Financial Markets And Institutions, Abridged, 11th Edition Solution Manual

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Chapter 1Role of Financial Markets and InstitutionsOutlineRoleof Financial MarketsAccommodating Investment NeedsAccommodating Corporate Finance NeedsPrimary Versus Secondary MarketsSecurities Traded in Financial MarketsMoney Market SecuritiesCapital Market SecuritiesDerivative SecuritiesValuation of SecuritiesSecurities RegulationsInternational Securities TransactionsGovernment Intervention in Financial MarketsRole of Financial InstitutionsRole of Depository InstitutionsRole of Nondepository Financial InstitutionsComparison of Rolesamong Financial InstitutionsRelative Importance of Financial InstitutionsConsolidation of Financial InstitutionsCredit Crisis for Financial InstitutionsSystemic Risk Duringthe Credit CrisisGovernment Response to the Credit Crisis

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Key Concepts1.Explain the role of financial intermediaries in transferring funds from surplus units to deficit units.2.Introduce the types of financial markets available and their functions.3.Introduce the various financial institutions that facilitate the flow of funds.4.Provide a preview of the course outline. Emphasize the linkages between the various sections of thecourse.POINT/COUNTER-POINT:WillComputerTechnologyCauseFinancialIntermediaries toBecomeExtinct?POINT: Yes. Financial intermediaries benefit from access to information. As information becomes moreaccessible, individuals will have the information they need before investing or borrowing funds. They willnot need financial intermediaries to make their decisions.COUNTER-POINT: No. Individuals rely not only on information, but also on expertise. Some financialintermediaries specialize in credit analysis so that they can make loans. Surplus units will continue toprovide funds to financial intermediaries rather than make direct loans, because they are not capable ofcredit analysis, even if more information about prospective borrowers is available. Some financialintermediaries no longer have physical buildings for customer service, but they still requireagentswhohave the expertise to assess the creditworthiness of prospective borrowers.WHO IS CORRECT? Use the Internetto learn more about this issueand then formulateyour ownopinion.ANSWER: Computer technology may reduce the need for some types of financial intermediaries such asbrokerage firms, because individuals can make transactions on their own (if they prefer to do so).However, loans will still require financial intermediaries because of the credit assessment that is needed.Questions1.Surplus and Deficit Units.Explain the meaning of surplus units and deficit units. Provide anexample of each. Which types of financial institutions do you deal with? Explain whether you areacting as a surplus unit or a deficit unit in your relationship with each financial institution.ANSWER: Surplus units provide funds to the financial markets while deficit units obtain funds fromthe financial markets. Surplus units include households with savings, while deficit units include firmsor government agencies that borrow funds.This exercise allows students to realize that they constantly interact with financial institutions, andthat they often play the role of a deficit unit (on car loans, tuition loans, etc.).

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2.Types of Markets.Distinguish between primary and secondary markets. Distinguish between moneyand capital markets.ANSWER: Primary markets are used for the issuance of new securities while secondary markets areused for the trading of existing securities.Money markets facilitate the trading of short-term (money market) instruments while capital marketsfacilitate the trading of long-term (capital market) instruments.3.Imperfect Markets.Distinguish between perfect and imperfect security markets. Explain why theexistence of imperfect markets creates a need for financial intermediaries.ANSWER: With perfect financial markets, all information about any securities for sale would befreely available to investors, information about surplus and deficit units would be freely available,and all securities could be unbundled into any size desired. In reality, markets are imperfect, so thatsurplus and deficit units do not have free access to information, and securities cannot be unbundled asdesired.Financial intermediaries are needed to facilitate the exchange of funds between surplus and deficitunits. They have the information to provide this service and can even repackage deposits to providethe amount of fundsthatborrowers desire.4.Efficient Markets.Explain the meaning of efficient markets. Why might we expect markets to beefficient most of the time? In recent years, several securities firms have been guilty of using insideinformation when purchasing securities, thereby achieving returns well above the norm (even whenaccounting for risk). Does this suggest that the security markets are not efficient? Explain.ANSWER: If markets are efficient then prices of securities available in these markets properly reflectall information. We should expect markets to be efficient because if they weren’t, investors wouldcapitalize on the discrepancy between what prices are and what they should be. This action wouldforce market prices to represent the appropriate prices as perceived by the market.Efficiency is often defined with regard to publicly available information. In this case, markets can beefficient, but investors with inside information could possibly outperform the market on a consistentbasis. A stronger version of efficiency would hypothesize that even access to inside information willnot consistently outperform the market.5.Securities Laws.What was the purpose of the Securities Act of 1933? What was the purpose of theSecurities Exchange Act of 1934? Do these laws prevent investors from making poor investmentdecisions? Explain.ANSWER: The Securities Act of 1933 was intended to assure complete disclosure of relevantfinancial information on publicly offered securities, and prevent fraudulent practices when sellingthese securities. The Securities Exchange Act of 1934 extended the disclosure requirements tosecondary market issues. It also declared a variety of deceptive practices illegal, but does not preventpoor investments.6.International Barriers.If barriers to international securities markets are reduced, will a country’sinterest rate be more or less susceptible to foreign lendingandborrowing activities? Explain.

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ANSWER: If international securities market barriers are reduced, a country’s interest rate will likelybecome more susceptible to foreign lending and borrowing activities. Without barriers, funds willflow more freely in between countries. Funds would seek out countries where expected returns arehigh. Then, the amount of foreign funds invested in any country could adjust abruptly and affectinterest rates.7.International Flow of Funds.In what way could the international flow of funds cause a decline ininterest rates?ANSWER: If a large volume of foreign funds was invested in the United States, it could placedownward pressure on U.S. interest rates. Without this supply of foreign funds, U.S. interest rateswould have been higher.8.Securities Firms.What are the functions of securities firms? Many securities firms employ brokersand dealers. Distinguish between the functions of a broker and those of a dealer, and explain howeach is compensated.ANSWER: Securities firms provide a variety of functions (such as underwriting and brokerage) thateitherenhancesa borrower’s ability to borrow funds or an investor’s ability to invest funds.Brokers are commonly compensated with commissions on trades, while dealers are compensated ontheir positions in particular securities. Some dealers also provide brokerage services.9.Standardized Securities.Whydo you thinksecuritiesare commonlystandardized? Explain whysome financial flows of funds cannot occur through the sale of standardized securities. If securitieswere not standardized, how would this affect the volume of financial transactions conducted bybrokers?ANSWER: Securities can be more easily traded when they are standardized because the specifics ofthe security transaction are well known. If securities were not standardized, transactions would beslowed considerably as participants would have to negotiate all the provisions.Some financial flows, such as most commercial loans, must be provided on a personal basis, since thefirms requesting loans have particular needs.If securities were not standardized, the volume of financial transactions conducted by brokers wouldbe reduced, because the documentation would be greater.10.Marketability.Commercial banks use some funds to purchase securities and other funds to makeloans. Why are the securities more marketable than loans in the secondary market?ANSWER: Securities are more standardized than loans and therefore can be more easily sold in thesecondary market. The excessive documentation on commercial loans limits a bank’s ability to sellloans in the secondary market.11.Depository Institutions.Explain the primary use of funds for commercial banks versus savingsinstitutions.

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ANSWER: Savingsinstitutionshave traditionally concentrated in mortgage lending, whilecommercial banks have concentrated in commercial lending. Savingsinstitutionsare now allowed todiversify their asset portfolio to a greater degree and will likely increase their concentration incommercial loans (but not to the same degree as commercial banks).12.Credit Unions.With regard to the profit motive, how are credit unions different from other financialinstitutions?ANSWER: Credit unions are non-profit financial institutions.13.Nondepository Institutions.Compare the main sources and uses of funds for finance companies,insurance companies, and pension funds.ANSWER: Finance companies sell securities to obtain funds, while insurance companies receiveinsurance premiums and pension funds receive employee/employer contributions. Finance companiesuse funds to provide direct loans to consumers and businesses. Insurance companies and pensionfunds purchase securities.14.Mutual Funds.What is the function of a mutual fund? Why are mutual funds popular amonginvestors? How does a money market mutual fund differ from a stock or bond mutual fund?ANSWER: A mutual fund sells shares to investors, pools the funds, and invests the funds in aportfolio of securities. Mutual funds are popular because they can help individuals diversify whileusing professional expertise to make investment decisions.A money market mutual fund invests in money market securities, whereas other mutual fundsnormally invest in stocks or bonds.15.Impact of Privatization on Financial Markets.Explain how the privatization of companies inEurope can lead to the development of new securities markets.ANSWER: The privatization of companies will force these companies to finance with stocks and debtsecurities, instead of relying on the federal government for funds. Consequently, secondary marketsfor stocks and debt securities will be developed over time.Advanced Questions16.Comparing Financial Institutions.Classify the types of financial institutions mentioned in thischapter as either depository or nondepository. Explain the general difference between depository andnondepository institution sources of funds. It is often stated that all types of financial institutions havebegun to offer services that were previously offered only by certain types. Consequently, manyfinancial institutions are becoming more similar.Nevertheless,performance levels still differsignificantly among types of financial institutions. Why?ANSWER: Depository institutions include commercial banks, savings and loan associations, andcredit unions. These institutions differ from nondepository institutions in that they accept deposits.Nondepository institutions include finance companies, insurance companies, pension funds, mutualfunds, and money market funds.

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Even though financial institutions are becoming more similar, they often differ distinctly from eachother in terms of sources and uses of funds. Therefore, their performance levels differ as well.17.Financial Intermediation.Look in a recent business periodical for news about a recent financialtransaction that involves two financial institutions. For this transaction, determine the following:a.How will each institution’s balance sheet be affected?b.Will either institution receive immediate income from the transaction?c.Who is the ultimate user of funds?d.Who is the ultimate source of funds?ANSWER: This exercise will force students to understand how the balance sheet and incomestatement of a financial institution are affected by various transactions. When a financial institutionsimply acts as an intermediary, income (fees or commissions) is earned, but the institution’s assetportfolio is not significantly affected.18.Role of Accounting in Financial Markets.Integrate the roles of accounting, regulations, andfinancial market participation. That is, explain how financial market participants rely on accounting,and why regulatory oversight of the accounting process is necessary.ANSWER: Financial market participants rely on financial information that is provided by firms. Thefinancial statements of firms must be audited to ensure that they accurately represent the financialcondition of the firm. However, the accounting standards are loose, so financial market participantscan benefit from strong accounting skills that may allow them to more properly interpret financialstatements.19. Impact of Credit Crisis on Liquidity.Explain why the credit crisis caused a lack of liquidity inthesecondary markets for many types of debt securities. Explain how such a lack of liquidity wouldaffect the prices of the debt securities in the secondary markets.ANSWER:Investors were less willing to invest in many debt securities because they were concernedthat these securities might default. As the investors reduced their investments, the secondary marketsfor these debt securities became illiquid. If there are many sellers of debt securities in the secondarymarket, and not many buyers, the prices of these securities should decline.20. Impact of Credit Crisis on Institutions.Explain why mortgage defaults during the credit crisisadversely affected financial institutions that did not originate the mortgages. What role did theseinstitutions play in financing the mortgages?ANSWER:Some financial institutions participated by issuing mortgage-backed securities thatrepresented mortgages originated by mortgage companies. Mortgage-backed securities performedpoorly during the credit crisis in 2008 because of the high default rate on mortgages. Some financialinstitutions that held a large amount of mortgage-backed securities suffered major losses at this time.21. Regulation of Financial Institutions.Financial institutions are subject to regulationsto ensurethatthey do not take excessive risk and they can safely facilitate the flow of funds through financialmarkets. Nevertheless, during the credit crisis, individuals were concerned about using financialinstitutions to facilitate their financial transactions. Why do you think the existing regulations wereineffective at ensuring a safe financial system?ANSWER:During the credit crisis in 2008, the failure of some financial institutions caused concernsthat others might fail, and disrupted the flow of funds in financial markets. The primary cause was

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that financial institutions experienced massive mortgage defaults. They should have recognized thatsubprime mortgages (unqualified borrowers, low down payment) may default. In addition, regulatorsshould have recognized that subprime mortgages may default and could have imposed regulations tolimit an institution’s exposure to subprime mortgages.22. Impact of the Greece Debt Crisis.European debt markets have become integrated over time,so thatinstitutional investors (such as commercial banks) commonly purchase debt issued in other Europeancountries. When the government of Greece experienced problems in meeting its debt obligations in2010, some investors became concerned that the crisis would spread to other European countries.Explain why integrated European financial markets might allow a debt crisis in one European countryto spread to other countries in Europe.ANSWER: Integration results in more international trade and capital flows, including loans extendedfrom European banks to Greece. The crisis in Greece may prevent the Greek government frommaking its loan payments to banks in other countries. Thus, these banks may suffer major losses,which could cause financial problems or even failure, and this can affect economic conditions in othercountries.23. Global Financial Market Regulations.Assume that countries A and B are of similar size,that theyhavesimilar economies, andthatthe government debt levels of both countries are within reasonablelimits. Assumethatthe regulations in country A require complete disclosure of financial reporting byissuers of debt in that country,but thatregulations in country B do not require much disclosure offinancial reporting. Explain why the government of country A is able to issue debt at a lower costthan the government of country B.ANSWER: Investors are more willing to invest in debt securities issued by the government of countryA because there is more transparent information that would suggest country A cancover its paymentsowed on its debt.If the government of Country B does not disclose its financial information, investorscannot assess the financial condition and ability of the government to cover its payments owed on itsdebt. Thus, they are less willing to invest in debt securities issued by country B, so country B willhave to offer a higher yield to entice investors.24.Influence of Financial MarketsSome countries do not have well established markets for debtsecurities or equity securities. Why do you think this can limit the development of the country,business expansion, and growth in national income in these countries?ANSWER:Businesses rely on financial markets to expand. If they cannot issue debt or equitysecurities, they cannot obtain funding to expand. Local investors who have money to invest will likelyinvest their money in other countries if the financial markets are not developed in their home market.Thus, they will essentially help other countries grow instead of helping their own country grow.25.Impact of Systemic RiskDifferent types of financial institutions commonly interact. They provideloans to each other, and take opposite positions on many different types of financial agreements,whereby one will owe the other based on a specific financial outcome. Explain why theirrelationships cause concerns about systemic risk.ANSWER:When financial institutions interact through transactions, the failure of one financialinstitution can cause financial problems for others. As one financial institution fails, it defaults onpayments owed on financial agreements with other financial institutions. Those institutions may havebeen relying on those payments to cover other obligations to another set of financial institutions.

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Thus,many financial institutions might be unable to cover their obligations, and this spreads fear thatthe financial system might collapse.Interpreting Financial News“Interpreting Financial News” tests your ability to comprehend common statements made by Wall Streetanalysts and portfolio managers who participate in the financial markets. Interpret the following:a.“The price of IBMstockwill not be affected by the announcement that its earnings haveincreased as expected.”The earnings level was anticipated by investors, so that IBM’s stock price already reflected thisanticipation.b.“The lending operations at BankofAmerica should benefit from strong economic growth.”High economic growthencourages expansion by firmswhichresults in a strong demand for loansprovided by BankofAmerica.c.“The brokerage and underwriting performance at Goldman Sachsshould benefit from strongeconomic growth.”High economic growth may result in a large volume of stock transactions in which GoldmanSachsmay serve as a broker. Also, Goldman Sachsunderwriters new securities that are issuedwhen firms raise funds to support expansion; firms are more willing to issue new securities toexpand during periods of high economic growth.Managing in Financial MarketsAs a financial manager of a large firm, you plan to borrow $70 million over the next year.a.What are the more likely alternatives for you to borrow $70 million?You could attempt to borrow $70 million from commercial banks, savings institutions, or financecompanies in the form of commercial loans. Alternatively, you may issue debt securities.b.Assuming that you decide to issue debt securities, describe the types of financial institutions thatmay purchase these securities.Financial institutions such as mutual funds, pension funds, and insurance companies commonlypurchase debt securities that are issued by firms. Other financial institutions such as commercialbanks and savings institutions may also purchase debt securities.c.How do individuals indirectly provide the financing for your firm when they maintain deposits atdepository institutions, invest in mutual funds, purchase insurance policies, or invest in pensions?

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Individuals provide funds to financial institutions in the form of bank deposits, investment inmutual funds, purchases of insurance policies, or investment in pensions. The financialinstitutions may channel the funds toward the purchase of debt securities (and even equitysecurities) that were issued by large corporations, such as the one where you work.Flow of Funds ExerciseRoles of Financial Markets and InstitutionsThis continuing exercise focuses on the interactions of a single manufacturing firm (Carson Company) inthe financial markets. It illustrates how financial markets and institutions are integrated and facilitate theflow of funds in the business and financial environment.At the end of every chapter, this exerciseprovides a list of questions about Carson Company that require the application of concepts learnedwithin the chapter, as related to the flow of funds.Carson Company is a large manufacturing firm in California that was created 20 years ago by the Carsonfamily.It was initially financed with an equity investment by the Carson family and ten other individuals.Over time, Carson Company has obtained substantial loans from finance companies and commercialbanks. The interest rate on the loans is tied to market interest rates, and is adjusted every six months.Thus, Carson’s cost of obtaining funds is sensitive to interest rate movements. It has a credit line with abank in case it suddenly needs to obtain funds for a temporary period. It has purchased Treasury securitiesthat it could sell if it experiences any liquidity problems.Carson Company has assets valued at about $50 million and generates sales of about $100 million peryear. Some of its growth is attributed to its acquisitions of other firms. Because of its expectations of astrong U.S. economy, Carson plans to grow in the future by expanding its business and throughacquisitions. It expects that it will need substantial long-term financing, and plans to borrow additionalfunds either through loans or by issuing bonds. It is also considering the issuance of stock to raise fundsin the next year. Carson closely monitors conditions in financial markets that could affect its cash inflowsand cash outflows and therebyaffect its value.a.In what way is Carson a surplus unit?Carson invests in Treasury securities and therefore is providing funds to the Treasury, the issuerof those securities.b.In what way is Carson a deficit unit?Carson has borrowed funds from financial institutions.c.How might finance companies facilitate Carson’s expansion?Finance companies can provide loans to Carson so that Carson can expand its operations.d.How might commercial banks facilitate Carson’s expansion?Commercial banks can provide loans to Carson so that Carson can expand its operations.e.Why might Carson have limited access to additional debt financing during its growth phase?

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Carson may have already borrowed up to its capacity. Financial institutions may be unwilling tolend more funds to Carson if it has too much debt.f.How mightsecurities firmsfacilitate Carson’s expansion?First,securities firmscould advise Carson on its acquisitions. In addition, they could underwritea stock offering or a bond offering by Carson.g.How might Carson use the primary market to facilitate its expansion?It could issue new stock or bonds to obtain funds.h.How might it use the secondary market?It could sell its holdings of Treasury securities in the secondary market.i.If financial markets were perfect, how might this have allowed Carson to avoid financialinstitutions?It would have been able to obtain loans directly from surplus units. It would have been able toassess potential targets for acquisitions without the advice of investmentsecurities firms. It wouldbe able to engage in a new issuance of stock or bonds without the help of asecurities firm.j.The loans that Carson has obtained fromcommercial banksstipulatethat Carsonmustreceivethebanks’approvalbefore pursuing any large projects. What is the purpose of this condition? Doesthis condition benefit the owners of the company?The purpose is to prevent Carson from using the funds in a manner that would be very risky, asCarson may default on its loans if it takes excessive risk when using the funds to expand itsbusiness. The owners of the firm may prefer to take more risk than the lenders will allow, becausethe owners would benefit directly from risky ventures that generate large returns. Conversely, thelenders simply hope to receive the repayments on the loan that they provided, and do not receivea share in the profits. They would prefer that the funds be used in a conservative manner so thatCarson will definitely generate sufficient cash flows to repay the loan.

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Chapter 2Determination of Interest RatesOutlineLoanable Funds TheoryHousehold Demand for Loanable FundsBusiness Demand for Loanable FundsGovernment Demand for Loanable FundsForeign Demand for Loanable FundsAggregate Demand for Loanable FundsSupply of Loanable FundsEquilibrium Interest RateFactorsThat Affect Interest RatesImpact of Economic Growth on Interest RatesImpact of Inflation on Interest RatesImpact of Monetary Policyon Interest RatesImpact of the Budget Deficit on Interest RatesImpact of Foreign Flows of Funds on Interest RatesSummary of ForcesThat Affect Interest RatesForecasting Interest Rates

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Key Concepts1.Explain the Loanable Funds Theory by deriving demand and supply schedules for loanable funds.2.Explain the Fisher Effect, and tie it in with Loanable Funds Theory by explaining how inflationaffects the demand and supply schedules for loanable funds.3.Provide additional applications (especially current events) one at a time to help illustrate how eventscan affect the demand and supply schedules, and therefore influence interest rates.4.Explain how forecasts of interest rates are needed to make financial decisions, which require forecastsof shifts in the demand and supply schedules for loanable funds.5.Introduce several possible events simultaneously to illustrate how difficult it can be to forecastinterest rate movements when several events are occurring at once.POINT/COUNTER-POINT:Does aLargeFiscalBudgetDeficitResult inHigherInterestRates?POINT: No. In some years (such as 2008), the fiscal budget deficit was large and interest rates were verylow.COUNTER-POINT: Yes. When the federal government borrows large amounts of funds, it can crowd outother potential borrowers, and the interest rates are bid up by the deficit units.WHO IS CORRECT? Use the Internetto learn more about this issueand then formulateyour ownopinion.ANSWER: A large budget deficit does not automatically cause high interest rates. However, it does resultin a large demand for funds, which will place upward pressure on interest rates unless there are offsettingforces.Questions1.Interest Rate Movements.Explain why interest rates changed as they did over the past year.ANSWER: This exercise should force students to consider how the factors that influence interestrates have changed over the last year, and assess how these changes could have affected interest rates.2.Interest Elasticity.Explain what is meant by interest elasticity. Would you expect federalgovernment demand for loanable funds to be more or less interest-elastic than household demand forloanable funds? Why?ANSWER: Interest elasticity of supply represents a change in the quantity of loanable funds suppliedin response to a change in interest rates. Interest elasticity of demand represents a change in thequantity of loanable funds demanded in response to a change in interest rates.

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The federal government demand for loanable funds should be less interest elastic than the consumerdemand for loanable funds, because the government’s planned borrowings will likely occur regardlessof the interest rate. Conversely, the quantity of loanable funds by consumers is more responsive to theinterest rate level.3.Impact of Government Spending.If the federal government planned to expand the space program,how might this affect interest rates?ANSWER: An expanded space program would (a) force the federal government to increase its budgetdeficit, (b) possibly force any firms involved in facilitating the program to borrow more funds.Consequently, there is a greater demand for loanable funds. The additional spending could causehigher income and additional saving. Yet, this impact is not likely to be as great. The likely overallimpact would therefore be upward pressure on interest rates.4.Impact of a Recession.Explain why interest rates tend to decrease during recessionary periods.Review historical interest rates to determine how they react to recessionary periods. Explain thisreaction.ANSWER: During a recession, firms and consumers reduce their amount of borrowing. The demandfor loanable funds decreases and interest rates decrease as a result.5.Impact of the Economy.Explain how the expected interest rate in one year dependson yourexpectation of economic growth and inflation.ANSWER:The interest rate in the future should increase if economic growth and inflation areexpected to rise, or decrease if economic growth and inflation are expected to decline.6.Impact of the Money Supply.Should increasing money supply growth place upward or downwardpressure on interest rates?ANSWER: If one believes that higher money supply growth will not cause inflationary expectations,the additional supply of funds places downward pressure on interest rates. However, if one believesthat inflation expectations do erupt as a result, demand for loanable funds will also increase, andinterest rates could increase (if the increase in demand more than offsets the increase in supply).7.Impact of Exchange Rates on Interest Rates.Assume that if the U.S. dollar strengthens, it canplace downward pressure on U.S. inflation. Based on this information, how might expectations of astrong dollar affect the demand for loanable funds in the United States and U.S. interest rates? Is thereany reason to think that expectations of a strong dollar could also affect the supply of loanable funds?Explain.ANSWER: As a strong U.S. dollar dampens U.S. inflation, it can reduce the demand for loanablefunds, and therefore reduce interest rates. The expectations of a strong dollar could also increase thesupply of funds because it may encourage saving (there is less concern to purchase goods beforeprices rise when inflationary expectations are reduced). In addition, foreign investors may invest morefunds in the United States if they expect the dollar to strengthen, because that could increase theirreturn on investment.8.Nominal versus Real Interest Rate.What is the difference between the nominal interest rate andreal interest rate? What is the logic behind the implied positive relationship between expectedinflation and nominal interest rates?

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ANSWER: The nominal interest rate is the quoted interest rate, while the real interest rate is definedas the nominal interest rate minus the expected rate of inflation. The real interest rate represents therecent nominal interest rate minus the recent inflation rate.Investors require a positive real return, which suggests that they will only invest funds if the nominalinterest rate is expected to exceed inflation. In this way, the purchasing power of invested fundsincreases over time. As inflation rises, nominal interest rates should rise as well since investors wouldrequire a nominal return that exceeds the inflation rate.9.Real Interest Rate.Estimate the real interest rate over the last year. If financial market participantsoverestimate inflation in a particular period, will real interest rates be relatively high or low? Explain.ANSWER: This exercise forces students to measure last year’s nominal interest rate and inflationrate.If inflation is overestimated, the real interest rate will be relatively high. Investors had required arelatively high nominal interest rate because they expected inflation to be high (according to theFisher effect).10.Forecasting Interest Rates.Why do forecasts of interest rates differ among experts?ANSWER: Various factors may influence interest rates, and changes in these factors will affectinterest rate movements. Experts disagree about how various factors will change. They also disagreeabout the specific influence these factors have on interest rates.Advanced Questions11.Impact of Stock Market Crises.Duringperiods wheninvestors suddenly become fearful that stocksare overvalued, they dump their stocks, and the stock market experiences a major decline. Duringthese periods, interest ratesalsotend to decline. Use the loanable funds framework discussed in thischapter to explain how the massive selling of stocks leads to lower interest rates.ANSWER: When investors shift funds out of stocks, they move it into money market securities,causing an increase in the supply of loanable funds, and lower interest rates.12.Impact of Expected Inflation.How might expectations of higher global oil prices affect the demandfor loanable funds, the supply of loanable funds, and interest rates in the United States? Will thisaffect the interest rates of other countries in the same way? Explain.ANSWER:The expectations of higher oil prices will cause concern about the possible increase ininflation. Since higher inflation can increase interest rates, it will cause an expectation of higherinterest rates in the U.S. Firms and government agencies may borrow more funds now before pricesincrease and before interest rates increase. Consumers may use their savings now to buy productsbefore the prices increase. Therefore, the demand for loanable funds should increase, the supply ofloanable funds should decrease, and interest rates should increase in the U.S.

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The impact of higher global oil prices in other countries is not necessarily the same. If the countryproduces its own oil, it can set the oil prices in its country. If it can prevent high oil prices in itscountry, then the prices of products (gasoline) and services (transportation) may not be affected.Therefore, interest rates may not be affected.13.Global Interaction of Interest Rates.Why might you expect interest rate movements of variousindustrialized countries to be more highly correlated in recent years than in earlier years?ANSWER: Interest rates among countries are expected to be more highly correlated in recent yearsbecause financial markets are more geographically integrated. More international financial flows willoccur to capitalize on higher interest rates in foreign countries, which affects the supply and demandconditions in each market. As funds leave a country with low interest rates, this places upwardpressure on that country’s interest rates. The international flow of funds caused this type of reaction.14.Impact of War.A war tends to cause significant reactions in financial markets. Why would a war inIraq place upward pressure on U.S. interest rates? Why might some investors expect a war like this toplace downward pressure on U.S. interest rates?ANSWER: A war in Iraqplacesupward pressure on U.S. interest rates because it (1) increasedinflationary expectations in the United States as oil prices increased abruptly, and (2) increased theexpected U.S. budget deficit as government expenditures were necessary to boost military support.However, it mayalso cause some analysts to revise their forecastsof economic growth downward.The slower economy reflects a reduced corporate demand for funds, which by itself places downwardpressure on interest rates. If inflation was not a concern, the Fed may attempt to increase moneysupply growth to stimulate the economy. However, theinflationary pressure can restrictthe Fed fromincreasing the money supply to stimulatethe economy (since any stimulative policy could causehigher inflation).15.Impact of September 11.Offer an argument for why the terrorist attack on the United States onSeptember 11, 2001 could have placed downward pressure on U.S. interest rates. Offer an argumentfor whythatattack could have placed upward pressure on U.S. interest rates.ANSWER: The terrorist attack could cause a reduction in spending related to travel (airlines, hotels),and would also reduce the expansion by those types of firms. This reflects a decline in the demand forloanable funds, and places downward pressure on interest rates. Conversely, the attack increases theamount of government borrowing needed to support a war, and therefore places upward pressure oninterest rates.16.Impact of Government Spending.Jayhawk Forecasting Services analyzed several factors that couldaffect interest rates in the future. Most factors were expected to place downward pressure on interestrates. Jayhawk alsoexpectedthat although the annual budget deficit was to be cut by 40 percent fromthe previous year, it would still be very large. Thus, Jayhawk believed that the deficit’s impact wouldmore than offset the effectsof other factors, so itforecast interest rates to increase by 2 percent.Comment on Jayhawk’s logic.ANSWER: A reduction in the deficit should free up some funds that had been used to support thegovernment borrowings. Thus, there should be additional funds available to satisfy other borrowingneeds. Given this situation plus the other information, Jayhawk should have forecasted lower interestrates.

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