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Chapter 4: Q.5CP (page 402)

The following questions have appeared on CFA examinations.

a. Which one of the following statements best expresses the central idea of countercyclical fiscal policy?

(1) Planned government deficits are appropriate during economic booms, and planned surpluses are appropriate during economic recessions.

(2) The balanced-budget approach is the proper criterion for determining annual budget policy.

(3) Actual deficits should equal actual surpluses during a period of deflation.

(4) Government deficits are planned during economic recessions, and surpluses are utilized to restrain inflationary booms.

b. Which one of the following propositions would a strong proponent of supply-side economics be most likely to stress?

(1) Higher marginal tax rates will lead to a reduction in the size of the budget deficit and lower interest rates because they expand government revenues.

(2) Higher marginal tax rates promote economic inefficiency and thereby retard aggregate output because they encourage investors to undertake low-productivity projects with substantial tax-shelter benefits.

(3) Income redistribution payments will exert little impact on real aggregate supply because they do not consume resources directly.

(4) A tax reduction will increase the disposable income of households. Thus, the primary impact of a tax reduction on aggregate supply will stem from the influence of the tax change on the size of the budget deficit or surplus.

Short Answer

Expert verified

Answer

a. 4

b. 4.

Step by step solution

01

Step by Step Solution Step 1: Explanation on ‘a’

Counter cyclical system is best expressed by the statement Government deficits are planned during economic recessions, and surpluses are utilized to restrain inflationary booms. Hence the correct option is ‘4’.

02

Explanation on ‘b’

A strong proponent of supply-side economics would most likely stress on the statement that “a tax reduction will increase the disposable income of households. Thus, the primary impact of a tax reduction on aggregate supply will stem from the influence of the tax change on the size of the budget deficit or surplus.” Hence the correct option is ‘4’.

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Most popular questions from this chapter

Chiptech, Inc., is an established computer chip firm with several profitable existing products as well as some promising new products in development. The company earned \(1 per share last year and just paid out a dividend of \).50 per share. Investors believe the company plans to maintain its dividend payout ratio at 50%. ROE equals 20%. Everyone in the market expects this situation to persist indefinitely

a. What is the market price of Chiptech stock? The required return for the computer chip industry is 15%, and the company has just gone ex-dividend (i.e., the next dividend will be paid a year from now, at t = 1).

b. Suppose you discover that Chiptech’s competitor has developed a new chip that will eliminate Chiptech’s current technological advantage in this market. This new product, which will be ready to come to the market in two years, will force Chiptech to reduce the prices of its chips to remain competitive. This will decrease ROE to 15%, and, because of falling demand for its product, Chiptech will decrease the plowback ratio to .40. The plowback ratio will be decreased at the end of the second year, at t = 2: The annual year-end dividend for the second year (paid at t = 2) will be 60% of that year’s earnings. What is your estimate of Chiptech’s intrinsic value per share?

( Hint: Carefully prepare a table of Chiptech’s earnings and dividends for each of the next three years. Pay close attention to the change in the payout ratio in t = 2.)

c. No one else in the market perceives the threat to Chiptech’s market. In fact, you are confident that no one else will become aware of the change in Chiptech’s competitive status until the competitor firm publicly announces its discovery near the end of year 2. What will be the rate of return on Chiptech stock in the coming year (i.e., between t = 0 and t = 1)? In the second year (between t = 1 and t = 2)? The third year (between t = 2 and t = 3)? ( Hint: Pay attention to when the market catches on to the new situation. A table of dividends and market prices over time might help.)

Use the following case in answering Problems 26 – 28:

Institutional Advisors for All Inc., or IAAI, is a consulting firm that primarily advises all types of institutions such as foundations, endowments, pension plans, and insurance companies. IAAI also provides advice to a select group of individual investors with large portfolios. One of the claims the firm makes in its advertising is that IAAI devotes considerable resources to forecasting and determining long-term trends; then it uses commonly accepted investment models to determine how these trends should affect the performance of various investments. The members of the research department

of IAAI recently reached some conclusions concerning some important macroeconomic trends. For instance, they have seen an upward trend in job creation and consumer confidence and predict that this should continue for the next few years. Other domestic leading indicators that the research department at IAAI wishes to consider are industrial production, average weekly hours in manufacturing, S&P 500 stock prices, M2 money supply, and the index of consumer expectations.

In light of the predictions for job creation and consumer confidence, the investment advisers at IAAI want to make recommendations for their clients. They use established theories that relate job creation and consumer confidence to inflation and interest rates and then incorporate the forecast movements in inflation and interest rates into established models for explaining asset prices. Their primary concern is to forecast how the trends in job creation and consumer confidence should affect bond prices and how those trends should affect stock prices.

The members of the research department at IAAI also note that stocks have been trending up in the past year, and this information is factored into the forecasts of the overall economy than they deliver. The researchers consider an upward-trending stock market a positive economic indicator in itself; however, they disagree as to the reason this should be the case.

Which of the domestic series that the IAAI research department listed for use as leading indicators is least appropriate?

a. Industrial production

b. Manufacturing average weekly hours

c. M2 money supply

Janet Ludlow is preparing a report on U.S.-based manufacturers in the electric toothbrush industry and has gathered the information shown in Tables 12.8 and 12.9. Ludlow’s report concludes that the electric toothbrush industry is in the maturity (i.e., late) phase of its industry life cycle.

a. Select and justify three factors from Table 12.8 that support Ludlow’s conclusion.

b. Select and justify three factors from Table 12.9 that refute Ludlow’s conclusion.

Which of the following is not a governmental structural policy that supply-side economists believe would promote long-term growth in an economy?

a. A redistributive tax system.

b. A promotion of competition.

c. Minimal government interference in the economy.

Use the following case in answering Problems 26 – 28:

Institutional Advisors for All Inc., or IAAI, is a consulting firm that primarily advises all types of institutions such as foundations, endowments, pension plans, and insurance companies. IAAI also provides advice to a select group of individual investors with large portfolios. One of the claims the firm makes in its advertising is that IAAI devotes considerable resources to forecasting and determining long-term trends; then it uses commonly accepted investment models to determine how these trends should affect the performance of various investments. The members of the research department

of IAAI recently reached some conclusions concerning some important macroeconomic trends. For instance, they have seen an upward trend in job creation and consumer confidence and predict that this should continue for the next few years. Other domestic leading indicators that the research department at IAAI wishes to consider are industrial production, average weekly hours in manufacturing, S&P 500 stock prices, M2 money supply, and the index of consumer expectations.

In light of the predictions for job creation and consumer confidence, the investment advisers at IAAI want to make recommendations for their clients. They use established theories that relate job creation and consumer confidence to inflation and interest rates and then incorporate the forecast movements in inflation and interest rates into established models for explaining asset prices. Their primary concern is to forecast how the trends in job creation and consumer confidence should affect bond prices and how those trends should affect stock prices.

The members of the research department at IAAI also note that stocks have been trending up in the past year, and this information is factored into the forecasts of the overall economy that they deliver. The researchers consider an upward-trending stock market a positive economic indicator in itself; however, they disagree as to the reason this should be the case.

Stock prices are useful as a leading indicator. To explain this phenomenon, which of the following is most accurate?

Stock prices:

a. Predict future interest rates and reflect the trends in other indicators.

b. Do not predict future interest rates, nor are they correlated with other leading indicators; the usefulness of stock prices as a leading indicator is a mystery.

c. Reflect the trends in other leading indicators only and do not have predictive power of their own.
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