Chapter 1
ANSWERS TO QUESTIONS
1. What is the typical relationship among interest rates on three-month Treasury bills, long-
term Treasury bonds, and Baa corporate bonds?
The interest rate on three-month Treasury bills fluctuates more than the other interest rates and
2. What effect might a fall in stock prices have on business investment?
3. Explain the main difference between a bond and a common stock.
A bond is a debt instrument, which entitles the owner to receive periodic amounts of money
(predetermined by the characteristics of the bond) until its maturity date. A common stock,
4. Explain the link between well-performing financial markets and economic growth. Name one
channel through which financial markets might affect economic growth and poverty.
Well performing financial markets tend to allocate funds to its more efficient use, thereby
allowing the best investment opportunities to be undertaken. The improvement in the
(and thereby poverty reduction).
5. What was the main cause of the recession that began in 2007?
The United States’ economy was hit by the worst financial crisis since the Great Depression.
Defaults in subprime residential mortgages led to major losses in financial institutions,
6. Can you think of a reason why people in general do not lend money to one another to buy a
house or a car? How would your answer explain the existence of banks?
In general, people do not lend large amounts of money to one another because of several
information problems. In particular, people do not know about the capacity of other people of
7. Name two institutions that are not important financial intermediaries in an economy.
Central banks and the Fed are the two institutions that are not important financial
8. Can you date the latest financial crisis in the United States or in Europe? Are there reasons
to think that these crises might have been related? Why?
The latest financial crisis in the United States and Europe occurred in 2007–2009. At the
beginning, it hit mostly the US financial system, but it then quickly moved to Europe, since
9. What is one of the reasons for inflation in your country? Provide empirical evidence to
support your answer.
Answers may vary. One of the main reasons for inflation is money supply, that is, there must be
a positive relationship between the growth rate of money supply and inflation in the country.
10. If history repeats itself and we see a decline in the rate of money growth, what might you
expect to happen to
a. real output?
b. the inflation rate?
c. interest rates?
11. When interest rates decrease, how might businesses and consumers change their economic
behavior?
Businesses would increase investment spending because the cost of financing this spending is
12. Is everybody worse off when interest rates rise?
No. It is true that people who borrow to purchase a house or a car are worse off because it
13. Why do managers of financial institutions care so much about the activities of the Federal
Reserve System?
Because the Federal Reserve affects interest rates, inflation, and business cycles, all of which
14. How does the current size of the U.S. budget deficit compare to the historical budget deficit
or surplus for the time period since 1950?
The deficit as a percentage of GDP expanded dramatically in 2007 but improved starting in
15. How would a fall in the value of the pound sterling affect British consumers?
It makes foreign goods more expensive, so British consumers will buy fewer foreign goods
16. When there is an increase in the value of the European Union’s euro, all else equal, how will
American businesses be affected? What will happen when there is a decrease in the value of
the American dollar relative to the Japanese yen, given all else is equal?
When the euro increases in value, American businesses find that the demand for their goods
17. How can changes in foreign exchange rates affect the profitability of financial institutions?
Changes in foreign exchange rates change the value of assets held by financial institutions
18. According to Figure 8, in which years would you have chosen to visit the Grand Canyon in
Arizona rather than the Tower of London?
In the mid– to late 1970s, the late 1980s to early 1990s, and 2008 to 2015, the value of the
dollar was low, making travel abroad relatively more expensive; thus, it was a good time to
vacation in the United States and see the Grand Canyon. With the rise in the dollar’s value in
Date
$/£
5-01
1.2917
5-02
1.2921
5-03
1.2916
5-04
1.2910
5-05
1.2950
05-08
1.2942
05-09
1.2939
05-10
1.2939
05-11
1.2885
05-12
1.2880
05-15
1.2917
05-16
1.2912
05-17
1.2944
05-18
1.3009
05-19
1.3018
05-22
1.3006
05-23
1.2984
05-24
1.2935
05-25
1.2954
05-26
1.2795
05-30
1.2858
05-31
1.2905
19. In July 2018 Yi Gang, Governor of the People’s Bank of China, said fluctuations in the
foreign exchange market were mainly due to factors like a stronger U.S. dollar and external
uncertainties. How can fluctuations in the currency exchange rate affect a country’s
economy?
Fluctuations in exchange rates influence consumers directly as they affect the cost of imports
and exports. On the one hand, if a country’s currency is weak, imports, traveling abroad, and
20. Much of the U.S. government debt is held by foreign investors as treasury bonds and bills.
How do fluctuations in the dollar exchange rate affect the value of that debt held by
foreigners?
As the dollar becomes stronger (worth more) relative to a foreign currency, one dollar is
equivalent to (can be exchanged for) more foreign currency. Thus, for a given face value of
ANSWERS TO APPLIED PROBLEMS
21. The following table lists the foreign exchange rate between U.S. dollars and British pounds
(GBP) during April 2017. Which day would have been the best for converting $250 into
British pounds? Which day would have been the worst? What would be the difference in
pounds?
Date
$/£
Date
$/£
4-01
1.9406
4-18
1.7346
4-04
1.9135
4-19
1.7097
4-05
1.8982
4-20
1.6756
4-06
1.9216
4-21
1.6562
4-07
1.9452
4-22
1.6526
4-08
1.8767
4-25
1.6516
4-11
1.8664
4-26
1.6699
4-12
1.8400
4-27
1.6767
4-13
1.7802
4-28
1.7043
4-14
1.7744
4-29
1.7354
4-15
1.7627
ANSWERS TO DATA ANALYSIS PROBLEMS
1. Go to the St. Louis Federal Reserve FRED database and find data on the three-month
treasury bill rate (TB3MS), the three-month AA nonfinancial commercial paper rate
(CPN3M), the 30-year treasury bond rate (GS30), the 30-year fixed rate mortgage average
(MORTGAGE30US), and the NBER recession indicators (USREC). For the mortgage rate
indicator, set the frequency setting to ‘monthly’.
a. In general, how do these interest rates behave during expansionary periods?
Generally speaking, the interest rates fall during recessions, and rise during expansionary
periods.
c. For the most recent available month of data, take the average of each of the three-month
rates and compare it to the average of the three-month rates from January 2000. How do
the averages compare?
May 2017
January 2000
Three-month rate avg.
0.92
5.53
30-year rate avg.
3.49
7.42
2. Go to the St. Louis Federal Reserve FRED database and find data on the M1 money supply
(M1SL) and the 10-year treasury bond rate (GS10). Add the two series into a single graph by
using the “Add Data Series” feature. Transform the M1 money supply variable into the M1
growth rate by adjusting the units for the M1 money supply to “Percent Change from Year
Ago.”
a. In general, how have the growth rate of the M1 money supply and the 10-year treasury
bond rate behaved during recessions and during expansionary periods since the year
2000?
b. In general, is there an obvious, stable relationship between money growth and the
10-year interest rate since the year 2000?
When money growth rises, the 10-year treasury rate appears to fall, and vice-versa;
however, this effect is more obvious over some periods than others.
May 2017
January 2000
M1 Money Growth
8.00
2.19
10-year Treasury rate
2.30
6.66