Chapter 14

Macroeconomics, 7e (Blanchard)
Chapter 14: Financial Markets and Expectations
14.1 Expected Present Discounted Values
1) Assume that the current one-year rate is 5% and the two-year rate is 7%. Given this
information, the one-year rate expected one year from now is
A) 5%.
B) 6%.
C) 7%.
D) 9%.
E) 12%.
Answer: D
Diff: 2
2) Suppose the current one-year interest rate is 4%, and financial markets expect the one-year
interest rate next year to be 8%. Given this information, the yield to maturity on a two-year bond
will be approximately
A) 4%.
B) 6%.
C) 8%.
D) 12%.
E) none of the above
Answer: B
Diff: 2
3) Suppose the current one-year interest rate is 4%. Also assume that financial markets expect
the one-year interest rate next year to be 5%, and expect the one-year rate to be 6% the year after
that. Given this information, the yield to maturity on a three-year bond will be approximately
A) 4%.
B) 5%.
C) 6%.
D) 15%.
Answer: B
Diff: 2
4) Which of the following bonds (of equal maturity) would have the largest risk premium?
A) U.S. government bonds
B) German government bonds
C) the bonds of a financially stable corporation, like IBM
D) Bondsbrated Aaa by Moody's
E) junk bonds
Answer: E
Diff: 1
1
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5) Suppose there is a decrease in the short-term interest rate. Give this reduction in the current
short-term interest rate, which of the following will most likely occur?
A) The long-term interest rate will increase.
B) The long-term interest rate will remain the same.
C) The long-term interest rate will decrease by more than the short-term rate.
D) The long-term interest rate will decrease by the same amount as the short-term rate.
E) The long-term interest rate will decrease, but by less than the short-term rate.
Answer: E
Diff: 2
6) Which of the following statements about indexed bonds is correct?

A) They were relatively recently introduced in the United States.
B) They exist in England.
C) They have a nominal interest rate that rises when the inflation rate rises.
D) all of the above
Answer: D
Diff: 1
7) Which of the following best explains why the long-term interest rate will generally change by
less than 1% when the short-term interest rate changes by 1%?
A) The mathematical calculations are more difficult for analysts in the case of long-term bonds.
B) Long-term rates are always lower than short-term rates, so there is less room for them to
change.
C) Financial market participants will not expect this increase in the short-term interest rate to
persist fully in the future.
D) Financial markets are often affected by bubbles and fads.
Answer: C
Diff: 2
8) Suppose the yield curve is initially horizontal. Suppose the current one-year interest rate
increases by 4% while the expected future one-year interest rate does not change. Which of the
following will tend to occur?
A) i2t will increase by 4%
B) i2t will increase by 2%
C) i2t will increase by less than 2%
D) i2t will decrease by 2%
Answer: B
Diff: 2
2
14.2 Bond Prices and Bond Yields
1) The length of time over which a bond promises to make payments to the holder is called
which of the following?
A) the term structure of interest rates
B) the face value
C) the yield to maturity
D) the holding period
Answer: E
Diff: 1
2) A "junk bond" is a bond with a

A) low yield to maturity.
B) value of zero.
C) low face value, but high coupon rate.
D) high default risk.
E) very low maturity.
Answer: D
Diff: 1
3) A bond has a face value of $10,000, a price of $12,000, and coupon payments of $2000 for
two years. The coupon rate of this bond is
A) 10%.
B) 16.7%.
C) 20%.
D) 30%.
Answer: C
Diff: 1
4) A discount bond is a bond

A) with no coupon payments.
B) where the price of the bond is greater than its face value.
C) where the interest rate is zero.
D) where the face value is zero.
E) that never matures.
Answer: A
Diff: 1
3
5) For this question, assume that one-year and two-year bonds have the same risk; therefore, you
can ignore risk here. Assuming that there is arbitrage between one-year bonds and two-year
bonds, we know that the expected rate of return on two-year bonds
A) will equal the expected rate of return from holding a one-year bond for one year.
B) will equal the expected rate of return from holding a one-year bond for two years.
C) will be larger than the expected rate of return from holding a one-year bond for one year.
D) will be smaller than the expected rate of return from holding a one-year bond for one year.
E) will be exactly half the rate of return on one-year bonds.
Answer: A
Diff: 2
6) A bond has a face value of $1,000, a price of $1,200, and coupon payments of $100 for two
years. The "current yield" of this bond is
A) 8.33%.
B) 10%.
C) 12%.
D) 83%.
Answer: A
Diff: 2
7) An upward-sloping yield curve suggests that financial market participants expect short-term
interest rates will
A) rise in the future.
B) fall in the future.
C) be unstable in the future.
D) not change in the future.
E) be equal to zero in the future.
Answer: A
Diff: 2
8) Suppose financial market participants expect short-term rates in the future to be less than
current short-term interest rates. Given this information, we would expect
A) an upward sloping yield curve.
B) a downward sloping yield curve.
C) an upward shifting yield curve.
D) a downward shifting yield curve.
E) a horizontal yield curve.
Answer: B
Diff: 2
4
9) Which of the following represents the ratio of coupon payments to the face value of a bond?
A) the interest rate
B) the discount rate
C) the coupon rate
D) the risk premium
E) the current yield
Answer: C
Diff: 1
10) Suppose a bond promises to make a single payment at maturity. These types of bond are
called
A) junk bonds.
B) indexed bonds.
C) corporate bonds.
D) discount bonds.
E) constant maturity bonds.
Answer: D
Diff: 1
11) Assume that the one-year interest rate is on the vertical axis of the IS-LM model and that the
yield curve is initially upward sloping. Suppose that financial market participants expect that the
central bank will pursue a monetary contraction in the future. Given this information, we would
expect which of the following to occur?
A) The yield curve will become steeper.
B) The yield curve will become flatter.
C) The yield curve will become horizontal.
D) The yield curve will become downward sloping.
Answer: A
Diff: 2
12) Suppose that financial market participants expect that the central bank will pursue a
monetary expansion in the future. Also assume that the yield curve is initially upward sloping.
Given this information, we would expect which of the following to occur?
B) i2t will increase.
C) i2t will decrease.
Answer: C
Diff: 2
5
13) Suppose that financial market participants now expect a future tax increase in one year. Also
assume that the yield curve is initially upward sloping. Given this information, we would expect
which of the following to occur?
B) i2t will increase
C) i2t will decrease
Answer: C
Diff: 2
14) Suppose that financial market participants now expect a future tax cut and that the yield
curve is initially upward sloping. Given this information, we would expect which of the
following to occur?
B) The yield curve will become flatter.
C) The yield curve will become horizontal.
Answer: A
Diff: 2
15) A bond has a face value of $10,000, a price of $12,000, and coupon payments of $2000 for
two years. The current yield of this bond is
A) 10%.
B) 16.7%.
C) 20%.
D) 30%.
Answer: B
Diff: 1
16) Assume that the current one-year rate is 3% and the two-year rate is 5%. Given this
information, the one-year rate expected one year from now is
A) 5%.
B) 6%.
C) 7%.
D) 9%.
E) 12%.
Answer: C
Diff: 2
6
17) Suppose the current one-year interest rate is 3%, and financial markets expect the one-year
interest rate next year to be 5%. Given this information, the yield to maturity on a two-year bond
will be approximately
A) 4%.
B) 6%.
C) 8%.
D) 12%.
Answer: A
Diff: 2
18) Which of the following represents the ratio of coupon payments to the price of a bond?
A) the interest rate
B) the discount rate
C) the coupon rate
D) the risk premium
E) the current yield
Answer: E
Diff: 1
19) The yield curve is

A) the term structure of interest rates.
B) the relation between maturity and yield of a bond.
C) maturity.
D) both A and B
E) all of the above
Answer: D
Diff: 1
20) Explain what the term structure of interest rates represents.

Answer: The term structure of interest rates illustrates the relationship between the yield to
maturity on bonds (with the same risk characteristics) and maturity.
Diff: 1
21) When interpreting bond prices as present values, discuss what factors determine the price of
a two-year discount bond. Include in your answer an explanation of how changes in each of these
factors affects the price of a two-year discount bond.
Answer: The price of the two-year bond will be a function of the face value, the current one-
year rate and the future expected one-year rate. An increase in either of the one-year rates will
reduce the present value of the bond and, therefore, reduce its price. An increase in the face value
(constant) would increase the price.
Diff: 2
7
22) The yield curve indicates that the two-year interest rate will be a function of what variables?
Include in your answer an explanation of how changes in these variables will affect the two-year
interest rate.
Answer: The two-year rate will be a function of the current one-year rate and the future
expected one-year rate. In fact, it will be approximately equal to the average of these two rates.
So, an increase in either rate will cause the two-year rate to rise.
Diff: 2
23) Suppose the yield curve is downward sloping. How should one interpret this particular yield
curve?
Answer: Downward sloping yield curve implies that the future expected one-year rate is lower
than the current one-year rate.
Diff: 2
24) Suppose the central bank implements a monetary expansion in the current period and is not
expected to continue this policy in the future. Explain what effect this policy will have on the
shape of the yield curve and on stock prices.
Answer: The current one-year rate will fall with no change in the expected future rate. The two-
year rate, given that it is an average of the two one-year rates, will fall. The change in the two-
year rate will approximately equal half the change in the one-year rate. The yield curve will shift
down and get steeper. What happens to stock prices depends on whether this was fully or
partially expected? If fully anticipated, stock prices do not change. If at least partially
unexpected, stock prices will rise because of the interest rate effect and the higher output
(changes in which were unexpected).
Diff: 2
25) Suppose the yield curve is upward sloping. How should one interpret this particular yield
curve?
Answer: Upward sloping yield curve implies that the future expected one-year rate is higher
than the current one-year rate.
Diff: 2
8
14.3 The Stock Market and Movements in Stock Prices
1) Equity finance is represented by which of the following?

A) when a firm borrows money from banks
B) when a firm sells bonds
C) when a firm sells shares of stock
D) when a firm draws down retained earnings
E) when a firm sells off part of its capital stock
Answer: C
Diff: 1
2) Among the following, which is the broadest measure of stock prices in the United States?
A) Dow Jones Index
B) FT index
C) Nikkei Index
D) Term Structure Index
E) Standard and Poor's 500 Composite Index
Answer: E
Diff: 1
3) The fundamental value of a share of stock is equal to which of the following?

A) the sum of expected dividends
B) the present value of expected dividends
C) the sum of coupon payments
D) the present value of coupon payments
E) the present value of the expected yield
Answer: B
Diff: 1
4) A share of stock will pay a dividend of $25 in one year, and will be sold for an expected price
of $500 at that time. If the current one-year interest rate is 5%, the current price of the stock will
be approximately equal to
A) $100.
B) $475.
C) $500.
D) $525.
Answer: C
Diff: 2
9
5) For this question, assume that there is perfect arbitrage in the stock market. Given this
assumption, economists believe that
A) movements in stock prices can be easily predicted.
B) movements in stock prices are largely unpredictable.
C) most stocks will diverge from their fundamental value.
D) stocks will generally earn a lower rate of return than bonds.
E) the rate of return on stocks will be equal to the rate of return on bonds.
Answer: B
Diff: 2
6) Suppose the central bank implements a monetary contraction that is fully expected by
financial market participants. Given this information, we would expect
A) stock prices to rise.
B) stock prices to fall.
C) stock prices to remain unchanged.
D) an ambiguous effect on stock prices.
E) stock prices to fall and the interest rate to rise.
Answer: C
Diff: 2
7) Suppose the central bank implements a monetary expansion that is not fully anticipated by
financial markets. Given this information, we would expect
A) stock prices to rise.
B) stock prices to fall.
C) stock prices to remain unchanged.
Answer: A
Diff: 2
8) Suppose policy makers implement a fiscal expansion that is not fully anticipated by financial
market participants. We know that this will
A) always cause stock prices to fall.
B) always cause stock prices to rise.
C) tend to cause stock prices to rise if the LM curve is very flat.
D) tend to cause stock prices to rise if the LM curve is vertical.
Answer: C
Diff: 2
10
9) Suppose policy makers implement an unexpected fiscal expansion. Further assume that
monetary policy is expected to keep interest rates constant in response to this unexpected fiscal
expansion. Given this information, we would expect that
A) stock prices will rise.
B) stock prices will remain constant.
C) this policy will have an ambiguous effect on stock prices.
D) the effect on stock prices will depend on the slope of the IS curve.
Answer: A
Diff: 2
10) Which of the following represents a stock's fundamental value?

A) the price the stock would sell at in the midst of a rational bubble
B) the price the stock would sell at if the interest rate were zero
C) the present value of its expected future dividend payments
D) the simple sum of its future dividend payments
Answer: C
Diff: 1
11) Which of the following does not represent a form of debt finance?
A) bonds
B) loans
C) stock
D) all of the above
Answer: C
Diff: 1
12) Which of the following represents a form of equity finance?

A) stock
B) loans
C) bonds
D) all of the above
Answer: A
Diff: 1
13) Which of the following variables would not influence the ex-dividend price of a share of
stock at time t?
A) i1et+1
B) i1t
C) $Det+1
D) none of the above
Answer: D
Diff: 1
11
14) An expected reduction in the money supply will tend to cause
A) an increase in stock prices.
B) a reduction in stock prices.
C) no change in stock prices.
Answer: C
Diff: 2
15) An expected increase in the money supply will tend to cause

Answer: C
Diff: 2
16) An expected tax cut will tend to cause

Answer: C
Diff: 2
17) An expected tax increase will tend to cause

Answer: C
Diff: 2
18) An unexpected reduction in the money supply will tend to cause

Answer: B
Diff: 2
19) An unexpected increase in the money supply will tend to cause

Answer: A
Diff: 2
12
20) Suppose households unexpectedly increase consumption. Which of the following will occur
as a result of this unexpected increase in consumption?
A) an increase in stock prices
B) a reduction in stock prices
C) no change in stock prices
D) an ambiguous effect on stock prices
Answer: D
Diff: 2
21) Suppose households unexpectedly decrease consumption. Which of the following will occur
as a result of this unexpected reduction in consumption?
A) an increase in stock prices
B) a reduction in stock prices
C) no change in stock prices
D) an ambiguous effect on stock prices
Answer: D
Diff: 2
22) Suppose there are two types of bonds (one-year bonds and two-year bonds) and that the yield
curve is initially upward sloping in period t. Note: For this question assume that: (1) expected
inflation is zero; and (2) the relevant interest rate on the vertical axis of the IS-LM model is the
one-year interest rate. Based on our understanding of the IS-LM model, of the yield curve and of
financial markets, we know with certainty that an announcement in period t of a partially
unexpected future increase in taxes (to be implemented in period t + 1) will have which of the
following effects?
A) stock prices will increase in period t
B) stock prices will fall in period t
C) the yield curve will become steeper in period t
D) none of the above
Answer: D
Diff: 2
23) For this question, assume that the Fed is expected to respond to any event by keeping the
interest rate constant (i.e., equal to its initial level). An unexpected tax increase will cause
A) stock prices to fall.
B) stock prices to rise.
Answer: A
Diff: 2
13
24) For this question, assume that the Fed is expected to respond to any event by keeping the
interest rate constant (i.e., equal to its initial level). An unexpected tax cut will cause
Answer: B
Diff: 2
25) For this question, assume that the Fed is expected to respond to any event by keeping output
constant (i.e., equal to its initial level). An unexpected increase in taxes will cause
Answer: B
Diff: 2
26) For this question, assume that the Fed is expected to respond to any event by keeping output
constant (i.e., equal to its initial level). An unexpected increase in government spending will
cause
Answer: A
Diff: 2
27) As the LM curve becomes steeper, an unexpected increase in consumer confidence

A) will cause a relatively large increase in output and relatively large increase in the interest rate.
B) will cause a relatively small increase in output and relatively small increase in the interest
rate.
C) is more likely to cause stock prices to rise.
D) is more likely to cause stock prices to fall.
Answer: D
Diff: 2
28) As the LM curve becomes steeper, an unexpected decrease in consumer confidence

A) will cause a relatively large increase in output and relatively large increase in the interest rate.
B) will cause a relatively small increase in output and relatively small increase in the interest
rate.
C) is more likely to cause stock prices to rise.
D) is more likely to cause stock prices to fall.
Answer: C
Diff: 2
14
29) A share of stock will pay a dividend of $20 in one year, and will be sold for an expected
price of $500 at that time. If the current one-year interest rate is 5%, the current price of the stock
will be approximately equal to
A) $100.
B) $495.
C) $500.
D) $525.
Answer: B
Diff: 2
30) Suppose individuals expect an increase in future taxes. Explain what effect this expected
increase in future taxes will have on the yield curve and on stock prices in the current period.
Answer: The increase in future taxes will cause the future one-year rate to fall. This reduction in
the expected one-year rate will cause the two-year rate to fall by approximately half the change
in the future expected rate. The current one-year rate does not change. So, the yield curve pivots;
it gets flatter (as the long-term rate falls). The effects on stock prices again depend on whether it
is anticipated or not. If anticipated, stock prices do not change. If partially unexpected, the effect
on stock prices is ambiguous: the drop in future i will increase stock prices while the drop in
future Y will depress stock prices.
Diff: 2
31) Explain what is meant by the fundamental value of a share of stock.

Answer: The fundamental value of a share of stock is simply the discounted present value of any
current and future expected dividends.
Diff: 2
32) Give two explanations why stock prices might deviate from their fundamental values.
Answer: Answers should discuss speculative bubbles and fads.
Diff: 2
33) Suppose the Fed implements a monetary expansion that is at least partially unexpected.
Explain what effect this will have on stock prices.
Answer: This will cause the interest rate to fall and output to rise. The lower interest rate will
increase the present value of future dividends. The increase in output will cause an increase in
expected dividends because profits are now expected to be higher. Both of these effects cause
stock prices to rise.
Diff: 2
34) Suppose a cut in government spending occurs that is at least partially unexpected. Explain
what effect this will have on stock prices.
Answer: Output falls and interest rates fall. Here, the effects are ambiguous. The drop in the
interest rate will raise stock prices while the drop in Y will lower them.
Diff: 2
15
35) Suppose there is a report that the unemployment rate unexpectedly increased in the previous
month. To what extent will the expected central bank response to this news affect how stock
prices will respond to this report of a higher than expected unemployment rate? Explain.
Answer: The effect on stock prices will be ambiguous, all else fixed. What the Fed is expected
to do in response can change this. If the Fed is expected to act to keep interest rates constant, Y
will fall and stock prices will fall. If the Fed is expected to offset any output effects by reducing
rates, stock prices will rise.
Diff: 2
36) Suppose the central bank implements a monetary contraction in the current period and is not
expected to continue this policy in the future. Explain what effect this policy will have on the
shape of the yield curve and on stock prices.
Answer: The current one-year rate will rise with no change in the expected future rate. The two-
year rate, given that it is an average of the two one-year rates, will rise. The change in the two-
year rate will approximately equal half the change in the one-year rate. The yield curve will shift
up and get flatter. What happens to stock prices depends on whether this was fully or partially
expected? If fully anticipated, stock prices do not change. If at least partially unexpected, stock
prices will fall because of the interest rate effect and the higher output (changes in which were
unexpected).
Diff: 2
37) Suppose individuals expect a cut in future taxes. Explain what effect this expected reduction
in future taxes will have on the yield curve and on stock prices in the current period.
Answer: The reduction in future taxes will cause the future one-year rate to rise. This increase in
the expected one-year rate will cause the two-year rate to rise by approximately half the change
in the future expected rate. The current one-year rate does not change. So, the yield curve gets
steeper (as the long-term rate rises). The effects on stock prices again depend on whether it is
anticipated or not. If anticipated, stock prices do not change. If partially unexpected, the effect on
stock prices is ambiguous: the rise in future i will decrease stock prices while the increase in
future Y will increase stock prices.
Diff: 2
38) Suppose an increase in government spending occurs that is at least partially unexpected.
Explain what effect this will have on stock prices.
Answer: Output rises and interest rates rise. Here, the effects are ambiguous. The rise in the
interest rate will reduce stock prices while the increase in Y will increase them.
Diff: 2
16
14.4 Risk, Bubbles, Fads, and Asset Prices
1) Which of the following bonds (of equal maturity) would have the lowest risk premium?
A) U.S. government bonds
B) German government bonds
C) the bonds of a financially stable corporation, like IBM
D) Bonds rated Aaa by Moody's
E) junk bonds
Answer: A
Diff: 1
2) Some economists argue that there were good reasons for housing price to rise. Explain their
argument.
Answer: First, the real interest rate was decreasing, increasing the present value of rents.
Second, the nominal interest rate was also decreasing, and this mattered because nominal interest
payments are tax deductible. Third, the mortgage market was changing: More people was able to
borrow and buy a house; people who borrowed were able to borrow a larger proportion of the
value of the house. Both of these factors led to an increase in demand, and thus an increase in
house prices.
Diff: 2
17

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Chapter 14

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Macroeconomics, 7e (Blanchard)

Chapter 14: Financial Markets and Expectations

14.1 Expected Present Discounted Values

6) Which of the following statements about indexed bonds is correct?

2) A "junk bond" is a bond with a

4) A discount bond is a bond

19) The yield curve is

20) Explain what the term structure of interest rates represents.

1) Equity finance is represented by which of the following?

3) The fundamental value of a share of stock is equal to which of the following?

10) Which of the following represents a stock's fundamental value?

12) Which of the following represents a form of equity finance?

15) An expected increase in the money supply will tend to cause

16) An expected tax cut will tend to cause

17) An expected tax increase will tend to cause

18) An unexpected reduction in the money supply will tend to cause

19) An unexpected increase in the money supply will tend to cause

27) As the LM curve becomes steeper, an unexpected increase in consumer confidence

28) As the LM curve becomes steeper, an unexpected decrease in consumer confidence

31) Explain what is meant by the fundamental value of a share of stock.

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