Knowledge Check Week essay

The Correct Answer is: C. Investors purchase assets based on a rational expectation of a stream of future income. The interest rate is based on what investors would receive if they placed their capital in a risk-free investment, such as a government bond r certificate of deposit that is guaranteed by a government agency. However, each investor has a certain risk tolerance and may elect to incur some risk; this is known as a risk premium. 3.

During periods of increasing inflationary pressure, the Federal Reserve should A. Buy member bank’s bonds to encourage increased lending to the public B. Sell bonds to member banks to discourage lending to the public reduce the discount rate to make it easier for small businesses to borrow money The Correct Answer is: B. Increasing inflationary pressures means that more dollars are in the economy than there are goods and services. This leads to a general price-level increase: inflation.

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When the Federal Reserve sells bonds, this restricts the amount Of money an individual bank may loan to individuals and firms under the fractional resent. ‘e requirement, thereby reducing the amount of money in circulation. 4. What is the increased moral hazard associated with the too big to fail (TPTB) bailouts of the largest of financial institutions? Financial institutions might misuse the bailout funds and continue the same practices that lead to the original failure. Depositors will lose their deposits.

Employees Of the financial institutions will lose their bobs. The Correct Answer is: A. When private institutions are allowed to fail, the investors bear the burden for the loss; they are also the first to benefit when correct decisions are made related to pricing and risk. This positive relationship between risk and profit is the backbone of a capitalistic economy. When banks become too large?with many interrelationships With other financial institutions?their ability to make decisions may become distorted by the loss reduction of the risk-price relationship. . The Federal Reserves primary tool for managing the money flow IS discount rate reserve ratio pen-market operations term auction facility The open-market operation affects both the money supply and the base, and it is used by the Federal Reserve every day. The Federal Reserves use of both the discount rate and term auction facility is initiated by the borrowers and is used for member banks to borrow to meet reserve requirements and not as a tool for controlling the money supply. Reserve ratios have fallen into disuse. Concept: Interest Rates 2.

Economists use two principle interest rates: nominal and real. The purpose of this distinction is to use nominal interest rates during periods when the economy is growing and real interest rates during economic down turns adjust for the influences that inflation may have on business profits account for and factor the influences that inflation may have on the behavior that consumers and firms use to determine how much to save out Of their incomes Real interest rates adjust for the loss or increase in purchasing power that consumers and firms experience.

Consumers and firms must adjust nominal or current values to account for the effects of inflation and to be able to impute their respective real purchasing power. Concept: Exchange Rates . Which of the following is a major drawback of a flexible exchange rate? Government intervention in the form of reserves use of exchange controls Discouraging the flow of trade due to risks and uncertainties Flexible exchange rates can be volatile, with changes occurring rapidly and in large amounts and with lengthy durations.

Businesses, institutions, and individual investors may not be risk tolerate and may seek to place their investments in other countries with a managed exchange rate with less volatility. By the definition of flexible exchange rate, there are little or no overspent controls or use of active government intervention.

The major advantage to a flexible exchange-rate policy is automatic adjustments to balance of payments relative interest rates between countries are automatically adjusted increased foreign investment increased overall wealth Changes in exchange rates are the result of changes in demand and supply factors for goods and services, such as changes in tastes, relative incomes, and relative prices. Under a flexible-rate policy, all domestic prices are linked with foreign prices. Any change in the exchange rate automatically alters the rises of all foreign goods to domestic goods.

The price change alters the relative attractiveness of imports and exports and maintains equilibrium in each trading partners balance of payments. 10. The explains that long-run trends in exchange rates are based on a predictable relationship between product price levels and exchange rates. Monetary approach to exchange rates asset market approach to exchange rates purchasing power parity The monetary approach to exchange rates relates money supply and demand as the key to understanding exchange rates.

The asset market approach to exchange rates emphasizes how financial investors reposition their portfolios and the subsequent effect this has on exchange rates. 11. A business traveler to Germany who, upon deplaning in Berlin, uses an airport ATM to withdraw 1 00 Euros from her U. S. Bank would receive which kind of exchange rate? Spot Forward Fixed Flexible A spot exchange rate is the rate in use at the time of the transaction. A forward exchange rate is the current set price, but the exchange takes place sometime in the future.

Both fixed and flexible exchange rates deal with policy for the long-run exchange markets set by each country. Concept: Trade and Specialization 8. Suggests that a country will engage in trade and export products that it can produce at a lower-opportunity cost than a competing nation. Comparative advantage Absolute advantage Arbitrage Hecklers-Olin theory By definition, comparative advantage means that a country can produce a specific product at a lower opportunity cost than others.

Absolute advantage is enjoyed by a country when that country has the highest productivity for a good or service production than the rest of the world. Arbitrage is the process of buying at a low price in one place and selling at a higher price in another lace. The Hecklers-Olin theory is similar to comparative advantage, but it solely relies on the importance of a country’s factors of production and not necessarily on a lower opportunity cost.

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