rate and the interest rate paid on excess reserves, a
decline in the reserve requirement decreases the demand of reserves, lowering the federal funds rate, everything else held constant.
51) Suppose, at a given federal funds rate, there is an excess demand for reserves in the federal funds market. If the Fed wants the
federal funds rate to stay at that level, then it should undertake an open market purchase of bonds, everything else held constant. If the
Fed does nothing, however, the federal funds rate will increase.
52) Suppose, at a given federal funds rate, there is an excess supply of reserves in the federal funds market. If the Fed wants the
federal funds rate to stay at that level, then it should undertake an open market sale of bonds, everything else held constant. If the Fed
does nothing, however, the federal funds rate will decrease.
53) Explain the Fedʹs three tools of monetary policy and how each is used to change the money supply. Does each tool affect the
monetary base or the money multiplier?
Answer: The three tools are open market operations, the purchase and sale of government securities; discount policy,
controlling the price and quantity of discount loans to banks; and reserve requirements, setting the percentage of deposits that
banks must hold in reserve. Open market operations and the discount rate affect the monetary base, and reserve requirements
affect the money multiplier.
54) State whether the following statement is true or false AND explain why: ʺA decrease in the discount rate will always cause a
decrease in the federal reserve funds rate.ʺ
Answer: False. Since the discount rate is set above the federal funds rate, a decrease in the discount rate will only cause a
decrease in the federal funds rate if the discount rate is decreased below the original federal funds rate level. If the decrease in
the discount rate is such that the new rate is still above the federal funds rate, then the federal funds rate does not change,
everything else held constant.
55) State whether the following statement is true or false AND explain why: ʺAn increase in the interest rate paid on excess reserves
will always cause an increase in the federal reserve funds rate.ʺ
Answer: False. If the interest rate paid on excess reserves is set below the federal funds rate, an increase in the interest rate
paid on excess reserves will only cause an increase in the federal funds rate if the interest rate paid on excess reserves is
increased above the original federal funds rate level. If the increase in the interest rate paid on excess reserves is such that the
new rate is still below the federal funds rate, then the federal funds rate does not change, everything else held constant.
15.2 Open Market Operations
1) Open market operations are the most important monetary policy tool because they are the primary determinant of changes in the
monetary base, the main source of fluctuations in the money supply.
2) Open market purchases raise the monetary base thereby raising the money supply.
3) Open market purchases raise reserves and the monetary base thereby raising the money supply.
4) Open market sales shrink reserves and the monetary base thereby lowering the money supply
5) Open market sales lower reserves and the monetary base thereby lowering the money supply.
6) The two types of open market operations are dynamic and defensive
7) There are two types of open market operations: dynamic open market operations are intended to change the level of reserves and
the monetary base, and defensive open market operations are intended to offset movements in other factors that affect the monetary
base.
8) Open market operations intended to offset movements in noncontrollable factors (such as float) that affect reserves and the
monetary base are called defensive open market operations.
9) When the Federal Reserve engages in a repurchase agreement to offset a withdrawal of Treasury funds from the Federal Reserve,
the open market operation is said to be defensive.
10) The Federal Open Market Committee makes the Fedʹs decisions on the purchase or sale of government securities, but these
purchases or sales are executed by the Federal Reserve Bank of New York.
11) The actual execution of open market operations is done at the Federal Reserve Bank of New York.
12) If float is predicted to decrease because of unseasonably good weather, the manager of the trading desk at the Federal Reserve
Bank of New York will likely conduct a defensive open market purchase of securities.
13) When bad storms slow the check-clearing process, float tends to increase causing the Fed to initiate defensive open market sales.
14) When good weather speeds the check-clearing process, float tends to decrease causing the Fed to initiate defensive open market
purchases.
15) When bad storms slow the check-clearing process, float tends to increase causing the Fed to initiate defensive open market sales.
16) When good weather speeds the check-clearing process, float tends to decrease causing the Fed to initiate defensive open market
purchases.
17) If float is predicted to increase because of bad weather, the manager of the trading desk at the New York Fed bank will likely
conduct defensive open market operations to drain reserves.
18) If float is predicted to decrease because of good weather, the manager of the trading desk at the New York Fed bank will likely
conduct defensive open market operations to inject reserves.
19) If Treasury deposits at the Fed are predicted to increase, the manager of the trading desk at the New York Fed bank will likely
conduct defensive open market operations to inject reserves.
20) If Treasury deposits at the Fed are predicted to increase, the manager of the trading desk at the New York Fed bank will likely
conduct defensive open market operations to inject reserves.
21) If Treasury deposits at the Fed are predicted to fall, the manager of the trading desk at the New York Fed bank will likely conduct
defensive open market operations to drain reserves.
22) If Treasury deposits at the Fed are predicted to fall, the manager of the trading desk at the New York Fed bank will likely conduct
defensive open market operations to drain reserves.
23) If the Fed expects currency holdings to rise, it conducts open market purchases to offset the expected decrease in reserves.
24) If the Fed expects currency holdings to fall, it conducts open market sales to offset the expected increase in reserves.
25) If the banking system has a large amount of reserves, many banks will have excess reserves to lend and the federal funds rate will
probably fall; if the level of reserves is low, few banks will have excess reserves to lend and the federal funds rate will probably rise.
26) The Federal Reserve will engage in a repurchase agreement when it wants to increase reserves temporarily in the banking
system.
27) If the Fed wants to temporarily inject reserves into the banking system, it will engage in a repurchase agreement.
28) The Fed can offset the effects of an increase in float by engaging in a matched sale-purchase transaction.
29) The Federal Reserve will engage in a matched sale-purchase transaction when it wants to decrease reserves temporarily in the
banking system.
30) Explain dynamic and defensive open market operations. What is the purpose of each type? Describe two situations when defensive
open market operations are used. How are defensive open market operations typically conducted?
Answer: Dynamic OMOs are used to permanently change the monetary base and money supply. Defensive operations are
used to offset temporary changes in the monetary base and/or money supply. Defensive operations are used to offset float,
shifts in Treasury balances into or out of the Fed, and temporary changes in currency. Defensive purchases are typically
conducted by using repurchase agreements, while reverse repos or matched sale-purchase transactions are used to conduct
defensive open market sales.
15.3 Discount Policy
1) Discount policy affects the money supply by affecting the volume of borrowed reserves and the monetary base
2) The discount rate is the interest rate the Fed charges on loans to banks.
3) The most common type of discount lending that the Fed extends to banks is called primary credit.
4) The most common type of discount lending, primary credit loans, are intended to help healthy banks with short-term liquidity
problems that often result from temporary deposit outflows.
5) When the Fed acts as a lender of last resort, the type of lending it provides is secondary credit.
6) The Fedʹs discount lending is of three types: primary credit is the most common category; seasonal credit is given to a limited
number of banks in vacation and agricultural areas; secondary credit is given to banks that have experienced severe liquidity
problems.
7) The discount rate is typically kept above the federal funds rate.
8) The discount rate refers to the interest rate on primary credit.
9) The interest rate on secondary credit is set 50 basis points above the primary credit rate.
10) The interest rate for primary credit is usually set 100 basis points above the federal funds rate. In March 2008, this gap was
changed to 25 basis points.
11) The interest rate on seasonal credit equals an average of the federal funds rate and rates on certificates of deposits.
12) The Fed is considering eliminating seasonal credit lending.
13) At its inception, the Federal Reserve was intended to be a lender-of-last-resort.
14) Much of the credit for prevention of a financial market meltdown after ʺBlack Mondayʺ (October 19, 1987) must be given to the
Federal Reserve System and its chairman Alan Greenspan.
15) A financial panic was averted in October 1987 following ʺBlack Mondayʺ when the Fed announced that it would provide
discount loans to any bank that would make loans to the security industry.
16) The facility that was created in December of 2007 that banks can use to borrow from the Fed that has less of a stigma for banks
compared to borrowing from the discount window is the Term Auction Facility
17) Which of the following special lending facilities set up by the Federal Reserve is reserve neutral?
A) Term Auction Facility
B) Primary Dealer Credit Facility
C) Term Securities Lending Facility
D) Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility
18) The Fedʹs lender-of-last-resort function creates a moral hazard problem.
19) The most important advantage of discount policy is that the Fed can use it to perform its role as lender of last resort.
15.4 Reserve Requirements
1) An increase in reserve requirements reduces the money supply since it causes the money multiplier to fall.
2) A decrease in reserve requirements increases the money supply since it causes the money multiplier to rise.
3) The Federal Reserve has had the authority to vary reserve requirements since the 1930s.
4) Since 1980, all depository institutions are subject to reserve requirements.
5) Funds held in all checkable deposits are subject to reserve requirements.
6) The policy tool of changing reserve requirements is no longer used.
15.5 Monetary Policy Tools of the European Central Bank
1) The European System of Central Banks signals the stance of its monetary policy by setting a target for the overnight cash rate.
2) When the European System of Central Banks uses main refinancing operations, it is similar to the Federal Reserve using defensive
open market operations.
3) When the European System of Central Banks uses long-term refinancing operations, it is similar to the Federal Reserve using
dynamic open market operations.
4) The equivalent to the Federal Reserveʹs discount rate in the European System of Central Banks is the marginal lending rate.
5) The Federal Reserve does not pay interest on reserves held on deposit. The European System of Central Banks does pay interest on
reserves held on deposit.
6) Since the European Central Bank pays interest on reserves, banks have a lower cost of complying with reserve requirements when
compared to banks complying with the reserve requirements of the Federal Reserve.

CHAPTER 17: The Foreign Exchange Market

17.1 Foreign Exchange Market
1) The exchange rate is the price of one currency relative to another.
2) Exchange rates are determined in the foreign exchange market.
3) Although foreign exchange market trades are said to involve the buying and selling of currencies, most trades involve the buying
and selling of A) bank deposits denominated in different currencies.
4) The immediate (two-day) exchange of one currency for another is a spot transaction.
5) An agreement to exchange dollar bank deposits for euro bank deposits in one month is a C) forward transaction.
6) Today 1 euro can be purchased for $1.10. This is the A) spot exchange rate.
7) In an agreement to exchange dollars for euros in three months at a price of $0.90 per euro, the price is the forward exchange rate.
8) When the value of the British pound changes from $1.25 to $1.50, the pound has appreciated and the U.S. dollar has depreciated
9)When the value of the British pound changes from $1.50 to $1.25, then the pound has depreciated and the U.S. dollar has appreciated
10) When the value of the dollar changes from £0.5 to £0.75, then the British pound has depreciated and the U.S. dollar has appreciated
11) When the value of the dollar changes from £0.75 to £0.5, then the British pound has appreciated and the U.S. dollar has depreciated
12) When the exchange rate for the Mexican peso changes from 9 pesos to the U.S. dollar to 10 pesos to the U.S. dollar, then the Mexican
peso has depreciated and the U.S. dollar has appreciated
13) When the exchange rate for the Mexican peso changes from 10 pesos to the U.S dollar to 9 pesos to the U.S. dollar, then the Mexican
peso has appreciated and the U.S. dollar has depreciated
14) On January 25, 2009, one U.S. dollar traded on the foreign exchange market for about 0.75 euros. Therefore, one euro would have
purchased about 1.33 U.S. dollars.
15) On January 25, 2009, one U.S. dollar traded on the foreign exchange market for about 49.0 Indian rupees. Thus, one Indian rupee
would have purchased about 0.02 U.S. dollars.
16) On January 25, 2009, one U.S. dollar traded on the foreign exchange market for about 1.15 Swiss francs. Therefore, one Swiss
franc would have purchased about 0.87 U.S. dollars.
17) On January 25, 2009, one U.S. dollar traded on the foreign exchange market for about 3.33 Romanian new lei. Therefore, one
Romanian new lei would have purchased about 0.30 U.S. dollars.
18) If the U.S. dollar appreciates from 1.25 Swiss franc per U.S. dollar to 1.5 francs per dollar, then the franc depreciates from 0.80
U.S. dollars per franc to 0.67 U.S. dollars per franc.
19) If the British pound appreciates from $0.50 per pound to $0.75 per pound, the U.S. dollar depreciates from £2 per dollar to £1.33
per dollar.
20) If the Japanese yen appreciates from $0.01 per yen to $0.02 per yen, the U.S. dollar depreciates from 100¥ per dollar to 50¥ per
dollar.
21) If the dollar appreciates from 1.5 Brazilian reals per dollar to 2.0 reals per dollar, the real depreciates from $0.67 per real to $0.50
per real.
22) When the exchange rate for the British pound changes from $1.80 per pound to $1.60 per pound, then, holding everything else
constant, the pound has depreciated and American wheat sold in Britain becomes more expensive.
23) If the dollar depreciates relative to the Swiss franc C) Swiss chocolate will become more expensive in the United States.
24) Everything else held constant, when a country's currency appreciates, the country's goods abroad become more expensive and
foreign goods in that country become less
25) Everything else held constant, when a country's currency depreciates, its goods abroad become less expensive while foreign goods
in that country become more expensive.
17.2 Exchange Rates in the Long Run
1) According to the law of one price, if the price of Colombian coffee is 100 Colombian pesos per pound and the price of Brazilian
coffee is 4 Brazilian reals per pound, then the exchange rate between the Colombian peso and the Brazilian real is: 25 pesos per real.
2) The starting point for understanding how exchange rates are determined is a simple idea called the law of one price , which states: if two
countries produce an identical good, the price of the good should be the same throughout the world no matter which country produces it.
3) The theory of purchasing power parity states that exchange rates between any two currencies will adjust to reflect changes in the
price levels of the two countries.
4) The theory of PPP suggests that if one country's price level rises relative to another's, its currency should A) depreciate.
5) The theory of PPP suggests that if one country's price level falls relative to another's, its currency should B) appreciate.
6) The theory of PPP suggests that if one country's price level falls relative to another's, its currency should B) appreciate in the long run.
7) The theory of purchasing power parity cannot fully explain exchange rate movements because C) some goods are not traded
between countries.
8) The theory of purchasing power parity states that exchange rates between any two currencies will adjust to reflect changes in D) the
price levels of the two countries.
9) If the real exchange rate between the United States and Japan is A) greater than 1.0 , then it is cheaper to buy goods in Japan than
in the United States.
10) According to PPP, the real exchange rate between two countries will always equal C) 1.0
11) The theory of PPP suggests that if one country's price level rises relative to another's, its currency should depreciate in the long run.
12) In the long run, a rise in a country's price level (relative to the foreign price level) causes its currency to depreciate;, while a fall
in the country's relative price level causes its currency to appreciate
13) If the 2005 inflation rate in Canada is 4 percent, and the inflation rate in Mexico is 2 percent, then the theory of purchasing power
parity predicts that, during 2005, the value of the Canadian dollar in terms of Mexican pesos will D) fall by 2 percent.
14) Assume that the following are the predicted inflation rates in these countries for the year: 2% for the United States, 3% for
Canada; 4% for Mexico, and 5% for Brazil. According to the purchasing power parity and everything else held constant, which of the
following would we expect to happen? A) The Brazilian real will depreciate against the U.S. dollar.
15) According to the purchasing power parity theory, a rise in the United States price level of 5 percent, and a rise in the Mexican
price level of 6 percent cause A) the dollar to appreciate 1 percent relative to the peso.
16) Higher tariffs and quotas cause a country's currency to appreciate in the long run, everything else held constant.
17) Lower tariffs and quotas cause a country's currency to depreciate in the long run, everything else held constant.
18) Anything that increases the demand for foreign goods relative to domestic goods tends to depreciation the domestic currency
because domestic goods will only continue to sell well if the value of the domestic currency is lower, everything else held constant.
19) Everything else held constant, increased demand for a country's exports causes its currency to appreciate in the long run, while
increased demand for imports causes its currency to depreciate.
20) Everything else held constant, increased demand for a country's exports causes its currency to appreciate in the long run, while
increased demand for imports causes its currency to depreciate
21) Everything else held constant, if a factor increases the demand for domestic goods relative to foreign goods, the domestic
currency will appreciate.
22) Everything else held constant, if a factor decreases the demand for domestic goods relative to foreign goods, the domestic
currency will depreciate.
23) An increase in productivity in a country will cause its currency to appreciate because it can produce goods at a lower price,
everything else held constant.
24) If, in retaliation for "unfair" trade practices, Congress imposes a 30 percent tariff on Japanese DVD recorders, but at the same
time, U.S. demand for Japanese goods increases, then, in the long run, the Japanese yen could appreciate, depreciate or remain
constant relative to the U.S. dollar everything else held constant
25) If the U.S. Congress imposes a quota on imports of Japanese cars due to claims of "unfair" trade practices, and Japanese demand
for American exports increases at the same time, then, in the long run the Japanese yen will depreciate relative to the U.S. dollar
everything else held constant.
26) If the inflation rate in the United States is higher than that in Mexico and productivity is growing at a slower rate in the United
States than in Mexico, then, in the long run,A) the Mexican peso will appreciate relative to the U.S. dollar, everything else held
constant.
27) If the Brazilian demand for American exports rises at the same time that U.S. productivity rises relative to Brazilian productivity,
then, in the long run,B) the Brazilian real will depreciate relative to the U.S. dollar, everything else held constant.
28) Explain the law of one price and the theory of purchasing power parity. Why doesn't purchasing power parity explain all exchange
rate movements? What factors determine long-run exchange rates?
Answer: With no trade barriers and low transport costs, the law of one price states that the price of traded goods should be the same in
all countries. The purchasing power parity theory extends the law of one price to total economies. PPP states that exchange rates
should adjust to reflect changes in the price levels between two countries. PPP may fail to fully explain exchange rates because goods
are not identical, and price levels include traded and nontraded goods and services. Long-run exchange rates are determined by
domestic price levels relative to foreign price levels, trade barriers, import and export demand, and productivity.
17.3 Exchange Rates in the Short Run: A Supply and Demand Analysis
1) The theory of asset demand suggests that the most important factor affecting the demand for
domestic and foreign assets is B) the expected return on these assets relative to one another.
2) The theory of asset demand suggests that the most important factor affecting the demand for domestic and foreign assets is the
expected return on domestic assets relative to foreign assets.
3) The theory of asset demand suggests that the most important factor affecting the demand for domestic and foreign assets is the
expected return on these assets relative to one another.
4) As the relative expected return on dollar assets increases, foreigners will want to hold more Dollar assets and less foreign assets,
everything else held constant.
5) When Americans or foreigners expect the return on Dollar assets to be high relative to the return on foreign assets, there is a higher
demand for dollar assets and a correspondingly lower demand for foreign assets.
6) When Americans or foreigners expect the return on Dollar assets to be high relative to the return on foreign assets, there is a
higher demand for dollar assets, everything else held constant.
7) When Americans or foreigners expect the return on dollar assets to be high relative to the return on foreign assets, there is a higher
demand for dollar assets and a correspondingly lower demand for foreign assets.
8) Everything else held constant, when the current value of the domestic currency increases, the quantity demanded of domestic
assets decreases.
9) Everything else held constant, when the current value of the domestic exchange rate increases,
the quantity supplied of domestic assets does not change.
17.4 Explaining Changes in Exchange Rates
1) An increase in the domestic interest rate causes the demand for domestic assets to increase and the domestic currency to
appreciate, everything else held constant.
2) An increase in the domestic interest rate causes the demand for domestic assets to shift to the right and the domestic currency to
appreciate, everything else held constant.
3) A decrease in the domestic interest rate causes the demand for domestic assets to decrease and the domestic currency to
depreciate, everything else held constant.
4) A decrease in the domestic interest rate causes the demand for domestic assets to shift to the left and the domestic currency to
depreciate, everything else held constant.
5) An increase in the domestic interest rate causes the demand for domestic assets to increase and the domestic currency to
appreciate, everything else held constant.
6) An increase in the domestic interest rate causes the demand for domestic assets to shift to the right and the domestic currency to
appreciate, everything else held constant.
7) A decrease in the domestic interest rate causes the demand for domestic assets to decrease and the domestic currency to
depreciate, everything else held constant.
8) A decrease in the domestic interest rate causes the demand for domestic assets to shift to the left and the domestic currency to
depreciate , everything else held constant.
9) An increase in the domestic interest rate causes the demand for domestic assets to increase and the domestic currency to
appreciate, everything else held constant.
10) An increase in the domestic interest rate causes the demand for domestic assets to shift to the right and the domestic currency to
appreciate, everything else held constant.
11) A decrease in the domestic interest rate causes the demand for domestic assets to decrease and the domestic currency to
depreciate, everything else held constant.
12) A decrease in the domestic interest rate causes the demand for domestic assets to shift to the left and the domestic currency to
depreciate, everything else held constant.
13) Suppose that the Federal Reserve enacts expansionary policy. Everything else held constant, this will cause the demand for U.S.
assets to decrease and the U.S. dollar to depreciate.
14) Suppose that the Federal Reserve conducts an open market sale. Everything else held constant, this will cause the demand for U.S.
assets to increase and the U.S. dollar will appreciate.
15) An increase in the foreign interest rate causes the demand for domestic assets to decrease and the domestic currency to
depreciate, everything else held constant.
16) An increase in the foreign interest rate causes the demand for domestic assets to shift to the left and the domestic currency to
depreciate, everything else held constant.
17) A decrease in the foreign interest rate causes the demand for domestic assets to increase and the domestic currency to appreciate,
everything else held constant.
18) A decrease in the foreign interest rate causes the demand for domestic assets to shift to the right and the domestic currency to
appreciate, everything else held constant.
19) A decrease in the foreign interest rate causes the demand for domestic assets to increase and the domestic currency to appreciate,
everything else held constant.
20) A decrease in the foreign interest rate causes the demand for domestic assets to shift to the right and the domestic currency to
appreciate, everything else held constant.
21) An increase in the foreign interest rate causes the demand for domestic assets to decrease and the domestic currency to
depreciate, everything else held constant.
22) An increase in the foreign interest rate causes the demand for domestic assets to shift to the left and the domestic currency to
depreciate, everything else held constant.
23) A decrease in the foreign interest rate causes the demand for domestic assets to increase and the domestic currency to appreciate,
everything else held constant.
24) A decrease in the foreign interest rate causes the demand for domestic assets to shift to the right and the domestic currency to
appreciate, everything else held constant.
25) An increase in the foreign interest rate causes the demand for domestic assets to decrease and the domestic currency to
depreciate, everything else held constant.
26) An increase in the foreign interest rate causes the demand for domestic assets to shift to the left and the domestic currency to
depreciate, everything else held constant.
27) Suppose that the European Central Bank enacts expansionary policy. Everything else held constant, this will cause the demand for
U.S. assets to increase and the U.S. dollar to appreciate.
28) Suppose that the European Central Bank conducts a main refinancing sale. Everything else held constant, this would cause the
demand for U.S. assets to decrease and the U.S. dollar will depreciate.
29) An increase in the expected future domestic exchange rate causes the demand for domestic assets to increase and the domestic
currency to appreciate , everything else held constant.
30) An increase in the expected future domestic exchange rate causes the demand for domestic assets to shift to the right and the
domestic currency to appreciate , everything else held constant.
31) A decrease in the expected future domestic exchange rate causes the demand for domestic assets to decrease and the domestic
currency to depreciate, everything else held constant.
32) A decrease in the expected future domestic exchange rate causes the demand for domestic assets to shift to the left and the
domestic currency to depreciate, everything else held constant.
33) An increase in the expected future domestic exchange rate causes the demand for domestic assets to increase and the domestic
currency to appreciate, everything else held constant.
34) An increase in the expected future domestic exchange rate causes the demand for domestic assets to shift to the right and the
domestic currency to appreciate, everything else held constant.
35) A decrease in the expected future domestic exchange rate causes the demand for domestic assets to decrease and the domestic
currency to depreciate, everything else held constant.
36) A decrease in the expected future domestic exchange rate causes the demand for domestic assets to shift to the left and the
domestic currency to depreciate, everything else held constant.
37) An increase in the expected future domestic exchange rate causes the demand for domestic assets to increase and the domestic
currency to appreciate, everything else held constant.
38) An increase in the expected future domestic exchange rate causes the demand for domestic assets to shift to the right and the
domestic currency to appreciate, everything else held constant.
39) A decrease in the expected future domestic exchange rate causes the demand for domestic assets to decrease and the domestic
currency to depreciate, everything else held constant.
40) A decrease in the expected future domestic exchange rate causes the demand for domestic assets to shift to the left and the
domestic currency to depreciate, everything else held constant.
41) Suppose the Federal Reserve releases a policy statement today which leads people to believe that the Fed will be enacting
expansionary monetary policy in the near future. Everything else held constant, the release of this statement would immediately cause
the demand for U.S. assets to decrease and the U.S. dollar to depreciate.
42) Suppose a report was released today that showed the Euro-Zone inflation rate is running above the European Central Bank's
inflation rate target. This leads people to expect that the European Central Bank will enact contractionary policy in the near future.
Everything else held constant, the release of this report would immediately cause the demand for U.S. assets to increase and the U.S.
dollar will appreciate
43) Suppose that the latest Consumer Price Index (CPI) release shows a higher inflation rate in the U.S. than was expected. Everything
else held constant, the release of the CPI report would immediately cause the demand for U.S. assets to decrease and the U.S. dollar
would depreciate.
44) In the long run, a one-time percentage increase in the money supply is matched by the same one-time percentage rise in the price
level, leaving unchanged the real money supply and other economic variables such as interest rates. This proposition is called
money neutrality.
45) Money neutrality means that in the long run the domestic interest rate remains unchanged from an increase in the money supply,
implying that the fall in the exchange rate is greater in the short run than in the long run, a phenomenon called exchange rate
overshooting.
46) Evidence from the United States during the period 1973-2002 indicates that the value of the dollar and the measure of the real
interest rate rose and fell together.
47) During the beginning on the subprime crisis in the United States when the effects of the crisis were mostly confined within the
United States, the U. S. dollar depreciated because demand for U.S. assets decreased.
48) When the effects of the subprime crisis started to spread more quickly throughout the rest of the world, the U.S. dollar
appreciated because demand for U.S. assets increased.
49) Explain and show graphically the effect of an increase in the expected future exchange rate on the equilibrium exchange rate,
everything else held constant.
Answer: See figure below.

When the expected future exchange rate increases, the relative expected return on the domestic assets increases. This will cause the
demand for domestic assets to increase and the current value of the exchange rate will appreciate.
50) Explain and show graphically the effect of an increase in the expected inflation rate on the equilibrium exchange rate, everything
else held constant.
Answer: See figure below.
When the expected inflation rate increases, the relative expected return on domestic assets is affected two ways. First, through the
Fisher effect, the domestic nominal interest rate will increase the expected return on domestic assets. Second, through purchasing
power parity, the future value of the domestic exchange rate will decline which will decrease the expected return on domestic assets.
Since it is generally believed that the effect of the change in the expected future value of the domestic exchange rate is larger than the
Fisher effect, the net effect is a lower expected return on domestic assets. This will decrease the demand for domestic assets, which
will cause the current value of the domestic exchange rate to depreciate.
17.5 APPENDIX: The Interest Parity Condition
1) The condition that states that the domestic interest rate equals the foreign interest rate minus the expected appreciation of the
domestic currency is called B) the interest parity condition.
2) If the interest rate is 7 percent on euro-denominated assets and 5 percent on dollar- denominated assets, and if the dollar is expected
to appreciate at a 4 percent rate, for Francois the Frenchman the expected rate of return on dollar-denominated assets is B) 9 percent.
3) If the interest rate is 7 percent on euro-denominated assets and 5 percent on dollar- denominated assets, and if the dollar is expected
to appreciate at a 4 percent rate, the expected return on ________-denominated assets in ________ percent. D) euro; dollars is 3
4) If the interest rate on euro-denominated assets is 13 percent and it is 15 percent on peso-denominated assets, and if the euro is
expected to appreciate at a 4 percent rate, for Manuel the Mexican the expected rate of return on euro-denominated assets is C) 17
percent.
5) If the interest rate on euro-denominated assets is 13 percent and it is 15 percent on peso-denominated assets, and if the euro is
expected to appreciate at a 4 percent rate, for Francois the Frenchman the expected rate of return on peso-denominated assets is A) 11
percent.
6) With a 10 percent interest rate on dollar deposits, and an expected appreciation of 7 percent over the coming year, the expected
return on dollar deposits in terms of the foreign currency is D) 17 percent.
7) With a 10 percent interest rate on dollar deposits, and an expected appreciation of 7 percent over the coming year, the expected
return on dollar deposits in terms of the dollar is B) 10 percent.
8) The expected return on dollar deposits in terms of foreign currency can be written as the ________ of the interest rate on dollar
deposits and the expected appreciation of the dollar. C) sum
9) In a world with few impediments to capital mobility, the domestic interest rate equals the sum of the foreign interest rate and the
expected depreciation of the domestic currency, a situation known as the A) interest parity condition.
10) According to the interest parity condition, if the domestic interest rate is 12 percent and the foreign interest rate is 10 percent, then
the expected ________ of the foreign currency must be ________ percent. B) appreciation; 2
11) According to the interest parity condition, if the domestic interest rate is 10 percent and the foreign interest rate is 12 percent, then
the expected ________ of the foreign currency must be ________ percent. C) depreciation; 2