Practice Quiz 1 – Short Questions/Answers
Spring 2021
Note: Although the answers provided here are the best possible answers there might be some alternative
explanation/ideas/wording. Therefore, your answers need not to be exactly the same as the answers provided
here.
Question 1 (Chapter 1):
A. How can changes in foreign exchange rates affect the profitability of financial institutions?
Answer: Changes in foreign exchange rates change the value of assets held by financial institutions
and thus lead to gains and losses on these assets. Also changes in foreign exchange rates affect the
profits made by traders in foreign exchange who work for financial institutions.
B. When the dollar is worth more in relation to currencies of other countries, are you more likely to
buy Canadian-made or foreign-made jeans? Are Canadian companies that manufacture jeans
happier when the dollar is strong or when it is weak? What about a Canadian company that is in
the business of importing jeans into Canada?
Answer: When the dollar increases in value, foreign goods become less expensive relative to
Canadian goods; thus, you are more likely to buy American-made jeans than Canadian-made jeans.
The resulting drop in demand for Canadian-made jeans because of the strong dollar hurts Canadian
jeans manufacturers. On the other hand, the Canadian company that imports jeans into Canada
now finds that the demand for its product has risen, so it is better off when the dollar is strong.
C. Much of the Canadian government debt is held by foreign investors as Canada bonds and bills.
How do fluctuations in the dollar exchange rate affect the value of that debt held by foreigners?
Answer: As the dollar becomes stronger (worth more) relative to a foreign currency, one dollar is
equivalent to (can be exchanged for) more foreign currency. Thus, for a given face value of bond
holdings, a stronger dollar will yield more home currency to foreigners, so the asset will be worth
more to foreign investors. Likewise, a weak dollar will lead to foreign bond holdings worth less to
foreigners.
Question 2 (Chapter 2):
A. If I can buy a car today for $5000 and it is worth $10 000 in extra income to me next year because
it enables me to get a job as a travelling salesperson, should I take out a loan from Larry the Loan
Shark at a 90% interest rate if no one else will give me a loan? Will I be better or worse off as a
result of taking out this loan? Can you make a case for legalizing loan sharking?
Answer: Yes, I should take out the loan, because I will be better off as a result of doing so. My
interest payment will be $4500 (90% of $5000), but as a result, I will earn an additional $10 000,
so I will be ahead of the game by $5500. Since Larry’s loan-sharking business can make some
people better off, as in this example, loan sharking may have social benefits. (One argument against
legalizing loan sharking, however, is that it is frequently a violent activity.)
B. Some economists suspect that one of the reasons economies in developing countries grow so slowly
is that they do not have well-developed financial markets. Does this argument make sense?
Answer: Yes, because the absence of financial markets means that funds cannot be channelled to
people who have the most productive use for them. Entrepreneurs then cannot acquire funds to set
up businesses that would help the economy grow rapidly.
Question 3 (Chapter 3):
A.
In April 2009, the growth rate of M1 in the United States fell to 6.1%, while the growth rate of M2
rose to 10.3%. In September 2013, the year-over-year growth rate of the M1 money supply was
6.5%, while the growth rate of the M2 money supply was about 8.3%. How should Federal Reserve
policymakers interpret these changes in the growth rates of M1 and M2?
Answer: During the period in question, the M1 growth rate fell by 0.4%, while the M2 growth rate
increased by 2.0%. Because these growth rates moved in opposite directions, it is difficult to
judge the appropriateness of monetary policy by just looking at the money supply measures alone.
One measure indicates that monetary policy is more expansionary, while the other indicates the
opposite.
B. Suppose a researcher discovers that a measure of the total amount of debt in the Canadian
economy over the past 20 years was a better predictor of inflation and the business cycle than
M1+ or M2+. Does this discovery mean that we should define money as equal to the total amount
of debt in the economy?
Answer: Not necessarily. Although the total amount of debt has predicted inflation and the
business cycle better than M1+ or M2+, it may not be a better predictor in the future. Without
some theoretical reason for believing that the total amount of debt will continue to predict well in
the future, we may not want to define money as the total amount of debt.
Question 4 (Chapter 4):
A.
Would a dollar tomorrow be worth more to you today when the interest rate is 20% or when it is
10%?
Answer: It would be worth 1/(1 + 0.20) = $0.83 when the interest rate is 20%, rather than 1/(1 +
0.10) = $0.91 when the interest rate is 10%. Thus, a dollar tomorrow is worth less with a higher
interest rate today.
B. To help pay for college, you have just taken out a $1000 government loan that makes you pay $126
per year for 25 years. However, you don’t have to start making these payments until you graduate
from college two years from now. Why is the yield to maturity necessarily less than 12%? (This is
the yield to maturity on a normal $1000 fixed-payment loan on which you pay $126 per year for
25 years.)
Answer: If the interest rate were 12%, the present discounted value of the payments on the
government loan are necessarily less than the $1000 loan amount because they do not start for two
years. Thus the yield to maturity must be lower than 12% in order for the present discounted value
of these payments to add up to $1000.
Question 5 (Chapter 5):
Suppose you visit with a financial adviser, and you are considering investing some of your wealth
in one of three investment portfolios: stocks, bonds, or commodities. Your financial adviser
provides you with the following table, which gives the probabilities of possible returns from each
investment:
Stocks
Bonds
Commodities
Probability Return Probability Return Probability Return
0.25
12%
0.6
10%
0.2
20%
0.25
10%
0.4
7.50%
0.25
12%
0.25
8%
0.25
6%
0.25
6%
0.25
4%
0.05
0%
A. Which investment should you choose to maximize your expected return: stocks, bonds, or
commodities?
Answer: The expected return on the stock portfolio is 0.25(12%) + 0.25(10%) + 0.25(8%)
+ 0.25(6%) = 9%. The expected return on the bond portfolio is 0.6(10%) + 0.4(7.5%) =
9%. The expected return on the commodities portfolio is 0.2(20%) + 0.25(12%) + 0.25(6%)
+ 0.25(4%) + 0.05(0%) = 9.5%. Since the commodities portfolio has the higher expected
return, you should choose that.
B. If you are risk-averse and have to choose between the stock and the bond investments,
which should you choose? Why?
Answer: In choosing between the stock or bond portfolio, they both have the same expected
return. However, since there is less uncertainty over the outcomes in the bond portfolio
than the stock portfolio, a risk-averse individual should choose the bond portfolio.