CHAPTER 4

TRUE-FALSE QUESTIONS

(T) 1. The real rate of interest can be viewed as the time value of not consuming.

(F) 2. The current rate of inflation affects the expected level of interest rates via the
Fisher Effect.

(T) 3. The market rate of interest can be viewed as approximately equal to the real rate
of interest plus a premium for the expected rate of inflation.

(F) 4. Declining interest rates can be caused by an upward shift in the demand for
loanable funds relative to the supply of loanable funds.

(F) 5. The expected real rate of interest is almost always negative.

(T) 6. The realized real rate of interest can be negative if expected inflation is less than
actual inflation.

(F) 7. An increase in desired investment shifts the desired savings supply line upward
to higher real rates of interest.

(T) 8. Nominal interest rates reflect anticipated inflation.

(F) 9. Expected increases in inflation usually drive up bond prices.

(F) 10. Interest rates are directly related to inflation expectations and inversely related to
the level of economic activity.

(F) 11. An upward shift in the supply of loanable funds is likely to increase interest
rates.

(T) 12. An increase in rates of return on real capital investment will increase real interest
rates.

(F) 13. An increase in the desired saving rate will increase real interest rates.

(F) 14. Deficit spending units supply loanable funds.

(F) 15. If yields on thirty-year U. S. Treasury bonds are 8% and the real rate of interest
is estimated at 3%, the historical rate of inflation is 5%.

(T) 16. The Fisher Effect holds that nominal interest rates include a premium for
expected inflation.

(T) 17. Economic models and flow-of-funds are two ways of forecasting interest rates.

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(F) 18. Economic models forecast interest rates then estimate measures of economic
output.

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(T) 19. The flow of funds forecasting method utilizes the concept of supply and demand
of loanable funds.
(F) 20. If a country’s currency is expected to depreciate, its interest rates may decrease.
(T) 21. Nominal rates generally exceed the real rate.

(T) 22. If a security's realized return is negative, the expected return was smaller than the
required return.

(F) 23. TIPS yields pay investors a higher coupon rate when inflation increases.

(T) 24. The European Central Bank has charged a negative nominal interest rates on
deposits.

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 MULTIPLE-CHOICE QUESTIONS

(d) 1. Interest is
a. the price of money.
b. the rent on money.
c. the time value of delayed consumption.
d. all of the above.

(c) 2. Which of the following does not add to the demand for funds?
a. consumer credit purchases
b. Federal government budget deficits
c. state budget surpluses
d. business investment

(e) 3. Which of the following factors influence the real rate of interest?
a. investor's positive time preference
b. the gold supply
c. return on capital investments
d. the rate of inflation
e. both a and c

(a) 4. All but one of the following factors influences the real rate of interest?
a. the rate of inflation
b. investor positive time preference for current versus future consumption.
c. the return on alternative real investments.
d. the real level of output in the economy.

(b) 5. ________ real rates are usually positive; _______real rates may be negative.
a. Realized; expected
b. Expected; realized
c. Government; private
d. Expected; expected

(c) 6. Which statement is true about interest rate movements?

a. Interest rates move counter-cyclically with the business cycle.
b. Long-term interest rates have greater swings than short-term rates.
c. The expected rate of inflation impacts the level of interest rates.
d. Bond prices and interest rates move directly with one another.

(c) 7. Which one of the following statements about interest rates is incorrect?
a. Bond prices and interest rates change inversely with one another.
b. The expected rate of inflation affects current market interest rates.
c. Short-term interest rates are not as volatile as long-term interest rates.
d. Interest rates are directly related to the level of output in the economy.

(b) 8. The Fisher effect is a theory which holds that

a. nominal rates include the real rate of interest plus past annual inflation rates.
b. nominal rates include the real rate of interest plus expected annual inflation rates.
c. real rates are always positive.
d. inflation has no impact upon interest rates.

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(b) 9. If nominal interest rates are 10% and expected inflation is 5%, according to the
approximate Fisher equation,
a. actual inflation exceeds 10%.
b. the real rate of interest is 5%.
c. market rates are expected to increase to 15%.
d. expected interest rates are 5%.

(d) 10. If the real rate of interest is 4%, actual inflation for the last year was 5%, and
expected inflation is 8%, the Fisher effect predicts what approximate current level of
nominal interest rates?
a. 9%
b. 8%
c. 13%
d. 12%

(a) 11. If current market rates on Treasury bonds are 6 percent and the real growth of the
economy has and will be expected to grow at 3 percent. According to the approximate
Fisher effect, what is the expected rate of inflation?
a. 3%
b. 9%
c. higher than 6%
d. -3%

(c) 12. The demand for loanable funds may shift upward (increase) from
a. a decline in the supply of loanable funds.
b. a decline in business prospects.
c. an improvement in technology.
d. an expectation of an upcoming recession.

(a) 13. Interest rates will decline when the demand for loanable funds
a. shifts to the left.
b. shifts to the right.
c. stays the same.
d. "a" and "c" above.

(b) 14. All but one of the following affects the supply of loanable funds?
a. the level of income
b. the investment opportunities in the economy.
c. the savings rate
d. Federal Reserve monetary policy actions.

(d) 15. An increase in the rate of expected inflation will

a. shift only the demand for loanable funds to the left (down).
b. shift only the supply of loanable funds to the left (down).
c. shift demand and supply for loanable funds decreasing interest rates.
d. shift demand and supply for loanable funds and increasing interest rates.

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(c) 16. Deficit spending units (DSU) are represented in loanable funds theory as
a. suppliers of loanable funds.
b. demanders of financial claims.
c. demanders of loanable funds.
d. DSUs are not represented in the loanable funds theory of interest rate
determination.

(b) 17. An economic recession would likely result in

a. a shift in the demand for loanable funds to the right associated with reduced
business investment demand and a decline in interest rates.
b. a shift in the demand for loanable funds to the left as real investment weakens, a
shift to the right of the supply of loanable funds as the Fed expands the money
supply, and a decrease in interest rates.
c. a movement along the demand for loanable funds as interest rates increase.
d. an increase in the supply of loanable funds as the level of savings increases with
income accompanied with an increase in the demand for loanable funds as
housing investment is increased, and a decrease in interest rates.

(c) 18. Increased government budget deficits

a. shifts the demand for loanable funds to the left, reducing interest rates.
b. shifts the supply of loanable funds to the right, reducing interest rates.
c. shifts the demand for loanable funs to the right, increasing interest rates.
d. shifts the supply of loanable funds to the left, reducing interest rates.

(a) 19. The realized rate of return may be negative if

a. investors' expected rate of inflation (P e) was less than actual inflation (P a).
b. investors' expected rate of inflation (P e) was greater than actual inflation (P a).
c. investors over-anticipated the level of inflation.
d. investors expected more inflation than was realized.

(d) 20. An increase (shift to right) in the supply of loanable funds (SL) may be related to
all but which one of the following:
a. an increase in the money supply.
b. an increase in household thriftiness.
c. an increase in household income.
d. an increase in personal income taxes.

(a) 21. If the competitive real rate of interest is 4% and the expected inflation rate is 7%,
a loan at 14%
a. the lender received more than a 4% real return.
b. the borrower paid less than a 4% real return.
c. the borrower exploited the lender.
d. none of the above

(b) 22. If the actual rate of inflation is less than the rate expected during a period,
a. borrowers benefited at the expense of lenders.
b. lenders benefited at the expense of borrowers.
c. both borrowers and lenders benefited as expected.
d. neither borrowers nor lenders benefited as expected.

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(c) 23. If expected inflation in a period exceeds actual inflation
a. borrowers will benefit.
b. savers will lose purchasing power.
c. SSUs will benefit at the expense of DSUs.
d. interest rates are likely to decrease in the future.

(b) 24. Interest rates should decease if

a. The economy is in a boom.
b. Inflationary expectations have decreased.
c. The Federal Reserve has decreased M1 and the supply of loanable funds.
d. Business investment demand has decreased significantly.

(d) 25. Which of the following may explain a decrease in interest rates?
a. a recession and a decline in inflationary expectations.
b. an acceleration in the growth rate of M1.
c. decreased real investment opportunities.
d. all of the above

(c) 26. An investor received an 8 percent coupon rate last year on a $1000 bond
purchased at par. The inflation rate during the year was 4 percent and is expected to be 5
percent next year. The realized real rate earned by the investor last year was
approximately:
a. 8%
b. 3%
c. 4%
d. -1 percent.

(a) 27. An investor earned 12 percent last year, a year when actual inflation was 9
percent and was expected to have been 6 percent. The investor’s realized real rate of
return was approximately:
a. 3%
b. 6%
c. 18%
d. 12%

(d) 28. Which of the following is more likely to affect long-term bond yields?
a. announcement of the last year's inflation rate
b. announcement of this month's inflation rate
c. a forecast of next month's inflation rate
d. a forecast of inflation for the next five years

(c) 29. Which of the following is more likely to adversely affect long-term bond prices?
a. a forecast of lower inflation in the future.
b. a forecast of a slower economy next year.
c. a forecast of higher inflation over the next ten years.
d. a forecast of lower government budget deficits.

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(a) 30. Negative realized real rates of interest are associated with periods where
a. inflation forecasts significantly underestimate actual inflation.
b. nominal interest rates were too high relative to actual inflation.
c. prior inflation forecasts overestimated inflation.
d. bond prices were priced too low relative to actual inflation.
(c) 31. Basic approaches to forecasting interest rates include
a. economic models
b. flow-of-funds
c. both of the above
d. none of the above
(c) 32. Economic models predict interest rates by estimating the statistical relationships
between the and the resulting .
a. level of inflation rates; measures of economic output
b. past level of interest rates; future level of interest rates
c. measures of economic output; level of interest rates
d. prior level of GNP; future level of interest rates

(d) 33. The Federal Reserve Bank of St. Louis develops quarterly forecasts of a number
of key economic statistics using only eight equations. This is an example of
a. a naive forecasting model.
b. the flow of funds approach.
c. a hedged forecast.
d. an economic forecasting model.

(a) 34. The flow of funds approach to interest rate forecasting is associated with all but
one of the following:
a. the National Income Accounts.
b. the Flow of Funds Accounts.
c. the loanable funds theory of interest
rate determination.
d. the Federal Reserve System.

(d) 35. Suppose the pound is currently worth $1.2234. If 6 month U.S. investments are
paying a 4% APR and 6 month British pound investments are paying a 5% APR what
should the pound be worth in 6 months?
a. $1.2352
b. $1.2294
c. $1.2117
d. $1.2174

(b) 36. Which of the following is correct about interest rate movements and inflation?
a. Interest rates move inversely with inflation.
b. Interest rates vary directly with expected inflation.
c. Interest rates vary directly with past inflation rates.
d. Inflation is impacted by expected interest rates.

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(c) 37. A decrease in the money stock by the Federal Reserve
a. shifts the demand of loanable funds to the left, decreasing interest rates.
b. shifts the demand for loanable funds to the left, increasing interest rates.
c. shifts the supply of loanable funds to the left, increasing interest rates.
d. shifts the supply of loanable funds to the right, increasing interest rates.

(c) 38. On any given day if the market interest rate is above the equilibrium interest rate
level,
a. the Fed will change reserve requirements.
b. there will be a shortage of loanable funds and interest rates will increase.
c. there will be a surplus of loanable funds at that rate and rates will decline to the
equilibrium rate.
d. there will be a shortage of loanable funds at that rate and rates will increase to
the equilibrium rate.

(d) 39. The lower a consumer's positive time preference for consumption,
a. the more savings they will accumulate.
b. the lower the level of interest rates.
c. the greater the supply of loanable funds.
d. all of the above.

(b) 40. A person with a very high positive time preference for consumption
a. will have a high savings rate.
b. will have a low savings rate.
c. prefers savings to consumption.
d. is not as likely to borrow money as other people with lower positive time
preference.

(c) 41. All else equal, a change from an income tax to a value added tax on consumption
a. should decrease the supply of loanable funds.
b. would decrease the demand for loanable funds.
c. should increase the supply of loanable funds.
d. should shift consumers' preferences toward consumption.

(d) 42. An increase in income tax rates

a. will decrease the savings rate.
b. will decrease the supply of loanable funds.
c. will increase interest rates.
d. all of the above.

(b) 43. Suppose the euro is currently worth $1.0654 and the three month forward rate for
the euro is $1.1102. If 3 month U.S. investments are paying a 4.25% APR what APR
should 3 month euro investments be paying?
a. 1.8021%
b. 2.4369%
c. 3.7824%
d. 4.7169%

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(c) 44. Suppose the dollar is currently worth 104.65 yen. If 1 year U.S. investments are
paying a 3.25% APR and 1 year yen investments are paying a 1.25% APR what should
the dollar be worth against the yen in one year?
a. 105.45 yen
b. 106.72 yen
c. 102.62 yen
d. 103.32 yen

(c) 45. An investor desires an exact 3% real return. If inflation is expected to be 4.5%,
what exact nominal return must the investor require?
a. 7.125%
b. 7.525%
c. 7.635%
d. 7.775%

(c) 46. An investor charged a 6.75% nominal interest rate when inflation was 2.75%.
What was the investor’s exact real return?
a. 4.00%
b. 3.76%
c. 3.89%
d. 3.88%

(a) 47. Which of the following would provide the best inflation protection to investors?
a. TIPS
b. long term fixed rate corporate bonds
c. long term fixed rate Treasury bonds
d. all of the above would provide equal protection

(c) 48. Which of the following actions will reduce the interest rate risk of the lender?
a. Make fixed interest rate loans.
b. Make fixed interest rate, long-term loans.
c. Make variable interest rate loans.
d. Invest in fixed rate Treasury bonds.

(d) 49. An investor loaned money at 14 percent with an expected rate of inflation of 11
percent. During the year the actual rate of inflation was 8 percent. The investor's
expected real rate of interest was approximately _____ and the realized real rate for the
investor was approximately______?
a. 14 percent; 8 percent.
b. 6 percent; 3 percent.
c. 3 percent; 3 percent.
d. 3 percent; 6 percent.

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(b) 50. An investor purchased a $1000 face value bond for $925. The bond has an 8
percent coupon rate, paid annually, and matures in five years. The investor sold the bond
one year later for $965, while the price level was increasing at 5 percent. Calculate the
approximate pre-tax real realized rate of return on the investment?
a. -.7%
b. 8%
c. 3%
d. 5%

(d ) 51. Which of the following is NOT an economic factor that cause a shift in the
desired lending curve changes the equilibrium rate of interest?
a. Federal Reserve increases in the money supply
b. Business savings
c. Government budget surpluses
d. Consumer credit purchases

(c ) 52. You go to Finance Yahoo! Website and find that yields on all corporate and Treasury
securities have increased. The yield increases may be explained by which one
of the following:
a. A decrease in current and expected future returns of real corporate
investments
b. Newly expected increase in the value of the dollar
c. An increase in U.S. inflationary expectations
d. Decreases in the U.S. Government budget deficit

(a ) 53. On August 7, 2011, Standard and Poors (S&P) announced a downgrade of the
rating of the U.S. long-term government debt from AAA to AA+. If other things are
equal, what is the impact on the yields on the Treasury securities?
a. Yields increase
b. Yields decrease
c. Yields are unchanged
d. One can’t tell the impact on yields from the information given

(b ) 54. If everything is equal, the most likely impact of a decrease in income tax rates on
the economy would be to
a. Decrease the supply of loanable funds
b. Increase the savings rate
c. Increase interest rates
d. Federal Reserve decreases in the money supply

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 ESSAY QUESTIONS

1. Using loanable funds theory, discuss how changes in consumer savings, business investment, and
in the money supply by the Federal Reserve System can influence the level of interest rates.

Answer:
Loanable funds theory holds that the level of interest rates is determined by the intersection of
demand and supply for loanable funds. Increased consumer saving shifts supply to the right,
decreasing interest rates. Increased business investment demand is represented by an upward
shift in demand for loanable funds and an increase in the level of interest rates. An increase in
the money supply shifts the supply curve to the right and lowers interest rates.

2. Explain how price expectations influence the level of interest rates. What impact has inflation
premiums had on interest rate levels in recent years?

Answer:
The Fisher Effect states that investors embody expected inflation in nominal interest rates. The
relatively low inflation rates of recent years has dampened expected inflation and lowered
nominal interest rates.

3. Explain why realized real rates of interest are sometimes negative, but expected real rates on
loans are usually positive. Give an example.

Answer:
Expected real rates of interest, an opportunity cost of real investment returns, will be positive in a
growing economy, but realized real rates of interest may be negative if lenders under-anticipate
inflation and charge nominal interest rates below the realized rate of inflation. Expected real
rates can be negative due to government intervention in the markets and due to the convenience
factor of having your money stored safely and be easily accessible via ATMs and point of sale
transactions. For this reason investors may pay a small negative rate of interest as a form of
convenience and safekeeping fee.

4. Calculate the price of a $1000 face value bond, maturing in three years with a 9 percent coupon
(paid semiannually) if current real rates of interest are 4 percent, historical inflation rates are 3
percent, and expected inflation rates are 4 percent. (Use if next chapter covered in exam)

Answer:
If the Fisher Effect applies the market interest rate on this bond is the sum of the real rate plus the
expected inflation rate or 8%. Discounting the $90/2 = $45 coupon payment over 3 x 2 = 6
periods at 8%/2 = 4% and a future maturity value of $1000, the present value price of the bond is
$1026.21.

5. Sam has just lent Mary $1000 for 1 year at 6%. Sam and Mary expect inflation to be 3% over
the next year. If inflation turns out to have been only 2%, what is the impact upon Sam and
Mary?

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45
 Answer:
Sam benefits at Mary’s expense. She paid 6% on a loan that should only have yielded 5% if
inflation had been correctly forecast.

6. You are the Chief Economist of Free Formosan Investment and are conducting research on
inflation forecasting by using the information of the Treasury Inflation-Protected Securities
(TIPS). The information that you have are as the following: Nominal yield on 10-year
nonindexed Treasury bond is 4.5%; Real yield on 10-year TIPS is 2.25%; the market adjustment
for inflation and liquidity risk is 45 basis-points. What is the expected annual inflation rate over
the next decade?

Answer: 4.5% - 2.25% - 0.45% = 1.80%

7. In January 2011, a Japanese investor placing money in dollar denominated assets desires a 5%
real rate of return. Then international expected inflation rate is about 2.5% and the dollar is
expected to decline against Japanese Yen by 10% over the investment period. What is the
approximate minimum required rate of return for this Japanese investor?

Answer:
This Japanese investor has to earn an additional 2.5% to cover the rising cost of goods and
services and an additional 10% to cover the loss in value of his dollars since the dollars he will
get back will buy fewer units of his home currency. All this is needed in order to preserve a 5%
increase in real purchasing power in his home country. Therefore it is approximately 5% + 2.5%
+ 10% = 17.5%.

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