Lesson 6.2: Practical Economics for Investors

Question 1

A business reporter claims that we are suffering from inertial inflation. This means:

Answer 1

the current rate of inflation will remain at this level until economic shocks cause it to change.

Inertial inflation means that there is not expected to be a change in the inflation rate until some kind of economic event shakes things up and causes the rate to move up or down.

Question 2

Over time, a country’s trade deficit will lead to a decline in the value of its currency because:

Answer 2

the country’s imports will exceed exports, creating selling pressure on its currency.

When a country’s imports exceed its exports, a trade deficit will occur. This causes selling pressure on the country’s currency, therefore lowering its exchange rate against other currencies. When a country’s currency declines in price relative to other currencies, exports tend to increase over time because they become less expensive in terms of foreign currency, thus reversing the trade deficit.

Question 3

Core inflation is best described as an inflation rate:

Answer 3

that excludes certain volatile goods prices.

Core inflation is measured using a price index that excludes food and energy prices. The primary reason for that is the volatility of those two.

Question 4

The Conference Board, a nongovernmental nonprofit organization, regularly publishes a list of economic indicators. What is an item that would be included in their list of leading indicators?

Answer 4

Average weekly initial claims for unemployment insurance

Of these, the only one that is included in the list of leading indicators is the average weekly initial claims for unemployment insurance. Manufacturing and trade sales is a coincident indicator, and average duration of unemployment and average prime rate are lagging indicators.

Question 5

The economic theory that says economic growth results from lower tax rates and reduced government regulation is:

Answer 5

supply-side theory.

Supply-side economics is the theory of Arthur Laffer, who believed that heavy taxing and government intervention have a negative effect on the economy.

Question 6

Define the Consumer Price Index (CPI)?

Answer 6

The average cost of goods and services (market basket) purchased by consumers, compared to those same goods and services purchased during a base period.

The Consumer Price Index (CPI) is the average cost of goods and services (market basket) purchased by consumers as compared to those same goods and services purchased during a base period. The CPI compares price inflation in one country and does not reflect the relative price changes of goods and services in one country with those of another. The CPI measures retail prices, not wholesale costs.

Question 7

An investor regularly reads financial blogs on the internet, and they are filled with articles suggesting that the economy is headed for a slump. Some are even saying that there will be price deflation. If these projections are accurate, the best place for the investor to place funds would probably be:

Answer 7

U.S. Treasury bonds

When the economy is headed downward, safety is the imperative, and nothing is as safe (at least for exam purposes) as U.S. Treasuries. Gold and most other commodities are a hedge against inflation, not deflation. In down times, real estate—both residential and commercial—usually underperforms.

Question 8

Describe the federal funds rate?

Answer 8

Rate charged on reserves traded among commercial banks for overnight use in amounts of $1 million or more

The federal funds rate represents the interest charged on reserves, traded among commercial banks for overnight use, in amounts of $1 million or more.

Question 9

If the dollar weakens:

Answer 9

A rise in U.S. interest rates might strengthen the dollar.

If U.S. interest rates rise, foreign investors would invest in U.S. dollar–denominated securities, thereby increasing the demand for dollars and causing the dollar to strengthen.

Question 10

When a bank’s reserve account is running low, it might choose to borrow from the Fed. When doing so, the bank will be charged:

Answer 10

the discount rate.

When a bank borrows from the Federal Reserve, it does so at the discount rate. When borrowing from another bank, it is at the federal funds rate. The prime rate is charged by the banks to their stronger borrowers, and the call loan rate is what broker-dealers pay on stock market collateral pledged for margin accounts.

Question 11

The Conference Board releases information about the economy on a monthly basis. Included are a number of different indicators. Economic indicators can be leading, lagging, or coincidental, which indicates the timing of their changes relative to how the economy as a whole changes. What is a coincident economic indicator?

Answer 11

Industrial production

Industrial production is a coincident indicator. The stock indices and manufacturing orders are leading indicators; economists do not use agricultural employment as an indicator.

Question 12

If the value of the U.S. dollar were to increase with respect to other currencies, it would do which of these?

I. Make U.S. exports, like heavy equipment, more competitive in foreign markets
II. Make U.S. exports, like heavy equipment, less competitive in foreign markets
III. Make foreign imports into the United States, such as cars, less competitive in U.S. markets
IV. Make foreign imports into the United States, such as cars, more competitive in U.S. markets

Answer 12

II and IV

When the value of the U.S. dollar rises in relation to other currencies, exported products become more expensive in those foreign markets and are less competitive. On the other hand, imported products become less expensive in U.S. markets and are more competitive.

Question 13

A significant increase in the importing of goods into the United States would likely have what effect on the strength of the U.S. dollar?

Answer 13

Weaken

Currency rates tend to ebb and flow as the balance of payments shift from positive to negative. A significant increase in imports represents a large outflow of U.S. dollars, which results in a negative trade balance. As this builds, the value of the dollar falls against those currencies that have a positive trade balance.

Question 14

If a country’s current account shows a trade deficit, it is most likely that:

Answer 14

imports are greater than exports.

A trade deficit occurs when imports are greater than exports.

Question 15

The final step in the approval process of the annual operating budget for the United States is:

Answer 15

the signature of the Speaker of the House.

The president submits a proposed budget to Congress. Once Congress comes up with an approved version, it is sent to the president. Once signed by the president, we have an approved budget.

Question 16

If the U.S. dollar has been appreciating against foreign currencies, all of the following statements are true except:

A) foreign goods become cheaper in the United States.
B) U.S. goods become more expensive in foreign countries.
C) the U.S. dollar buys more of foreign currencies.
D) U.S. exports become more competitive.

Answer 16

D) U.S. exports become more competitive.

The U.S. exports will cost more to foreigners and become less competitive. The dollar is worth more in terms of foreign currencies and will purchase more foreign goods per dollar.

Question 17

The monetarist economic position?

Answer 17

The amount of money in the economy determines the overall price level over time; therefore, the Federal Reserve should control the growth of the amount of money in the economy in a gradual and predictable way.

Monetarists believe that the economy and inflation are best controlled through the management of the money supply rather than through fiscal policy stimulation.

Question 18

Among the effects of a country devaluating its currency is that there will probably be which of these?

I. A credit to that nation’s trade account balance
II. A debit to that nation’s trade account balance
III. An increase in that nation’s exports
IV. An increase in that nation’s imports

Answer 18

I and III

When a currency is devalued by a country, it means that foreigners will find their money has more buying power in that country. Therefore, it would be expected that foreigners would buy more goods produced in that country, causing an increase in exports. Those exports result in a credit to the country’s trade account balance.

Question 19

All of the following are leading indicators for economic growth except:

A) average weekly initial claims for state unemployment compensation.
B) stock prices as measured by the S&P 500 index.
C) average prime rate.
D) orders for durable goods.

Answer 19

C) average prime rate.

The average prime rate is a lagging indicator. The duration of unemployment is also a lagging indicator, but the number of initial unemployment claims is a leading indicator. The S&P 500 index and orders for durable goods are leading economic indicators.

Question 20

What is not a leading economic indicator?

Answer 20

Duration of unemployment

The average amount of time it takes for an unemployed person to find a new job is a lagging indicator, not a leading one. Employment is usually one of the last things to pick up as the economy enters a period of expansion. Layoffs are one of the last resorts for companies when the economy turns down.

Question 21

A free trade agreement is entered into between Country A and Country B. As time goes on, the value of Country A’s currency increases while that of Country B’s decreases. The effect of this will likely be that:

Answer 21

Country A’s imports from Country B will increase.

As a country’s currency increases in value, its exports become more expensive, so they will fall. On the other hand, with a stronger currency, the country’s citizens will have a greater buying power, and this will cause imports to increase.

Question 22

What is not a characteristic of expansionary monetary policy?

Answer 22

The reserve requirement will be increased.

Expansionary monetary policy is also referred to as easy monetary policy. The Federal Reserve follows an easy monetary policy when it wants to expand the level of income and employment. The Federal Reserve may decrease rather than increase the reserve requirement, affording banks the opportunity to loan more money to borrowers.

Question 23

he primary function of the Federal Reserve System (the Fed) is to:

Answer 23

carry out monetary policy.

The Federal Reserve controls the money supply, enabling it to significantly affect interest rates. The Fed will follow a loose, or easy, monetary policy when it wants to increase the money supply to expand the levels of income and employment. In times of inflation, when it wants to constrict the money supply, the Fed will follow a tight monetary policy. The U.S. Treasury issues bonds to the general public to finance the budget deficits of the federal government.

Question 24

Stock market indices have a variety of uses. What is least accurate regarding the use of stock market indices?

Answer 24

They are a lagging indicator of an economy’s corporate performance.

The stock market and market indices are leading indicators of the economy’s corporate and financial performance.

Question 25

You note that an article in the Wall Street Journal points out that the money supply has been increasing. This economic measure is:

Answer 25

a leading indicator

Among the list of leading indicators is the money supply.

Question 26

All of the following actions will increase the deficit in the U.S. balance of payments except

A) investments by U.S. firms abroad.
B) U.S. foreign aid.
C) Americans buying Japanese cars.
D) the purchase by foreigners of U.S. securities.

Answer 26

D) the purchase by foreigners of U.S. securities.

A debit in the U.S. balance of payments occurs when the country pays out more abroad than it takes in. This occurs when the U.S. imports more than it exports, invests money abroad, or sends money to foreign countries in the form of foreign aid.

Question 27

What best describes what will happen when the value of the American dollar rises in relation to foreign currencies?

Answer 27

Foreign goods and services will become less expensive for Americans.

When the value of the dollar rises, it will buy more foreign money, making foreign goods and services less expensive for Americans. Because foreign securities are valued in foreign currencies, shares of foreign stock will be worth fewer American dollars when the value of the dollar increases.

Question 28

Which school of economists encourages a government to spend money to move the economy into an expansionary phase?

Answer 28

Keynesians advocate government intervention in the workings of the economy through increased government spending, which in turn increases aggregate demand.

Question 29

Country A develops a new product that is in high demand around the world. The likely effect of this would be:

Answer 29

a trade surplus for Country A.

When exports exceed imports (the likely case here), it leads to a trade surplus. Invariably, that causes a positive balance of payments, which has the tendency to increase the value of that country’s currency relative to others. There is no way to know how this new product will impact the tax legislation of Country A.

Question 30

Under the concept of inertial inflation,

Answer 30

prices tend to increase at a steady rate until the system receives an economic shock.

Inertial inflation is an economic condition where the rate of price increases reaches a stable equilibrium and stays there until a shock to the system occurs, at which time, the rate of inflation changes. It is true that most economists view the core inflation rate as a more accurate measure of true inflation than the CPI, but that has nothing to do with inertial inflation.

Question 31

If disposable personal income has fallen steadily over the past year, what is most likely going to be affected?

Answer 31

The automobile industry is cyclical and, of the choices, the most likely to be affected by a change in the business cycle as indicated by declining personal income. The tobacco industry and producers of nondurable consumer goods (e.g., toilet paper and basic clothing) are considered defensive industries: those where the demand is relatively constant, regardless of economic conditions. The defensive industry relies on government spending and is affected by conditions not related to our personal incomes. Even when your income falls, you still need to buy your medications, tobacco products (if you are a smoker), and nondurable consumer goods like food and clothing.

Question 32

The business cycle has expanded, peaked, and contracted. The current economic activity could best be described as a trough. Which of the following would most likely be found in the trough?

I. A high rate of inflation
II. A low rate of inflation
III. A high rate of unemployment
IV. A low rate of unemployment

Answer 32

II and III

A trough is the latter stage of a recession. Unemployment is higher than normal, and with a lesser demand for goods and services, the inflation rate is low.

Question 33

Statements about the Consumer Price Index (CPI)

Answer 33

A) The CPI is computed monthly.
B) The CPI measures the increase in the general price level of a basket of consumer goods.
D) The CPI measures the rate of increase or decrease in a broad range of prices, such as food, housing, medical care, and clothing.

The CPI does not measure the increase or decrease in the level of consumer prices with respect to the level of wholesale prices. The CPI only measures retail prices, whether or not wholesale prices are passed through to the consumer.

Question 34

An expansionary fiscal policy would usually result in:

Answer 34

a government increasing government spending to stimulate economic activity.

An expansionary fiscal policy is one that is deliberately implemented to boost demand. Increased spending would be an expansionary policy.

Question 35

A securities analyst’s approach is to look at the overall economy and try to forecast which industry will outperform. Then, the analyst searches for those individual companies within that industry that appear to have the best expected return and adds those to their recommended list. In so doing, this analyst is using:

Answer 35

the top-down approach.

This is the basic approach of top-down analysis—start with the big picture and narrow it down to the most attractive individual stocks.

Question 36

Which of the following would lead to a debit to our foreign account balance?

A) An increase in exports
B) Foreign governments repaying loans to U.S. banks
C) U.S. residents taking vacations abroad
D) Residents of other countries buying apartments here

Answer 36

C) U.S. residents taking vacations abroad

When our foreign account balance is debited, that creates a negative action. It is like a charge on your credit card—your account is debited. On the other hand, a credit to your card account is money coming to you. Our foreign-accounts balance will be debited whenever our money goes out rather than coming in. When U.S. residents take vacations abroad, our money is being spent on hotels, restaurants, and other items in foreign countries. The other choices represent a credit to our foreign account balance. When exports increase, more foreign money comes in. When foreigners buy property here, we get their money, and when loans are repaid here, once again, foreign money comes into the United States.

Question 37

What generally happens to outstanding fixed-income securities when the rate of inflation slows?

Answer 37

Prices go up

When the rate of inflation slows and is expected to remain stable, coupons on new issue bonds will often decline to offer lower yields. The prices of outstanding bonds will go up to adjust to the lower yields on bonds of similar quality.

Question 38

A securities analyst’s stock selection method is to begin by looking for superior companies, regardless of their industry sector or the condition of the overall economy. In so doing, this analyst is using:

Answer 38

This is the basic approach of bottom-up analysis. Rather than focusing the attention on the overall market (the macro view of the economy) or the sectors that are likely to outperform, this approach seeks to identify—usually based on the company’s fundamentals—the most attractive individual stocks.

Question 39

When a bank that is a member of the Federal Reserve System borrows from another member bank, the rate that is charged is known as:

Answer 39

the federal funds rate

Loans between banks, usually on an overnight basis, are made at the federal funds rate. It is the most volatile of the money market rates. The discount rate is the rate charged when banks borrow directly from the Federal Reserve.

Question 40

Increases in which indicators are regarded as predictors of the level of business activity?

Answer 40

Building permits

Increases in building permits are indicative of increased future business activity and therefore are considered a leading economic indicator. Increases in personal income reflect current, not future, activity and are therefore considered a coincident indicator. Increases in inventories indicate that goods are not being sold in anticipated quantities, so they function as a disincentive to manufacturing. Buildup in inventories is a lagging economic indicator. Corporate profits are not included in the Conference Board’s list of economic indicators.

Question 41

An economic condition where the rate of price increases reaches a stable equilibrium and stays there until a shock to the system occurs—at which time, the rate of inflation changes—is known as:

Answer 41

inertial inflation

This is a definition of inertial inflation. Just like it sometimes takes a shock to get people moving (lack of inertia), it can require a shock to move the economy. It is unlikely that any of the other terms shown here will appear as a correct answer on your exam.

Question 42

During an economic downturn, one would expect to see:

Answer 42

higher unemployment

When the economy enters the contraction portion of the business cycle, employers cut costs by letting employees go, thus increasing the number of unemployed persons. With less money in the economy, the CPI will generally remain level or even decline. Manufacturing sales will slow, so their inventories will rise as it takes longer to move product, and we can expect a reduction in interest rates, which will cause bond prices to rise.

Question 43

A research analyst studying the performance of ABC Industries compares that with reports from other analysts reviewing other companies in other industries. This is known as:

Answer 43

Bottom-up analysis starts by attempting to find superior performing companies, regardless of the industry. Those analysts believe that these companies will provide attractive returns even if they are in an industry sector that is in a negative position in the economic cycle.

Question 44

Overnight loans between banks are made at:

Answer 44

When a bank borrows from another bank on an overnight basis, it is at the federal funds rate. When a bank borrows from the Federal Reserve, it does so at the discount rate. The prime rate is charged by the banks to their stronger borrowers, and the call loan rate is what broker-dealers pay on stock market collateral pledged for margin accounts.

Question 45

The Conference Board releases information about the economy on a monthly basis. Included are a number of different indicators. Economic indicators can be leading, lagging, or coincidental, which indicates the timing of their changes relative to how the economy as a whole changes. What is a lagging economic indicator?

Answer 45

Average prime rate

Both the S&P 500 and housing permits are leading economic indicators, as is the measure of hours worked because it reflects changes in the average workweek during the current period. The average prime rate is a lagging indicator because, in an economic downturn, the longer rates stay low, the quicker the recovery should be.

Question 46

The Conference Board releases information about the economy on a periodic basis. Included are a number of different indicators. These indicators can be used to predict how the economy as a whole might change. Which of the following would be considered a leading indicator?

Answer 46

Stock prices as measured by a broad index such as the S&P 500

The stock market, which anticipates economy activity, is a leading economic indicator. Industrial production is a coincident, or current, economic indicator. The CPI for services is a lagging indicator. GDP is not included in the Conference Board’s list of economic indicators.

Question 47

All the pundits are predicting bad times ahead—not only a recession but a period where prices actually fall (deflation). If they are right, the best place for your client would probably be:

Answer 47

U.S. Treasury securities

It is times like this that the flight to safety has investors commit their funds to U.S. government securities. Gold (and other commodities) tends to increase in price during inflationary, not deflationary, periods. Both real estate and equities tend to rise when things are good, not during recessions.

Question 48

Among the responsibilities of the Federal Reserve (the Fed) is influencing the supply of money and credit in the economy. When performing this function, adjusting what is not a tool at its disposal?

Answer 48

The prime rate is set by the banks. All of the others are under the control of the Fed.

Question 49

A coincident economic indicator?

Answer 49

Industrial production is a coincident indicator. The stock indexes and manufacturing orders are leading indicators. Economists do not use agricultural employment as an indicator.

Question 50

Which of the following statements about the federal government’s fiscal policy are true?

I. The federal government’s fiscal policy is its policy for managing taxation, spending, and debts.
II. The federal government’s fiscal policy can have a great impact on the securities markets.
III. The federal government finances its deficit spending by selling bonds.

Answer 50

I, II, and III

The federal government’s fiscal policy establishes the government’s taxation, spending, and debt practices. Fiscal policy can affect the securities markets because it can be used to regulate prices, employment, and economic growth. If fiscal policy includes deficit spending, the government sells bonds to make up the deficit.