Ch1 Flashcards
The price elasticity of demand for a good is 2.0, and the quantity demanded is 5,000 units. The price increases by 10%. What is the new quantity demanded?
A.
1,000
B.
4,000
C.
4,500
D.
6,000
B
Ed = percentage change in quantity demanded
—————————————
percentage change in price
2.0 = percentage change in quantity demanded/10%
percentage change in quantity demanded= 20%
5000*20%= 1000 decrease
5000-1000=4000
All of the following statements about monetary aggregates are true, except
A.
They include the monetary base, M1 and M2.
B.
Changes in them provide a relatively poor guide to changes in output and inflation in coming months.
C.
Changes in them provide a very precise guide to changes in output and inflation in coming months.
D.
They have become harder to predict as financial markets have become more complex.
Choice C (Correct): The links between changes in monetary aggregates, output, and inflation are weak, with lags that are long and variable (with potentially years of delay). M1 and M2 are the most-commonly computed and reported monetary aggregates today. Changes in financial markets often result in changes in how consumers and firms store their wealth (cash vs. other assets, etc.).
Which of the following is true about international trade and investment?
A.
Companies always benefit from setting up factories in countries with the lowest wages, independently of other considerations such as transportation costs, labor productivity, or how secure property rights may be. (7%)
B.
Many companies are shifting lower-value-added tasks to countries with lower wages. (80%)
C.
Companies operating across countries each match their assets and liabilities across countries and currencies. (4%)
D.
Companies operating across countries each match their flows of revenues and costs across countries and currencies. (6%)
Choice B (Correct) and Choices A, C, D (Incorrect): Many companies are shifting lower-value-added tasks to developing countries with lower wages, whereas higher-value-added tasks remain in developed countries. Countries with low wages and insecure property rights are not necessarily attracting much investment. Whereas matching assets and liabilities and flows of revenues and expenses by currency may reduce exchange rate risk, achieving that goal is (1) not necessarily easy and (2) is only one goal among many.
An importing partnership has experienced a dramatic surge in its exporting business and is looking for ways to minimize its risks from foreign currency fluctuations. The partnership’s imports and exports to European Union countries are at similar levels. Which of the following methods most effectively minimizes risk?
A.
Purchase futures of the currency in which the payables will be paid.
B.
Hold payables and receivables due in the same currency and amount.
C.
Enter into an interest rate swap to mitigate the effects of exchange rate fluctuations.
D.
Conduct all foreign transactions in U.S. dollars.
B
Companies operating in different countries often enact transactions in more than one currency. Financial statements require converting any foreign currency transactions into the currency of the country in which the company is headquartered. A change in currency exchange rates presents translation (accounting) risk.
Companies may manage translation risk by negotiating related asset and liability transactions in the same currency. If an entity maintains similar levels of exports (eg, receivables from) and imports (eg, payables to) in the same currency, the risk of foreign currency fluctuation is minimized. For example, any currency fluctuation that increases payables will be offset by an increase in receivables.
(Choice A) Holding futures in the currency in which liabilities will be paid protects against foreign currency risk on liabilities but offers no protection for receivables.
(Choice C) Interest rate swaps mitigate risks associated with changes in interest rates, not changes in foreign currency exchange rates.
(Choice D) Although conducting all foreign transactions only in U.S. dollars does manage translation risk, it allows no flexibility in the currency used. It is unlikely that a company will be able to convince all customers to pay for exports in U.S. dollars or that all vendors will accept payment in U.S. dollars.
Things to remember:
Foreign currency fluctuation risks can be minimized by negotiating related asset and liability transactions in the same currency. Should currency fluctuations occur, the change in liabilities will be offset by the change in assets.
One euro will buy U.S. $1.48, and a British pound will buy U.S. $2.06. What is the cross rate of euros per pound?
A.
0.72
B.
1.39
C.
1.48
D.
2.06
B
A cross exchange rate consists of a pair of currencies, neither of which is the currency of the home country. In this scenario, the currency pair is the euro and the British pound sterling (BPS) and the home currency is the U.S. dollar (USD).
A cross exchange rate is often used by currency traders when currency pairs are inactively traded. The exchange rate can be determined through a currency pair’s relationship to a widely traded third currency. Speculators also use cross exchange rates to make interest rate plays and a quick profit in trading back and forth between the three currencies.
To determine the cross rate of euros (€) per BPS (£), first restate each exchange rate as a function of USD (or desired currency), as follows:
If €1 = $1.48, then $1 = €0.676 (€1 / $1.48)
If £1 = $2.06, then $1 = £0.485 (£1 = $2.06)
Substitute the restated rate for the euro and the pound, and solve as follows:
Euro/BPS*=Euro/USD×USD/BPS
=.676/1.00×1.00/.485
=1.39
Things to remember:
A cross exchange rate consists of a pair of currencies, neither of which is the currency of the home country. To determine the cross rate, restate each exchange rate as a function of the home currency (eg, if €1 = $1.48, then $1 = €0.676), substitute the restated amount into the cross exchange formula, and solve.
A company manufactures goods in Esland for sale to consumers in Woostland. Currently, the economy of Esland is booming and imports are rising rapidly. Woostland is experiencing an economic recession, and its imports are declining. How will the Esland currency, $E, react with respect to the Woostland currency, $W?
A.
The $E will remain constant with respect to the $W.
B.
The $E will increase with respect to the $W.
C.
The $E will decline with respect to the $W.
D.
Changes in imports and exports will not affect currency changes
Choice C (Correct) and Choices A, B, D (Incorrect): Esland’s increased demand for Woostland’s goods increases demand for $W, the currency required to pay for Woostland’s goods. Esland’s additional demand for $W will increase the price of $W in terms of $E. Since $W will be more expensive in terms of $E, the value of $E will decline with respect to $W.
Platinum Co. has a receivable due in 30 days for 30,000 euros. The treasurer is concerned that the value of the euro relative to the dollar will drop before the payment is received. What should Platinum do to reduce this risk?
A.
Buy 30,000 euros now.
B.
Enter into an interest rate swap contract for 30 days.
C.
Enter into a forward contract to sell 30,000 euros in 30 days.
D.
Platinum cannot effectively reduce this risk
Choice C (Correct): A forward contract to sell euros in 30 days establishes today the rate at which Platinum will be able to exchange the 30,000 euros to be received at the end of 30 days into dollars. As a result, Platinum avoids the risk associated with a reduction in the exchange rate, although it will also not be able to take advantage of an increase in the exchange rate.
Which of the following strategies would the Federal Reserve most likely pursue under an expansionary policy?
A.
Purchase federal securities and lower the discount rate.
B.
Reduce the reserve requirement while raising the discount rate.
C.
Raise the reserve requirement and lower the discount rate.
D.
Raise the reserve requirement and raise the discount rate.
A
When the Federal Reserve (the Fed) is concerned about a recession (ie, slow economic growth and high unemployment), it invokes an expansionary monetary policy. Expansionary policies are designed to stimulate aggregate demand, which in turn will promote consumer and business spending. Eventually the economy will turn from a contractionary phase of the business cycle to an expansionary phase.
Ultimately, the goal is to increase the money supply, which in turn encourages consumer and business spending, and capital investment. Expansionary policies include purchasing federal securities, lowering the discount rate, and decreasing reserve requirements for member banks. When the Fed purchases federal securities (ie, Treasuries) using cash, more money is placed into circulation, which in turn stimulates demand and production.
Things to remember:
Expansionary policies are designed to increase the money supply, which in turn encourages consumer and business spending, and capital investment. These policies include purchasing federal securities, lowering the discount rate, and decreasing reserve requirements for member banks.
A company currently sells 100,000 units of product A at $10 per unit. The company also sells 100,000 units of product B at the same price. The company raises the price of both products by 10%. Product A has an elasticity of 1.5. Product B has an elasticity of 3.0. Which of the following effects will the price increase most likely have on company revenues?
A.
Company revenues will increase for both products.
B.
Company revenues will decrease for both products.
C.
Company revenues will increase for product A but not product B.
D.
Company revenues will increase for product B but not product A.
B
In economics, elasticities measure the sensitivity of one thing (eg, quantity demanded) to changes in something else (eg, price). There are various types of elasticity, including price elasticity of demand, price elasticity of supply, income elasticity of demand, and cross elasticity of demand.
The price elasticity of demand (Ed) measures how responsive the quantity demanded of a good or service is to a change in its price. If Ed is greater than 1, demand is elastic, and total revenue will decline if the price is increased. Conversely, if Ed is less than 1, demand is considered inelastic, and total revenue will increase if the price is increased. Unit elasticity exists when Ed is exactly equal to 1.
Given that Product A’s Ed = 1.5 and Product B’s Ed = 3.0 (ie, both are greater than 1), company revenues will decrease for both products when prices for both products increase by 10% (Choices A, C, and D).
Things to remember:
The price elasticity of demand (Ed) measures how responsive the quantity demanded of a good or service is to a change in its price. If Ed is greater than 1, demand is elastic, and total revenue will decline if the price is increased. Conversely, if Ed is less than 1, demand is considered inelastic, and total revenue will increase if the price is increased.
Which of the following strategies would the federal government most likely pursue under a contractionary fiscal policy?
A.
A decrease in the government budget surplus.
B.
A reduction in export subsidies to manufacturers.
C.
An increase in spending for roads and bridges.
D.
An expansion of eligibility for unemployment benefits.
B
Fiscal policy involves governments setting, applying, and changing levels of taxes, subsidies, and government spending. Contractionary fiscal policies are designed to constrain economic growth. Contractionary policies are usually not intended to literally contract (ie, shrink) the size of an economy but to prevent an economy from growing too rapidly.
Export subsidies are payments made by the government to domestic businesses designed to increase exports. A reduction in export subsidies has a direct contractionary impact due to lower available manufacturing revenue. The result is fewer purchases of materials and cutbacks on employee hours. The effects filter through the economy as other impacted suppliers and employees reduce their spending accordingly.
(Choice A) With contractionary fiscal policy, governments increase, not decrease, budget surpluses by increasing taxes and reducing government spending.
(Choice C) Increasing spending on roads and bridges generates additional sales revenue for construction firms that supply the materials and machinery for construction projects. The construction firms can then hire additional workers. Aggregate demand is stimulated by the increased disposable income, which is an expansionary fiscal policy.
(Choice D) Increasing government transfer payments is an expansionary policy. Expanded eligibility for unemployment benefits generally results in more total money being paid to beneficiaries. The consequence is greater consumption spending and a higher GDP.
Things to remember:
Increased taxation and reduced spending are contractionary fiscal policies. A reduction in export subsidies reduces government payments to exporting businesses. The effect of the subsidy reduction will filter through the economy as suppliers and their employees cut back spending.
A company has a capital project with before-tax cash inflows in real dollars that are expected to be $200,000 within two years. The inflation rate is expected to be 6% each year during that period. What is the before-tax cash inflow expressed in nominal dollars?
A.
$177,999
B.
$178,571
C.
$224,000
D.
$224,720
D
Economic activity is recorded at nominal (ie, current) prices. The amount is affected by actual price changes and inflation or deflation. Because inflation and deflation distort the magnitude of the “true” price change, a price index is used to calculate real prices. In other words, real prices remove the effects of inflation and deflation. They represent a “constant” amount.
For example, a common comparison is the starting salary of a CPA just out of college. To compare 1980’s starting salary to 2020’s salary, the 2020 salary must be adjusted to remove the effects of inflation. A price index “strips out” inflation, leaving the true change in salary.
Nominal values (represented by the green line in the image above) are useful for anticipating future amounts. Real values (represented by the red line in the image above) are used to measure changes in purchasing power over time. In this scenario, real after-tax cash flow is expected to be $200,000 within two years. Inflation is predicted to be 6% for each of the next two years. Therefore, the before-tax cash inflow expressed in nominal dollars is $224,720 ($200,000 × 1.06 × 1.06).
Things to remember:
Economic activity is recorded at nominal (ie, current) prices. The amount is affected by true price changes and inflation or deflation. Because inflation and deflation distort the magnitude of the “true” price change, a price index is used to calculate real prices.
A country’s currency conversion value has recently changed from 1.5 to the U.S. dollar to 1.7 to the U.S. dollar. Which of the following statements about the country is correct?
A.
Its exports are less expensive for the United States.
B.
Its currency has appreciated.
C.
Its imports of U.S. goods are more affordable.
D.
Its purchases of the U.S. dollar will cost less.
A
Exchange rate increase
FX rate U.S. dollar cost
- 5 1 / 1.5 = $0.67
- 7 1 / 1.7 = $0.59
When a currency’s exchange rate increases in relation to the U.S. dollar (eg, 1.5 to 1.7), holders of U.S. dollars (USD) will be able to buy more of the foreign currency (FC) with the same amount of dollars. One unit of FC previously cost $0.67 but now costs only $0.59; USD purchases of the FC have become less expensive. Conversely, FC purchases of the USD have become more expensive (Choice D).
The exchange rate for that foreign country has depreciated (ie, is less valuable). If the price of goods denominated in that FC does not change, it will require fewer USD to buy them, making exports from that country relatively less expensive. As a result, the quantity of goods exported to the U.S. will increase and the quantity of goods imported from the U.S. will decrease.
(Choice B) When a FC appreciates against the USD (ie, it cost less to buy USD), that FC becomes more valuable. At the same time, USD would buy fewer units of the foreign currency.
(Choice C) Since it now requires more units of the FC to buy USD, U.S. goods (ie, imports to that country) are relatively more expensive for the foreign country.
Things to remember:
When a foreign country’s currency depreciates against the U.S. dollar, the foreign currency becomes less expensive for individuals and businesses who make purchses in U.S. dollars. That foreign country’s exports are then less expensive for the U.S. while its imports from the U.S. are more expensive.
Which of the following indicates that the economy is in a recessionary phase?
A.
The rate of unemployment decreases.
B.
The purchasing power of money declines rapidly.
C.
Potential national income exceeds actual national income.
D.
There is a shortage of essential raw materials and costs are rising.
C
Business cycles are fluctuations in economic production (output) that typically last several years. Business cycles vary in duration from less than two years to more than a decade. A full cycle consists of a peak, contraction (ie, recession), trough, and expansion.
The economy is typically considered in recession following two consecutive quarters of negative GDP growth. Recessions are accompanied by declines in employment and increases in unemployment rates (Choice A).
In a recession, actual national income is less than potential national income. Actual national income is the total (ie, actual) monetary value of a country’s output of goods and services for a given period of time. Potential national income represents what could have been the total monetary value of a country’s goods and services assuming that resources were used efficiently.
(Choice B) A decline in the purchasing power of money generally indicates an increase in the demand for goods and services (causes prices to rise), which is typical of a growing (inflationary) economy.
(Choice D) A shortage of raw materials and rising costs typically occur in a growing economy with inflationary pressure. During a recession, production is typically stagnant.
Things to remember:
The economy is typically considered in recession following two consecutive quarters of negative GDP growth. One indicator of a recession is that the actual national income is less than potential national income. Recessions are also accompanied by declines in employment and increases in unemployment rates.
International trade has increased greatly in recent decades as a result of all of the following, except:
A.
Falling transportation costs.
B.
Falling information costs.
C.
Drastic reductions on non-tariff barriers to trade (such as health and safety standards).
D.
Reductions in tariffs applied to imports.
Choice C (Correct) and Choices A, B, D (Incorrect): Non-tariff barriers to trade have not experienced drastic reductions in recent decades.
A hospital is comparing last year’s emergency rescue services expenditures to those from 10 years ago. Last year’s expenditures were $100,500. Ten years ago, the expenditures were $72,800. The CPI for last year was 168.5, compared to 121.3 ten years ago. After adjusting for inflation, what percentage change occurred in expenditures for emergency rescue services?
A.
38.0% increase
B.
13.8% increase.
C.
0.61% decrease.
D.
18.1% decrease.
C
The consumer price index (CPI) is a common measure of inflation. It compares the price of goods and services in a base year to the price of the same goods and services at a later year. The CPI is commonly used to convert figures not readily comparable across years into figures that are more comparable.
In this case, the expenditure from 10 years ago is first converted to equivalent dollars today.
expenditure ($72,800) × (current year CPI of 168.5CPI 10 years ago of 121.3)=$72,800 × 1.389=$101,119
Prior period expenditures converted to equivalent dollars today ($101,119) compared to current period expenditures ($100,500) results in a $619 decrease. This represents a 0.61% decrease relative to current period emergency rescue service expenditures ($619 / 100,500).
(Choices A, B, and D) These changes are not calculated, as shown above. For example, the 38.0% increase does not adjust for the impact of inflation. It is based on the change in expenditures ($100,500 – 72,800) divided by the base year expenditure ($72,800).
Things to remember:
The consumer price index (CPI) is calculated annually to measure changes in prices of goods and services. Prior period amounts can be converted to current dollars using the CPI.
The Federal government wishes to conduct expansionary fiscal policy. Which of the following approaches will be most successful?
A.
Increase excise taxes on vehicle motor fuel.
B.
Increase infrastructure spending on highways and bridges.
C.
Decrease budget deficits by raising corporate income taxes.
D.
Decrease spending on unemployment benefits.
B
The immediate impact of increased spending on highways and bridges is the additional sales revenue for the firms that supply the materials, labor, and machinery used in the construction projects. With increased revenue, these firms can then expand their businesses and hire additional workers. As a result, aggregate demand is stimulated by the increased disposable income that trickles down to consumers.
(Choices A and D) Increasing excise taxes and decreasing spending on unemployment benefits both decrease consumers’ disposal income. This puts downward pressure on GDP and therefore is a contractionary policy.
(Choice C) Raising corporate income taxes reduces investments and hiring. This is a contractionary policy, not an expansionary policy.
Things to remember:
Expansionary fiscal policy includes increased government spending on public projects such as improving infrastructure. With increased revenue, construction firms can expand their businesses and hire additional workers. Aggregate demand is therefore stimulated by the increased disposable income that trickles down to consumers and suppliers.
What would be likely to cause the currency of country A to depreciate relative to the currency of country B?
A.
Country A experiences lower inflation than country B.
B.
Country A has higher real interest rates than country B.
C.
Country A has a trade surplus with country B.
D.
Country A is a small, developing country, country B has large, stable financial markets, and an international financial crisis takes place.
Choice D (Correct) and Choices A, B, C (Incorrect): During financial crises, the currencies of stable countries appreciate relative to those of other countries. Lower inflation leads currencies to appreciate. Higher real interest rates lead currencies to appreciate. Trade surpluses lead currencies to appreciate.
NOTE:
-The higher interest rates that can be earned tend to attract foreign investment, increasing the demand for and value of the home country’s currency.
-Currency appreciation usually reduces inflation because imports become cheaper and the lower prices lead to lower inflation.
If the yields for 10-year conventional and TIPS Treasuries are 3% and 1% respectively, what inflation rates do investors roughly expect over the next ten years?
A.
1%
B.
2%
C.
3%
D.
4%
Choice B (Correct) and Choices A, C, D (Incorrect): Holders of TIPS are compensated for actual inflation, and the stated yield in TIPS is thus net of an inflation premium (1%). Holders of conventional bonds demand a premium for expected inflation. The difference between yields on conventional and TIPS Treasuries are thus an indicator of investors’ expectations for inflation (2 = 3 - 1).
What preceded most recessions during the second half of the twentieth century?
A.
Brief periods of falling prices.
B.
Extended periods of falling prices
C.
Congress attempting to fight inflation through large increases in tax rates
D.
The Federal Reserve attempting to fight inflation through higher interest rates.
Choice D (Correct): During the second half of the twentieth century, most recessions followed efforts by the Federal Reserve to forestall current or expected increases in inflation rates through higher interest rates.
Choice A (Incorrect): During the second half of the twentieth century, most recessions followed efforts by the Federal Reserve to forestall current or expected increases in inflation rates through higher interest rates. Brief periods of falling prices, in many cases, characterize a recession rather than the period preceding one.
Choice B (Incorrect): During the second half of the twentieth century, most recessions followed efforts by the Federal Reserve to forestall current or expected increases in inflation rates through higher interest rates. Extended periods of falling prices, in many cases, characterize a depression, rather than the period preceding a recession.
Choice C (Incorrect): During the second half of the twentieth century, most recessions followed efforts by the Federal Reserve to forestall current or expected increases in inflation rates through higher interest rates. Most recessions have not been preceded by increases in tax rates.
Which of the following statements is correct if there is an increase in the resources available within an economy?
A.
More goods and services will be produced in the economy.
B.
The economy will be capable of producing more goods and services.
C.
The standard of living in the economy will rise.
D.
The technological efficiency of the economy will improve.
Choice B (Correct): An increase in available resources increases the economy’s capacity to produce more goods and services. The increase in capacity does not automatically increase the amount of goods and services produced if the additional resources are not utilized. Nor does it automatically increase the standard of living if the additional resources are not utilized in the production of additional goods and services. The increase in capacity does not automatically increase technological efficiency. There will be no technological efficiency gains if the additional resources are not utilized for the production of additional goods and services.
Each of the following describes predatory pricing characteristics, except
A.
Reducing product quality in the long run.
B.
Setting prices low for a short period of time.
C.
Requiring a firm to sustain losses for a certain time period.
D.
Detering new firms from entering an industry.
B
Predatory pricing occurs when a firm temporarily lowers prices with the intention of both driving out competitors and preventing new companies from entering the marketplace (Choice D). Predatory pricing usually takes place during a price war over a lengthy period of time. The predator firm will probably sustain losses for a certain time, so only large, established firms tend to employ this strategy (Choice C).
In the short run, a buyer’s market is created where consumers can shop around, obtaining goods and services at low prices. However, after competitors have been driven out, the surviving firms raise prices above the market equilibrium price to recoup losses. In addition, the quality of the product often suffers since only a limited number of competitors can offer consumers an alternative product (Choice A). Innovation may also suffer because there is no incentive to make improvements.
Predatory pricing is illegal in the U.S. However, it is difficult to prove and prosecute because it can be disguised as intense market competition, which is legal.
Things to remember:
Predatory pricing is intended to drive out competitors and prevent new firms from entering an industry. It takes place during a price war over a lengthy period of time. The predator firm will probably sustain losses for a certain time, so only large, established firms tend to employ this strategy.
References
BEC 1.07 : Economic Concepts: Market Structure and Industry Analysis
To address inflation, which of the following policies would the Fed not use
A.
Increase the target for the federal funds rate. (19%)
B.
Sell more Treasury bills. (10%)
C.
Sell more Treasury and Agency bonds (i.e., unwind quantitative easing). (7%)
D.
Decrease the discount rate.
Choice D (Correct) and Choices A, B, C (Incorrect): Decreasing the discount rate is expansionary monetary policy that would not address inflation.
To address inflation, which of the following policies would the Fed not use
A.
Increase the target for the federal funds rate. (19%)
B.
Sell more Treasury bills. (10%)
C.
Sell more Treasury and Agency bonds (i.e., unwind quantitative easing). (7%)
D.
Decrease the discount rate.
Choice D (Correct) and Choices A, B, C (Incorrect): Decreasing the discount rate is expansionary monetary policy that would not address inflation.
How does inflation distort reported income?
A.
Wages are not reflective of current labor rates. (17%)
B.
Sales are not reflective of current product prices. (24%)
C.
Depreciation is not reflective of current fixed-asset replacement costs. (39%)
D.
Interest expense is not reflective of current borrowing rates.
C
Inflation is the percentage rate of increase in the price of goods and services. From a financial statement perspective, inflation affects accounting measures that take place over extended periods of time (eg, depreciation using historic values) more than it affects measures that take place within a shorter period of time.
Revenues and expenses based on current market conditions (eg, sales, wages, interest expense) would not be as impacted by inflation as items based on historical costs (eg, depreciation associated with assets purchased in prior years). The cost of replacing an asset will be higher than the original cost due to inflation. Because depreciation allocates the historical cost of an asset, it does not reflect current asset replacement costs.
(Choice A) Wages reflect current labor rates because workers negotiate to offset the rising cost of living and employers compete to retain talented workers.
(Choice B) Sales reflect current product prices. Firms adjust the prices of products in periods of inflation.
(Choice D) Inflation may cause interest rates to rise on new loans. However, interest expense on old loans with historical rates would not distort income.
Things to remember:
Expense items based on historical costs are more likely to distort reported income during a period of inflation. These items do not reflect current market costs. Items that stay current (eg, wages, sales) are not based on historical costs and therefore do not distort reported income.
