Which of the following statements concerning interest rates in the financial system is (are) correct?
I The rate of interest is the price of credit, the use of loan funds for a period of time.
II Interest rates act as price signals, and higher rates cause the volume of savings to fall while increasing the volume of borrowing and investment.
A. I only
II is incorrect because higher interest rates generally lead to a higher volume of savings and to a lower level of borrowing and investment.
All the following statements concerning the functions of the interest rates in the economy are correct, EXCEPT:
C. It helps assure that investment will flow into current savings.
The interest rate helps assure that funds are saved in the economy and that they become available to those wishing to invest.
According to the classical theory of interest rates, all the following statements concerning household savings are correct, EXCEPT:
A. Under the substitution effect, having higher interest rates will reduce the volume of current savings.
According to the classical theory, the substitution effect refers to the fact that interest rates induce people to save now, rather than to spend now. Higher rates will lead to a higher volume of current saving.
Which of the following defines the risk-free rate of interest?
D. It is the opportunity cost of holding idle money and is a part of all other interest rates.
The risk-free rate of interest is the lowest rate in the financial markets, so A is incorrect. The fact that it is a risk-free rate means that the security to which it is attached, such as a 90-day U.S. Treasury bill, carries virtually no risk of loss for the investor.
Which of the following statements concerning saving by business firms is (are) correct?
I Retained earnings are the savings of business firms and supply most of the funds used for business investment.
II The retention ratio, the ratio of retained earnings to business profits after taxes, determines the volume of business saving.
C. Both I and II
Both statements correctly describe saving by business firms in the form of retained earnings.
Which of the following statements concerning saving by government units is (are) correct?
I The level of interest rates is the key factor in the volume of saving by government units.
II Governments save more than households or business firms.
D. Neither I nor II
I is incorrect because saving by government units, that is, a budget surplus, is rare, usually accidental, and not related to the level of interest rates. II is incorrect because households and business firms each save far more than governments.
All the following statements concerning business investment are correct, EXCEPT:
D. Net investment is the sum of gross investment and replacement investment.
Net investment is the difference between gross investment and replacement investment. Net investment refers to the net addition to the total stock of capital that occurs when total or gross investment exceeds the volume needed to replace worn out capital items.
Which of the following defines correctly the internal rate of return?
D. It is the present value of the net future cash flows expected from an investment.
The internal rate of return is the discount rate that equates the present value of the benefits from an investment project with the present value of the costs of the project.
Which of the following statements concerning the investment decision-making process is (are) correct?
I If the internal rate of return exceeds the cost of borrowing, an investment project is acceptable.
II If the cost of borrowing exceeds the internal rate of return, an investment project is not acceptable.
C. Both I and II
An IRR that exceeds the cost of capital means a net gain to the investor, whereas an IRR that is lower than the cost of capital means a net loss to the investor.
According to the classical theory, all the following statements concerning the interest rate and the demands for investment funds are correct, EXCEPT:
C. The slope of the demand curve relating interest rates and investment volume reflects the increasing net marginal productivity of investment.
According to the classical theory, the demand curve slopes down and to the right. This means that as more and more investment projects are taken on, their net marginal productivity becomes lower and lower.
Which of the following statements concerning the limitations of the classical theory of interest is (are) correct?
I It ignores the powers of the commercial banking system to create money and credit that can finance investment and ignores consumers and governments as important borrowers.
II It assumes that income, rather than interest rates, is the most important determinant of the volume of household savings.
A. I only
The classical theory overlooks the ability of the banking system to create money and the importance of government and consumers as borrowers. Also, the classical theory assumes that interest rates, not income levels, are the principal determinant of the volume of household savings.
According to the liquidity preference theory, all the following statements concerning the demand for money and motives for holding money are correct, EXCEPT:
B. The total demand for money is the sum of the transactions and precautionary demands, less the speculative demand for money.
Under the liquidity preference theory, the total demand for money is the sum of three components: the transactions demand, the precautionary demand, and the speculative demand.
According to the liquidity preference theory, which of the following statements concerning the supply of money is correct?
D. It is closely regulated or controlled by government.
According to the liquidity preference theory, the supply of money is basically inelastic, or unresponsive to changes in interest rate levels, so A is incorrect. The theory holds that the size of the money supply is controlled by government based on its desire to enhance the public welfare. Being inelastic relative to interest rates, the money supply is depicted graphically as a vertical line.
All the following statements concerning the liquidity preference theory are correct, EXCEPT:
B. It considers the liquidity, income, and price expectations effects in explaining why interest rates must rise as the money supply increases.
As the money supply increases, excess liquidity is created, causing interest rates to fall. Later, however, additional spending will occur, causing higher incomes, which may lead to rising interest rates. If this generates inflationary expectations, interest rates may rise still further.
According to the loanable funds theory, all the following are sources of the demand for loanable funds, EXCEPT:
A. Saving targets of households
Savings on the part of households are part of the supply of loanable funds, not the demand.
According to the loanable funds theory, which of the following summarizes the principal source of loanable funds?
D. The supply of savings by households and retained earnings of firms
Savings by households and retained earnings by businesses are by far the major sources of funds according to the loanable funds theory of interest rates.
According to the loanable funds theory of interest rates, a stable equilibrium interest rate will be characterized by which of the following conditions?
I Planned saving = planned investment across the entire economic system.
II Money supply = money demand.
III Quantity of loanable funds supplied = quantity of loanable funds demanded.
C. I, II, and III
A stable equilibrium interest rate will be characterized by all three of the conditions listed. In addition, the net demand for or supply of loanable funds from foreigners will be equal to the net exports from or imports into the domestic economy.
According to the rational expectations theory of interest rates, which of the following statements is (are) correct?
I It is possible to gain consistent profits using publicly-known information in efficient markets on the basis of past interest rates.
II Equilibrium interest rates are not likely to vary much unless new, unexpected information appears, and the result of that information depends on current public expectations.
B. II only
I is incorrect because, according to the rational expectations theory, money and capital markets are highly efficient in extremely rapidly digesting and reacting to new information, and the way markets react has no relation to past interest rate levels. If this is true, it is impossible for one to consistently outguess the markets as to whether interest rates are going to rise or fall in the future.
All the following statements concerning interest rates are correct, EXCEPT:
A. Interest rates were not closely correlated with inflation in the 1970s, 1980s, and 1990s.
The correlation between interest rates and inflation rates has been direct and quite close over the years including the periods of the 1970s, 1980s, and 1990s. As inflation rates rose, so did interest rates. When inflation cooled, interest rates declined.
Which of the following statements concerning the Fisher effect is (are) correct?
I The nominal interest rate reflects the real interest rate and the effects of an inflation premium.
II Real interest rates change in the short run in response to changes in expected rates of inflation.
A. I only
II is incorrect because, according to the Fisher theory, real interest rates tend to be stable over time, depending on long-term factors such as the productivity of capital and the volume of saving taking place in the economy.
If the expected rate of inflation rose from 8% to 10%, which of the following would be expected results of the Fisher effect?
I The inflation premium would rise by 2 points.
II The nominal interest rate would rise by 2 points.
III The real interest rate would rise by 2 points.
B. I and II only
The two-point increase in the expected rate of inflation would cause an equal increase in the inflation premium and, therefore, in the nominal interest rate. However, the real interest rate would not change in the short run, so III is incorrect.
Which of the following effects indicates that the nominal interest rate will rise by more than a given rise in the expected rate of inflation?
B. The inflation-caused income tax effect
The income effect and depreciation effect cause the nominal rate to rise less than the rise in the expected inflation rate. The Fisher effect causes the nominal rate to rise equally to the increase in the expected inflation rate. Only the income tax effect causes nominal rates to rise faster than expected inflation rates rise.
Which of the following statements concerning the inflation-caused income effect on nominal interest rates is (are) correct?
I A rise in the expected rate of inflation may lead to increases in real income and savings that affect nominal interest rates.
II The income effect requires time before its influence on nominal interest rates is felt.
C. Both I and II
Both statements correctly describe the income effect on nominal interest rates.
Which of the following statements concerning conclusions from current research on the relationship between inflation and interest rates is (are) correct?
I More rapid rates of inflation tend to cause higher nominal rates of interest.
II There is no clearly accepted measure of the relationship.
C. Both I and II
If a company enters into nominal contracts that provide for sale of its products at a 3% increase for the coming year, what will be the likely effect on its profits and share price?
B. Results will depend on the actual rate of inflation.
The concept of nominal contracts attempts to explain the effect of inflation on profits and share price. The effect of inflation may vary depending on the actual rate of inflation and the terms of the nominal contracts. In this question, profits will increase if inflation is less than 3% and the share price will rise. If inflation is more than 3%, profits will decrease and share price will decline. So the results will depend on the actual rate of inflation.
If an investor bought a TIPS bond for $1,000 that will pay a 3% coupon rate per year, what is the amount of interest that will be paid for the first year if inflation is 5% for the year?
A. $ 31.50
The TIPS bond will increase in principal amount from $1,000 to $1,050. The coupon rate is applied to this principal amount, so the interest will be .03 x $1,050 = $31.50.