, Answers
to End-of-Chapter
Questions and Problems
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 is lower on average. The interest rate on Baa corporate bonds is higher on
average than the other interest rates.
2. What effect does high volatility of financial markets have on people's willingness to
spend?
The high volatility of financial markets decreases people's willingness to spend,
primarily because it directly affects their wealth, and also because high volatility
indicates that there are considerable fluctuations in the prices of securities over a
short time span. It increases insecurities about the future of an economy. Refer to
Figure 2 to see the extremely volatile nature of stock prices between 1950 and 2020.
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, however, represents a share of ownership in the institution that has
issued the stock. In addition to its definition, it is not the same to hold bonds or stock
of a given corporation, since regulations state that stockholders are residual claimants
(i.e., the corporation has to pay all bondholders before paying stockholders).
4. What is the main role of a financial intermediary? Name two financial
intermediaries.
A financial intermediary is a firm or institution that channels savings into
investments––that is, it borrows funds from individuals who have saved and provides
loans to those who need funds. Banks and mutual funds are two examples of such
intermediaries.
5. What was the main cause of the global recession in 2020?
The recession in 2020, sometimes referred to as the COVID-19 Recession, was
mainly caused by the global pandemic caused by the infectious coronavirus disease
(Covid-19). In March 2020, the stock market fell by 25% in a single month.
, According to the World Bank’s June 2020 Global Economic Prospects, the volatility
induced by the coronavirus pandemic, lockdowns, and other preventive measures
taken by global economies to contain it have led to a severe contraction in the global
economy.
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 repaying their debts, or the effort they will provide to repay their debts.
Financial intermediaries, in particular commercial banks, tend to solve these problems
by acquiring information about potential borrowers and writing and enforcing contracts
that encourage lenders to repay their debt and/or maintain the value of the collateral.
7. Why are banks important to the financial system?
Banks are one of the major financial intermediaries. They channel savings from
private institutions or the general public to other institutions or people who need a
loan. Well-functioning banks are very important for the savings-to-loans cycle and for
the housing market.
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 U.S. financial system, but it then quickly moved to
Europe, since financial markets are highly interconnected. One specific way in which
these markets were related is that some financial intermediaries in Europe held
securities backed by mortgages originated in the United States, and when these
securities lost their a considerable part of their value, the balance sheet of European
financial intermediaries was adversely affected.
9. Has the inflation rate in the United States increased or decreased in the past few
years? What about interest rates?
Since 2015, inflation has been around 2%, with some brief dips in 2015 and 2020. In
2015, the interest rate on three-month Treasury bills was near zero, and it then rose to
just over 2% in 2019, only to fall back near to zero in 2020.-
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?
The data in Figures 3, 5, and 6 suggest that real output, the inflation rate, and interest
rates would all fall.
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 now lower, and consumers would be more likely to purchase a house or a
car because the cost of financing their purchase is lower.
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 costs them more to finance their purchase; however, savers benefit because
they can earn higher interest rates on their savings.
13. What is the main role of a central bank? Why are central banks, like the European
Central Bank (ECB), important to financial analysts?
Central banks oversee the monetary policy for a specific country or a group of nations
(as in the case of the ECB). This is done by setting a base interest rate or by forward
guidance, which impacts the financial and real economy. Since money affects many
economic variables that are important to the health of an economy, financial analysts
(including politicians and policymakers) take an interest in the conduct of monetary
policy, as well as in the management of money and interest rates.
14. Germany is one of the few countries that has maintained a budget surplus in the last
five years, and according to Reuters, the federal government made a record surplus
of €13.5 billion in 2019. How does a budget surplus arise?
A budget surplus results from tax revenues exceeding government expenditure, which
leads to lower government debt burdens.
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 and more domestic goods.
16. How would an increase in the value of the pound sterling affect American
businesses?
It makes British goods more expensive relative to American goods. Thus, American
businesses will find it easier to sell their goods in the United States and abroad, and
the demand for their products will rise.
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 and thus lead to gains and losses on these assets. Also changes in foreign
exchange rates affect the profits made by traders in foreign exchange who work for
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 the early 1980s, late 1990s, and after 2015, travel abroad became
to End-of-Chapter
Questions and Problems
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 is lower on average. The interest rate on Baa corporate bonds is higher on
average than the other interest rates.
2. What effect does high volatility of financial markets have on people's willingness to
spend?
The high volatility of financial markets decreases people's willingness to spend,
primarily because it directly affects their wealth, and also because high volatility
indicates that there are considerable fluctuations in the prices of securities over a
short time span. It increases insecurities about the future of an economy. Refer to
Figure 2 to see the extremely volatile nature of stock prices between 1950 and 2020.
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, however, represents a share of ownership in the institution that has
issued the stock. In addition to its definition, it is not the same to hold bonds or stock
of a given corporation, since regulations state that stockholders are residual claimants
(i.e., the corporation has to pay all bondholders before paying stockholders).
4. What is the main role of a financial intermediary? Name two financial
intermediaries.
A financial intermediary is a firm or institution that channels savings into
investments––that is, it borrows funds from individuals who have saved and provides
loans to those who need funds. Banks and mutual funds are two examples of such
intermediaries.
5. What was the main cause of the global recession in 2020?
The recession in 2020, sometimes referred to as the COVID-19 Recession, was
mainly caused by the global pandemic caused by the infectious coronavirus disease
(Covid-19). In March 2020, the stock market fell by 25% in a single month.
, According to the World Bank’s June 2020 Global Economic Prospects, the volatility
induced by the coronavirus pandemic, lockdowns, and other preventive measures
taken by global economies to contain it have led to a severe contraction in the global
economy.
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 repaying their debts, or the effort they will provide to repay their debts.
Financial intermediaries, in particular commercial banks, tend to solve these problems
by acquiring information about potential borrowers and writing and enforcing contracts
that encourage lenders to repay their debt and/or maintain the value of the collateral.
7. Why are banks important to the financial system?
Banks are one of the major financial intermediaries. They channel savings from
private institutions or the general public to other institutions or people who need a
loan. Well-functioning banks are very important for the savings-to-loans cycle and for
the housing market.
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 U.S. financial system, but it then quickly moved to
Europe, since financial markets are highly interconnected. One specific way in which
these markets were related is that some financial intermediaries in Europe held
securities backed by mortgages originated in the United States, and when these
securities lost their a considerable part of their value, the balance sheet of European
financial intermediaries was adversely affected.
9. Has the inflation rate in the United States increased or decreased in the past few
years? What about interest rates?
Since 2015, inflation has been around 2%, with some brief dips in 2015 and 2020. In
2015, the interest rate on three-month Treasury bills was near zero, and it then rose to
just over 2% in 2019, only to fall back near to zero in 2020.-
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?
The data in Figures 3, 5, and 6 suggest that real output, the inflation rate, and interest
rates would all fall.
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 now lower, and consumers would be more likely to purchase a house or a
car because the cost of financing their purchase is lower.
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 costs them more to finance their purchase; however, savers benefit because
they can earn higher interest rates on their savings.
13. What is the main role of a central bank? Why are central banks, like the European
Central Bank (ECB), important to financial analysts?
Central banks oversee the monetary policy for a specific country or a group of nations
(as in the case of the ECB). This is done by setting a base interest rate or by forward
guidance, which impacts the financial and real economy. Since money affects many
economic variables that are important to the health of an economy, financial analysts
(including politicians and policymakers) take an interest in the conduct of monetary
policy, as well as in the management of money and interest rates.
14. Germany is one of the few countries that has maintained a budget surplus in the last
five years, and according to Reuters, the federal government made a record surplus
of €13.5 billion in 2019. How does a budget surplus arise?
A budget surplus results from tax revenues exceeding government expenditure, which
leads to lower government debt burdens.
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 and more domestic goods.
16. How would an increase in the value of the pound sterling affect American
businesses?
It makes British goods more expensive relative to American goods. Thus, American
businesses will find it easier to sell their goods in the United States and abroad, and
the demand for their products will rise.
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 and thus lead to gains and losses on these assets. Also changes in foreign
exchange rates affect the profits made by traders in foreign exchange who work for
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 the early 1980s, late 1990s, and after 2015, travel abroad became
