,Chapter 1 zl
ANSWERS TO QUESTIONS zl zl
1. What is the typical relationship among interest rates on three-
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month Treasury bills, long-term Treasury bonds, and Baa corporate bonds?
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The interest rate on three-
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month Treasury bills fluctuates more than the other interest rates and is lower on averag
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e. The interest rate on Baa corporate bonds is higher on average than the other interest
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rates.
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2. What effect does high volatility of financial markets have on people's willingness to sp
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end?
The high volatility of financial markets decreases people's willingness to spend, primar
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ily because it directly affects their wealth, and also because high volatility indicates tha
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t there are considerable fluctuations in the prices of securities over a short time span. It i
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ncreases insecurities about the future of an economy. Refer to Figure 2 to see the extre
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mely volatile nature of stock prices between 1950 and 2020.
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3. Explain the main difference between a bond and a common stock.
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A bond is a debt instrument, which entitles the owner to receive periodic amounts of mo
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ney (predetermined by the characteristics of the bond) until its maturity date. A commo
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n stock, however, represents a share of ownership in the institution that has issued the st
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ock. In addition to its definition, it is not the same to hold bonds or stock of a given corpo
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ration, since regulations state that stockholders are residual claimants (i.e., the corporati
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on has to pay all bondholders before paying stockholders).
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4. What is the main role of a financial intermediary? Name two financial int
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ermediaries.
A financial intermediary is a firm or institution that channels savings into investments–
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–
that is, it borrows funds from individuals who have saved and provides loans to those w
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ho need funds. Banks and mutual funds are two examples of such intermediaries.
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5. What was the main cause of the global recession in 2020?
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The recession in 2020, sometimes referred to as the COVID-
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19 Recession, was mainly caused by the global pandemic caused by the infectious cor
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onavirus disease (Covid- zl zl
19). In March 2020, the stock market fell by 25% in a single month.
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, According to the World Bank’s June 2020 Global Economic Prospects, the volatility in zl zl zl zl zl zl zl zl zl zl zl zl
duced by the coronavirus pandemic, lockdowns, and other preventive measures taken b
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y global economies to contain it have led to a severe contraction in the global economy.
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6. Can you think of a reason why people in general do not lend money to one another to buy
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a house or a car? How would your answer explain the existence of banks?
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In general, people do not lend large amounts of money to one another because of several info
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rmation problems. In particular, people do not know about the capacity of other people of r
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epaying their debts, or the effort they will provide to repay their debts.
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Financial intermediaries, in particular commercial banks, tend to solve these problems by
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acquiring information about potential borrowers and writing and enforcing contracts that e
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ncourage lenders to repay their debt and/or maintain the value of the collateral.zl zl zl zl zl zl zl zl zl zl zl zl
7. Why are banks important to the financial system?
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Banks are one of the major financial intermediaries. They channel savings from private
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institutions or the general public to other institutions or people who need a loan. Well- zl zl zl zl zl zl zl zl zl zl zl zl zl zl
functioning banks are very important for the savings-to- zl zl zl zl zl zl zl
loans cycle and for the housing market. zl zl zl zl zl zl
8. Can you date the latest financial crisis in the United States or in Europe? Are there rea
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sons to think that these crises might have been related? Why?
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The latest financial crisis in the United States and Europe occurred in 2007–
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2009. At the beginning, it hit mostly the U.S. financial system, but it then quickly move
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d to Europe, since financial markets are highly interconnected. One specific way in whi
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ch these markets were related is that some financial intermediaries in Europe held secur
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ities backed by mortgages originated in the United States, and when these securities los
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t their a considerable part of their value, the balance sheet of European financial interm
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ediaries was adversely affected. zl zl zl
9. Has the inflation rate in the United States increased or decreased in the past few ye
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ars? What about interest rates? zl zl zl zl
Since 2015, inflation has been around 2%, with some brief dips in 2015 and 2020. In 201
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5, the interest rate on three-
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month Treasury bills was near zero, and it then rose to just over 2% in 2019, only to fall b
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ack near to zero in 2020.-
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10. If history repeats itself and we see a decline in the rate of money growth, what might you
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expect to happen to
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a. real output? zl
b. the inflation rate? zl zl
c. interest rates? zl
The data in Figures 3, 5, and 6 suggest that real output, the inflation rate, and interest rat
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es would all fall.
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11. When interest rates decrease, how might businesses and consumers change their ec
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onomic behavior? zl
, Businesses would increase investment spending because the cost of financing this spen zl zl zl zl zl zl zl zl zl zl zl
ding is now lower, and consumers would be more likely to purchase a house or a car bec
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ause the cost of financing their purchase is lower.
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12. Is everybody worse off when interest rates rise?
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No. It is true that people who borrow to purchase a house or a car are worse off because i
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t costs them more to finance their purchase; however, savers benefit because they can ear
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n higher interest rates on their savings.
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13. What is the main role of a central bank? Why are central banks, like the European Ce
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ntral Bank (ECB), important to financial analysts?
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Central banks oversee the monetary policy for a specific country or a group of nations (as
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in the case of the ECB). This is done by setting a base interest rate or by forward guidan
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ce, which impacts the financial and real economy. Since money affects many economic
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variables that are important to the health of an economy, financial analysts (including p
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oliticians and policymakers) take an interest in the conduct of monetary policy, as well a
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s in the management of money and interest rates.
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14. Germany is one of the few countries that has maintained a budget surplus in the last five
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zlyears, and according to Reuters, the federal government made a record surplus of €13
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.5 billion in 2019. How does a budget surplus arise?
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A budget surplus results from tax revenues exceeding government expenditure, which le
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ads to lower government debt burdens.
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15. How would a fall in the value of the pound sterling affect British consumers?
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It makes foreign goods more expensive, so British consumers will buy fewer foreign go
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ods and more domestic goods. zl zl zl zl
16. How would an increase in the value of the pound sterling affect American bu
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sinesses?
It makes British goods more expensive relative to American goods. Thus, American b
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usinesses will find it easier to sell their goods in the United States and abroad, and the
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demand for their products will rise. zl zl zl zl zl
17. How can changes in foreign exchange rates affect the profitability of financial in
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stitutions?
Changes in foreign exchange rates change the value of assets held by financial instituti
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ons and thus lead to gains and losses on these assets. Also changes in foreign exchange rate
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s affect the profits made by traders in foreign exchange who work for financial institutio
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ns.
18. According to Figure 8, in which years would you have chosen to visit the Grand Can zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl
yon in Arizona rather than the Tower of London?
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In the mid-to- zl zl
late 1970s, the late 1980s to early 1990s, and 2008 to 2015, the value of the dollar was low
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, making travel abroad relatively more expensive; thus, it was a good time to vacation in the
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United States and see the Grand Canyon. With the rise in the dollar’s value in the early 1
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980s, late 1990s, and after 2015, travel abroad became
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ANSWERS TO QUESTIONS zl zl
1. What is the typical relationship among interest rates on three-
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month Treasury bills, long-term Treasury bonds, and Baa corporate bonds?
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The interest rate on three-
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month Treasury bills fluctuates more than the other interest rates and is lower on averag
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e. The interest rate on Baa corporate bonds is higher on average than the other interest
zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl
rates.
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2. What effect does high volatility of financial markets have on people's willingness to sp
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end?
The high volatility of financial markets decreases people's willingness to spend, primar
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ily because it directly affects their wealth, and also because high volatility indicates tha
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t there are considerable fluctuations in the prices of securities over a short time span. It i
zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl
ncreases insecurities about the future of an economy. Refer to Figure 2 to see the extre
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mely volatile nature of stock prices between 1950 and 2020.
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3. Explain the main difference between a bond and a common stock.
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A bond is a debt instrument, which entitles the owner to receive periodic amounts of mo
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ney (predetermined by the characteristics of the bond) until its maturity date. A commo
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n stock, however, represents a share of ownership in the institution that has issued the st
zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl
ock. In addition to its definition, it is not the same to hold bonds or stock of a given corpo
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ration, since regulations state that stockholders are residual claimants (i.e., the corporati
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on has to pay all bondholders before paying stockholders).
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4. What is the main role of a financial intermediary? Name two financial int
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ermediaries.
A financial intermediary is a firm or institution that channels savings into investments–
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–
that is, it borrows funds from individuals who have saved and provides loans to those w
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ho need funds. Banks and mutual funds are two examples of such intermediaries.
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5. What was the main cause of the global recession in 2020?
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The recession in 2020, sometimes referred to as the COVID-
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19 Recession, was mainly caused by the global pandemic caused by the infectious cor
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onavirus disease (Covid- zl zl
19). In March 2020, the stock market fell by 25% in a single month.
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, According to the World Bank’s June 2020 Global Economic Prospects, the volatility in zl zl zl zl zl zl zl zl zl zl zl zl
duced by the coronavirus pandemic, lockdowns, and other preventive measures taken b
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y global economies to contain it have led to a severe contraction in the global economy.
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6. Can you think of a reason why people in general do not lend money to one another to buy
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a house or a car? How would your answer explain the existence of banks?
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In general, people do not lend large amounts of money to one another because of several info
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rmation problems. In particular, people do not know about the capacity of other people of r
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epaying their debts, or the effort they will provide to repay their debts.
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Financial intermediaries, in particular commercial banks, tend to solve these problems by
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acquiring information about potential borrowers and writing and enforcing contracts that e
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ncourage lenders to repay their debt and/or maintain the value of the collateral.zl zl zl zl zl zl zl zl zl zl zl zl
7. Why are banks important to the financial system?
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Banks are one of the major financial intermediaries. They channel savings from private
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institutions or the general public to other institutions or people who need a loan. Well- zl zl zl zl zl zl zl zl zl zl zl zl zl zl
functioning banks are very important for the savings-to- zl zl zl zl zl zl zl
loans cycle and for the housing market. zl zl zl zl zl zl
8. Can you date the latest financial crisis in the United States or in Europe? Are there rea
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sons to think that these crises might have been related? Why?
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The latest financial crisis in the United States and Europe occurred in 2007–
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2009. At the beginning, it hit mostly the U.S. financial system, but it then quickly move
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d to Europe, since financial markets are highly interconnected. One specific way in whi
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ch these markets were related is that some financial intermediaries in Europe held secur
zl zl zl zl zl zl zl zl zl zl zl zl zl
ities backed by mortgages originated in the United States, and when these securities los
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t their a considerable part of their value, the balance sheet of European financial interm
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ediaries was adversely affected. zl zl zl
9. Has the inflation rate in the United States increased or decreased in the past few ye
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ars? What about interest rates? zl zl zl zl
Since 2015, inflation has been around 2%, with some brief dips in 2015 and 2020. In 201
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5, the interest rate on three-
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month Treasury bills was near zero, and it then rose to just over 2% in 2019, only to fall b
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ack near to zero in 2020.-
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10. If history repeats itself and we see a decline in the rate of money growth, what might you
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expect to happen to
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a. real output? zl
b. the inflation rate? zl zl
c. interest rates? zl
The data in Figures 3, 5, and 6 suggest that real output, the inflation rate, and interest rat
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es would all fall.
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11. When interest rates decrease, how might businesses and consumers change their ec
zl zl zl zl zl zl zl zl zl zl zl
onomic behavior? zl
, Businesses would increase investment spending because the cost of financing this spen zl zl zl zl zl zl zl zl zl zl zl
ding is now lower, and consumers would be more likely to purchase a house or a car bec
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ause the cost of financing their purchase is lower.
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12. Is everybody worse off when interest rates rise?
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No. It is true that people who borrow to purchase a house or a car are worse off because i
zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl
t costs them more to finance their purchase; however, savers benefit because they can ear
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n higher interest rates on their savings.
zl zl zl zl zl zl
13. What is the main role of a central bank? Why are central banks, like the European Ce
zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl
ntral Bank (ECB), important to financial analysts?
zl zl zl zl zl zl
Central banks oversee the monetary policy for a specific country or a group of nations (as
zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl
in the case of the ECB). This is done by setting a base interest rate or by forward guidan
zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl
ce, which impacts the financial and real economy. Since money affects many economic
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variables that are important to the health of an economy, financial analysts (including p
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oliticians and policymakers) take an interest in the conduct of monetary policy, as well a
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s in the management of money and interest rates.
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14. Germany is one of the few countries that has maintained a budget surplus in the last five
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zlyears, and according to Reuters, the federal government made a record surplus of €13
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.5 billion in 2019. How does a budget surplus arise?
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A budget surplus results from tax revenues exceeding government expenditure, which le
zl zl zl zl zl zl zl zl zl zl zl
ads to lower government debt burdens.
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15. How would a fall in the value of the pound sterling affect British consumers?
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It makes foreign goods more expensive, so British consumers will buy fewer foreign go
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ods and more domestic goods. zl zl zl zl
16. How would an increase in the value of the pound sterling affect American bu
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sinesses?
It makes British goods more expensive relative to American goods. Thus, American b
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usinesses will find it easier to sell their goods in the United States and abroad, and the
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demand for their products will rise. zl zl zl zl zl
17. How can changes in foreign exchange rates affect the profitability of financial in
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stitutions?
Changes in foreign exchange rates change the value of assets held by financial instituti
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ons and thus lead to gains and losses on these assets. Also changes in foreign exchange rate
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s affect the profits made by traders in foreign exchange who work for financial institutio
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ns.
18. According to Figure 8, in which years would you have chosen to visit the Grand Can zl zl zl zl zl zl zl zl zl zl zl zl zl zl zl
yon in Arizona rather than the Tower of London?
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In the mid-to- zl zl
late 1970s, the late 1980s to early 1990s, and 2008 to 2015, the value of the dollar was low
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, making travel abroad relatively more expensive; thus, it was a good time to vacation in the
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United States and see the Grand Canyon. With the rise in the dollar’s value in the early 1
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980s, late 1990s, and after 2015, travel abroad became
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