EoCB_ch2_self-study_problems_&_solutions

Question 1

2.1 Economic units that need to borrow money are said to be:
a. Lender–savers
b. Borrower–spenders
c. Balanced budget keepers.
d. None of the above.

Answer 1

Solution: Such units are said to be (b) Borrower-spenders.

Question 2

2.2 Explain what the marketability of a security is and how it is determined.

Answer 2

Marketability refers to the ease with which a security can be sold and converted into cash. The level of marketability depends on the cost of trading the security and the cost of searching for information. The lower these costs are, the greater the security’s marketability.

Question 2

2.3 What are over-the-counter markets (OTCs), and how do they differ from organized exchanges?

Answer 2

Securities that are not listed on an organized exchange are sold OTC. An OTC market differs from an organized exchange in that there is no central trading location. OTC security transactions are made via phone or computer as opposed to on the floor of an exchange.

Question 3

2.4 What effect does an increase in the demand for business goods and services have on the real interest rate? What other factors can affect the real interest rate?

Answer 3

An increase in the demand for business goods and services will cause the borrowing schedule in Exhibit 2.4 to shift to the right, thus increasing the real rate of interest. Other factors that can affect the real interest rate include increases in productivity, changes in technology, or changes in the corporate tax rate.

Demographic factors, such as growth or age of the population, and cultural
differences can also affect the real rate of interest.

Question 4

2.5 How does the business cycle affect the nominal interest rate and inflation rate?

Answer 4

Both the nominal interest and inflation rates tend to follow the business cycle; that
is, they rise with economic expansion and fall during a recession.

Question 5

2.6.1 You lent $100 to a friend for one year at a nominal rate of interest of 3 percent. Inflation during that year was 2 percent. Did you experience an increase or decrease in the
purchasing power of your money? How much did it increase or decrease?

Answer 5

Since the interest rate that you received (3 percent) exceeded the rate of inflation,
the amount that you received from your friend when the loan was repaid had greater purchasing power than $100. The amount by which the purchasing power increased can be calculated using Equation 2.1:
1 + i = (1 + r) × (1+ ∆Pe)
Solving for r yields:
r = (1 + i)/(1 + ∆Pe) - 1
r = (1 + 0.03)/(1 + 0.02) - 1
r = 0.0098, or 0.98%
Therefore, the purchasing power increased by slightly less than 1 percent.