Final Exam Examples

PART A. TOTAL 30 MARKS (1 MARK EACH QUESTION)

A1) Sometimes one observes that the price of a company's stock falls after the announcement of
favorable earnings. This phenomenon is ________.
A) clearly inconsistent with the efficient markets hypothesis
B) consistent with the efficient markets hypothesis if the earnings were not as high as anticipated
C) consistent with the efficient markets hypothesis if the earnings were not as low as anticipated
D) consistent with the efficient markets hypothesis if the favorable earnings were expected

A2) Assume that the following are the predicted inflation rates in these countries for the year: 2 percent
for Canada, 3 percent for Canada; 4 percent for Mexico, and 5 percent for Brazil. According to the
purchasing power parity and everything else held constant, which of the following would we expect to
happen?
A) The Brazilian real will depreciate against the Canadian dollar.
B) The Mexican peso will depreciate against the Brazilian real.
C) The Canadian dollar will depreciate against the Mexican peso.
D) The Canadian dollar will depreciate against the Canadian dollar.

A3) Increased uncertainty resulting from the subprime crisis ________ the required return on
investment in equity.
A) raised
B) lowered
C) had no impact on
D) decreased

A4) An unanticipated decline in the price level increases the burden of debt on borrowing firms but does
not raise the real value of borrowing firms' assets. The result is ________.
A) that net worth in real terms declines
B) that adverse selection and moral hazard problems are reduced
C) an increase in the real net worth of the borrowing firm
D) an increase in lending

A5) The purchase of private sector assets by the central bank in critical markets is known as ________.
A) quantitative easing
B) conditional statements about the future path of the policy rate
C) managing interest rate expectations
D) credit easing

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A6) If the probability of a bond default increases because corporations begin to suffer large losses, then
the default risk on corporate bonds will ________ and the expected return on these bonds will
________, everything else held constant.
A) decrease; increase
B) decrease; decrease
C) increase; increase
D) increase; decrease

A7) In the market for settlement balances, when the overnight interest rate is below the bank rate and
above the bank rate less 50 basis points, the supply curve of reserves is ________.
A) vertical
B) horizontal
C) positively sloped
D) negatively sloped

A8) If the Taylor Principle is not followed and nominal interest rates are increased by less than the
increase in the inflation rate, then real interest rates will ________ and monetary policy will be too
________.
A) rise; tight
B) rise; loose
C) fall; tight
D) fall; loose

A9) A monetary expansion ________ stock prices due to a decrease in the ________ and an increase in
the ________, everything else held constant.
A) reduces; future sales price; expected rate of return
B) reduces; current dividend; expected rate of return
C) increases; required rate of return; future sales price
D) increases; required rate of return; dividend growth rate

A10) If during the past decade the average rate of monetary growth has been 5 percent and the average
inflation rate has been 5 percent, everything else held constant, when the Bank of Canada announces
that the new rate of monetary growth will be 10 percent, the adaptive expectation forecast of the
inflation rate is ________.
A) 5 percent
B) between 5 and 10 percent
C) 10 percent
D) more than 10 percent

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A11) The economy recovers quickly from most recessions, but the increase in adverse selection and
moral hazard problems in the credit markets caused by ________ led to the severe economic
contraction known as The Great Depression.
A) debt deflation
B) illiquidity
C) an improvement in banks' balance sheets
D) increases in bond prices

A12) Which of the following is a true statement?

A) The conversion of a barter economy to one that uses money increases efficiency by increasing the
cost of exchange.
B) The conversion of a barter economy to one that uses money increases efficiency by increasing the
cost to those who wish to specialize.
C) The conversion of a barter economy to one that uses money increases efficiency by reducing
transactions costs.
D) The conversion of a barter economy to one that uses money does not increases efficiency.

A13) If a corporation begins to suffer large losses, then the default risk on the corporate bond will
________, everything else held constant.
A) increase and the bond's return will become more uncertain, meaning the expected return on the
corporate bond will fall
B) increase and the bond's return will become less uncertain, meaning the expected return on the
corporate bond will fall
C) decrease and the bond's return will become less uncertain, meaning the expected return on the
corporate bond will fall
D) decrease and the bond's return will become less uncertain, meaning the expected return on the
corporate bond will rise

A14) Suppose that the Bank of Canada enacts expansionary policy. Everything else held constant, this
will cause the demand for Canadian assets to ________ and the Canadian dollar to ________ relative to
the US dollar.
A) increase; appreciate
B) decrease; appreciate
C) increase; depreciate
D) decrease; depreciate

A15) You read a story in the newspaper announcing the proposed merger of Dell Computer and
Gateway. The merger is expected to greatly increase Gateway's profitability. If you decide to invest in
Gateway stock, you can expect to earn ________.
A) above average returns since you will share in the higher profits
B) above average returns since your stock price will definitely appreciate as higher profits are earned

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C) below average returns since computer makers have low profit rates
D) a normal return since stock prices adjust to reflect expected changes in profitability almost
immediately

A16) That most used cars are sold by intermediaries (i.e., used car dealers) provides evidence that these
intermediaries ________.
A) have been afforded special government treatment, since used car dealers do not provide information
that is valued by consumers of used cars
B) are able to prevent potential competitors from free-riding off the information that they provide
C) have failed to solve adverse selection problems in this market because "lemons" continue to be
traded
D) have solved the moral hazard problem by providing valuable information to their customers

A17) If in an efficient market all prices are correct and reflect market fundamentals, which of the
following is a false statement?
A) A stock that has done poorly in the past is more likely to do well in the future
B) One investment is as good as any other because the securities' prices are correct
C) A security's price reflects all available information about the intrinsic value of the security
D) Security prices can be used by managers to assess their cost of capital accurately

A18) Which of the following $1000 face-value securities has the highest yield to maturity?
A) A 5 percent coupon bond selling for $1000
B) A 10 percent coupon bond selling for $1000
C) A 12 percent coupon bond selling for $1000
D) A 12 percent coupon bond selling for $1100

A19) The Bank of Canada commitments regarding the operating band for the overnight interest rate to
align market expectations of future short-term interest rates with those of the Bank are known as
________.
A) quantitative easing
B) conditional statements about the future path of the policy rate
C) interest rate expectations
D) credit easing

A20) People hold money even during inflationary episodes when other assets prove to be better stores
of value. This can be explained by the fact that money is all of the following except ________.
A) perfectly liquid
B) a unique good for which there are no substitutes
C) the only thing accepted in economic exchange

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D) backed by gold

A21) If the possibility of a default increases because corporations begin to suffer losses, then the default
risk on corporate bonds will ________, and the bonds' returns will become ________ uncertain,
meaning that the expected return on these bonds will decrease, everything else held constant.
A) increase; less
B) increase; more
C) decrease; less
D) decrease; more

A22) Which of the following statements concerning an independent central bank are true?
A) Politicians may prefer an independent central bank, as it can be used as a "whipping boy" or
"scapegoat" for poor economic performance.
B) Politicians in a democratic society may be short-sighted because of their desire to win re-election;
thus, the political process may generate a political business cycle, in which just before an election
expansionary policies are pursued to lower unemployment and interest rates.
C) Putting the Bank of Canada under control of the government may place too much pressure on the
Bank to finance federal budget deficits, thereby imparting an inflationary bias to monetary policy.
D) All of the above are true statements.

A23) A key finding of the economic analysis of financial structure is that ________.
A) the existence of the free-rider problem for traded securities helps to explain why banks play a
predominant role in financing the activities of businesses
B) while free-rider problems limit the extent to which securities markets finance some business
activities, nevertheless the majority of funds going to businesses are channeled through securities
markets
C) given the great extent to which securities markets are regulated, free-rider problems are not of
significant economic consequence in these markets
D) economists do not have a very good explanation for why securities markets are so heavily regulated

A24) If an individual moves money from a chequing account to a money market mutual fund, ________.
A) M1+ decreases and M2+ increases
B) M1+ stays the same and M2+ increases
C) M1+ decreases and M2+ stays the same
D) M1+ increases and M2+ decreases

A25) If the yield curve is flat for short maturities and then slopes downward for longer maturities, the
liquidity premium theory (assuming a mild preference for shorter-term bonds) indicates that the market
is predicting ________.
A) a rise in short-term interest rates in the near future and a decline further out in the future

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B) constant short-term interest rates in the near future and a decline further out in the future
C) a decline in short-term interest rates in the near future and a rise further out in the future
D) a decline in short-term interest rates in the near future and an even steeper decline further out in the
future

A26) Which of the following is not one of the eight basic puzzles about financial structure?
A) Debt contracts are typically extremely complicated legal documents that place substantial restrictions
on the behavior of the borrower.
B) Indirect finance, which involves the activities of financial intermediaries, is many times more
important than direct finance, in which businesses raise funds directly from lenders in financial markets.
C) Collateral is a prevalent feature of debt contracts for both households and business.
D) There is very little regulation of the financial system.

A27) Quantitative easing is regarded as an unconventional form of monetary policy because it targets
the ________.
A) the price of liquidity
B) the overnight interest rate
C) the amount of liquidity provided by the central bank instead of targeting the price of liquidity
D) settlement balances

A28) Credit rating agencies were subject to conflicts of interest in the subprime mortgage market
because ________.
A) banks were earning large fees by underwriting the mortgage-backed securities
B) they had little incentives to make sure that the mortgage was a good credit risk
C) they had weak incentives to make sure that the holders of the securities would be paid back
D) they were earning fees from rating the mortgage-backed securities and from advising clients on how
to structure the securities to get the highest ratings

A29) Suppose that the European Central Bank conducts a main refinancing sale. Everything else held
constant, this would cause the demand for Canadian assets to ________ and the Canadian dollar will
________.
A) increase; appreciate
B) increase; depreciate
C) decrease; appreciate
D) decrease; depreciate

A30) Bank of Canada standing facilities ________.

A) refers to participant borrowing form each other to bring their settlement balances to zero at the end
of the banking day
B) refers to the Bank of Canada refusal to lend to or borrow from a participant to bring

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their settlement balances to zero at the end of the banking day
C) refers to the Bank of Canada's building in Ottawa
D) refers to the Bank of Canada being ready to lend to or borrow from a participant to bring
their settlement balances to zero at the end of the banking day

PART B. TOTAL 25 MARKS (5 MARKS EACH QUESTION)

B1) Explain how asymmetric information can lead to market failures in financial markets. Provide two (2)
different examples of a market failure that occurs in financial markets due to asymmetric information. In
each case, explain in detail how banks and other financial intermediaries could reduce the incidence of
these market failures. (5 marks)

B2) List three functions of money. Explain each function. List three forms of money widely used in
Canada not including bank notes and coins. (5 marks)

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B3) Write down the present value formula for (a) fixed payment loan, (b) a coupon bond, (c) discount
bond, and (d) a consol or perpetuity. Define the yield to maturity on a bond. (5 marks)

B4) Show in detail that the annual rate of return on a 2- year bond is approximately equal to the average
rate of return of two one-year (sequential) bonds according to the expectations theory.

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PART C. TOTAL 20 MARKS (10 MARKS EACH QUESTION)

C1. Use the Dornbusch's Overshooting Model (1976) to explain how the foreign exchange rate may
temporarily overreact to changes in monetary policy. Provide all the assumptions and theory behind the
model. Illustrate the impact on the exchange rate over time.

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C2. Demonstrate using balance sheet accounting (for a central bank, commercial bank, etc.) the impact
of contractionary monetary policy, specifically Quantitative Tightening (the opposite of Quantitative
Easing). Explain how interest rates are impacted. What is the impact on aggregate demand and inflation
in the economy?

END OF EXAMPLES

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