Questions and Problems

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Questions marked with an asterisk are answered at the end of the book in an appendix, "Answers to Selected Questions and Problems."

1. Has the inflation rate in the United States increased or decreased in the past few years? What about interest rates?

* 2. If history repeats itself and we see a decline in the rate of money growth, what might you expect to happen to:

a. real output b. the inflation rate, and c. interest rates?

3. When was the most recent recession?

* 4. When interest rates fall, how might you change your economic behavior?

5. Can you think of any financial innovation in the past ten years that has affected you personally? Has it made you better off or worse off? Why?

* 6. Is everybody worse off when interest rates rise?

7. What is the basic activity of banks?

*8. Why are financial markets important to the health of the economy?

9. What is the typical relationship between interest rates on three-month Treasury bills, long-term Treasury bonds, and Baa corporate bonds?

*10. What effect might a fall in stock prices have on business investment?

11. What effect might a rise in stock prices have on consumers' decisions to spend?

*12. How does a fall in the value of the pound sterling affect British consumers?

13. How does an increase in the value of the pound sterling affect American businesses?

*14. Looking at Figure 3, in what years would you have chosen to visit the Grand Canyon in Arizona rather than the Tower of London?

15. When the dollar is worth more in relation to currencies of other countries, are you more likely to buy American-made or foreign-made jeans? Are U.S. companies that manufacture jeans happier when the dollar is strong or when it is weak? What about an American company that is in the business of importing jeans into the United States?

1. In this exercise we are going to practice collecting data from the Web and graphing it using Excel. Use the example in the text as a guide. Go to /data/index.htm, click on "stock indices" at the top of the page then choose the U.S. Stock indices -monthly option. Finally, choose the Dow Jones Industrial Average option.

a. Using the method presented in this chapter, move the data into an Excel spreadsheet.

b. Using the data from a, prepare a graph. Use the graphing wizard to properly label your axes.

2. In Web Exercise 1 you collected and graphed the Dow Jones Industrial Average. This same site reports forecast values of the DJIA. Go to /data/index.htm and click on "FFC Home" at the top of the page. Click on the Dow Jones Industrial link under Forecasts in the far left column.

a. What is the Dow forecast to be in 3 months?

b. What percentage increase is forecast for the next three months?

Increased Money SupplyMoney Supply

issued the security acquires no new funds. A corporation acquires new funds only when its securities are first sold in the primary market. Nonetheless, secondary markets serve two important functions. First, they make it easier and quicker to sell these financial instruments to raise cash; that is, they make the financial instruments more liquid. The increased liquidity of these instruments then makes them more desirable and thus easier for the issuing firm to sell in the primary market. Second, they determine the price of the security that the issuing firm sells in the primary market. The investors that buy securities in the primary market will pay the issuing corporation no more than the price they think the secondary market will set for this security. The higher the security's price in the secondary market, the higher will be the price that the issuing firm will receive for a new security in the primary market, and hence the greater the amount of financial capital it can raise. Conditions in the secondary market are therefore the most relevant to corporations issuing securities. It is for this reason that books like this one, that deal with financial markets, focus on the behavior of secondary markets rather than primary markets.

Exchanges and



Detailed market and security information for the NASDAQ OTC stock exchange.

Secondary markets can be organized in two ways. One is to organize exchanges, where buyers and sellers of securities (or their agents or brokers) meet in one central location to conduct trades. The New York and American stock exchanges for stocks and the Chicago Board of Trade for commodities (wheat, corn, silver, and other raw materials) are examples of organized exchanges.

The other method of organizing a secondary market is to have an over-the-counter (OTC) market, in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities "over the counter" to anyone who comes to them and is willing to accept their prices. Because over-the-counter dealers are in computer contact and know the prices set by one another, the OTC market is very competitive and not very different from a market with an organized exchange.

Many common stocks are traded over-the-counter, although a majority of the largest corporations have their shares traded at organized stock exchanges such as the New York Stock Exchange. The U.S. government bond market, with a larger trading volume than the New York Stock Exchange, is set up as an over-the-counter market. Forty or so dealers establish a "market" in these securities by standing ready to buy and sell U.S. government bonds. Other over-the-counter markets include those that trade other types of financial instruments such as negotiable certificates of deposit, federal funds, bankers acceptances, and foreign exchange.

Money and Another way of distinguishing between markets is on the basis of the maturity of the

Capital Markets securities traded in each market. The money market is a financial market in which only short-term debt instruments (generally those with original maturity of less than one year) are traded; the capital market is the market in which longer-term debt (generally those with original maturity of one year or greater) and equity instruments are traded. Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid. In addition, as we will see in Chapter 4, short-term securities have smaller fluctuations in prices than long-term securities, making them safer investments. As a result, corporations and banks actively use the money market to earn interest on surplus funds that they expect to have only temporarily. Capital market securities, such as stocks and long-term bonds, are often

International Bond Market, Eurobonds, and Eurocurrencies held by financial intermediaries such as insurance companies and pension funds, which have little uncertainty about the amount of funds they will have available in the future.1

The growing internationalization of financial markets has become an important trend. Before the 1980s, U.S. financial markets were much larger than financial markets outside the United States, but in recent years the dominance of U.S. markets has been disappearing. The extraordinary growth of foreign financial markets has been the result of both large increases in the pool of savings in foreign countries such as Japan and the deregulation of foreign financial markets, which has enabled them to expand their activities. American corporations and banks are now more likely to tap international capital markets to raise needed funds, and American investors often seek investment opportunities abroad. Similarly, foreign corporations and banks raise funds from Americans, and foreigners have become important investors in the United States. A look at international bond markets and world stock markets will give us a picture of how this globalization of financial markets is taking place.

The traditional instruments in the international bond market are known as foreign bonds. Foreign bonds are sold in a foreign country and are denominated in that country's currency. For example, if the German automaker Porsche sells a bond in the United States denominated in U.S. dollars, it is classified as a foreign bond. Foreign bonds have been an important instrument in the international capital market for centuries. In fact, a large percentage of U.S. railroads built in the nineteenth century were financed by sales of foreign bonds in Britain.

A more recent innovation in the international bond market is the Eurobond, a bond denominated in a currency other than that of the country in which it is sold— for example, a bond denominated in U.S. dollars sold in London. Currently, over 80 percent of the new issues in the international bond market are Eurobonds, and the market for these securities has grown very rapidly. As a result, the Eurobond market is now larger than the U.S. corporate bond market.

A variant of the Eurobond is Eurocurrencies, which are foreign currencies deposited in banks outside the home country. The most important of the Eurocurrencies are Eurodollars, which are U.S. dollars deposited in foreign banks outside the United States or in foreign branches of U.S. banks. Because these short-term deposits earn interest, they are similar to short-term Eurobonds. American banks borrow Eurodollar deposits from other banks or from their own foreign branches, and Eurodollars are now an important source of funds for American banks (over $190 billion outstanding).

Note that the new currency, the euro, can create some confusion about the terms Eurobond, Eurocurrencies, and Eurodollars. A bond denominated in euros is called a

1If you would like more detail about the different types of money and capital market instruments, you can find this information in an appendix to this chapter, which can be found on this book's web site at

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  • eunice
    What effect might a fall in stock prices have on business investment?
    8 years ago
    Is everybody worse off is interest rates rise?
    8 years ago
  • LEON
    Has the inflation rate in the united states increased or decreased in the past few years?
    8 years ago

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