Economics Assignment Solution

Economics Assignment Solution

Question 1

Part. 1a Why is a share of Microsoft common stock an asset for its owner and a liability for Microsoft?

Share of a company is the division of companies core capital amongst the shareholders in equal denominations. A share of a company entitles the holder to be the part of the company’s operational performance as well as management in case of equity shares. The capital invested is also redeemable upon the liquidation and the holders have the right to claim for the same in event of liquidation.

An individual investing in shares of Microsoft is thus entitled with a right to the share of Microsoft’s earning available for shareholders as well as is entrusted with the right to claim for the capital investment in the event of its liquidation, thus going by the definition of assets in words of which says that, assets is any resource which is held with the expectation of future economic benefits. Hence, the shares for its holders are its assets whereas from the viewpoint of Microsoft, it is bound to cater to their shareholders demand of return as well as the capital investment. A share becomes a liability.

Part.1b Why have some economists described money during the hyperinflation as a “hot potato” that is quickly passed from one person to another?

It is observed that money usually loses value in the stage of hyperinflation, thus an individual seeks to hold it for a lesser period than in normal times. Thus, money can be called as a hot potato that is quickly passed on from one person to another in times of hyperinflation.

Part.1c Explain how the following events will affect the demand for money according to the “portfolio theories” of money demand:

  • The economy experience a business cycle contraction.
  • Brokerage fees decline, making bond transactions cheaper.
  • The stock market crashes (Hint: consider both the increase in stock price volatility following a market crash and the decrease in wealth of the stock holders).
  1. The economy works in conjunction with cyclical changes and this is a reason behind several cyclical changes in the operations.
  2. Lower brokerage fees for corporate bonds would make them more liquid and this will in turn lead to rise in their demand.
  3. In the events of financial crisis, the risk of erosion of investment base is a fatal phenomenon. Moreover, the risk of it gets further amplified which creates a downfall in stock prices and capital base erosions and thus crashing the overall stock market.

 Question 2

Part.2a Is it better for bond holders when the yield to maturity increases or decreases? Explain.

From the view point of a rationale investor it is always advisable for the Yield to Maturity to decrease because, in case where the yield to maturity increases this would in turn signify a decrease in the prices of bonds. Thus, if the bond holder will sell the bond at a lower price, the capital gains would also be lower, therefore, making the investor worse off.

Part.2b‘Risk Premiums’ on corporate bonds are usually anti-cyclical; that is, they decrease during business cycle expansion and increase during recessions. Why is this so?

During the phase of business cycle booms, lesser organisations go bankrupt and hence there is lesser risk of default on corporate bonds, which in turn lowers there risk premium.  On the other hand, in times of recession, default risk on corporate bonds increases and so increases the risk premium. Thus the risk premium on corporate bonds can be called as anti cyclical i.e. rising during recessions and falling during booms.

 Question 3

 Part.3a which firms are most likely to use bank financing rather than to issue bonds or stocks to finance their activities? Small scale organisations that are not having a high goodwill and market reputation are most likely to use bank financing. This is because of the reason that it is harder for investors to collect information about such entities, thus it becomes hard for such organisations to market their securities. Banks having expertise in financing these smaller organisations are thus, more likely to exclusively finance such entities only.

Part.3b Can a person with rational expectations expect the price of  “Google” to rise by 10% in the next month? No, if a person does not has better information about the rest of the market. An expectation of a rise in price of 10% over the month implies 100% return annually on the Google’s share. This certainly exceeds the equilibrium return. This implies that there shall be existing an unexploited profit opportunity in the market. Which, would have been eliminated in an efficient market. The only time that the person’s expectations could be rational is if the person had information unavailable to the market that allowed him or her to beat the market.

Part.3c “Foreign exchange rates, like stock prices, should follow a random walk”.  Is this statement true? False?, or uncertain ? Explain your answer

This statement is ‘true’ in the principal that, foreign exchange rates are a random walk in a short period such as a week, because changes in the exchange rate are unpredictable, in case the changes would have been predictable, there would be existing a large unexploited profit opportunities in the foreign exchange market. In case where the foreign exchange market is efficient, the unexploited profit opportunities would not exist and thus the foreign exchange rate shall follow a random walk.

Question 4

Part.4a During the holiday season, when the public’s holdings of currency increase, what defensive open market operations typically occur? And,   Why?

When the public holding of currency increases during the holiday periods, the currency checkable ratio deposits ratio rises while the money supply diminishes. To counterfeit this fall in the money supply the state conducts a defensive open market purchase of securities.

Part.4b “Because inflation targeting focuses on achieving the inflation target, it will lead to excessive output fluctuations”. Is this statement true? False?, or, Uncertain?  Explain

This statement is ‘false’ because inflation targeting not specifically focuses on only inflation. In actual practice inflation targetters do worry about output fluctuations, and its worth being noted that, inflation targeting may even be able to reduce the output fluctuations as it allows monetary policy makers to cater to declines in demand more aggressively as they don’t have to worry that resultant expansionary monetary policy will lead to a sharp rise in inflation expectations.

Part.4c Why aren’t central banks more proactive at trying to use monetary policy to eliminate asset-price bubbles?

There exist several reasons as to why monetary policy may not be really effective in eliminating the asset price bubble. The main reason for this is that asset price bubbles are extremely difficult to identify in real time. In several cases, by the time is achieved a consensus amongst the policy makers and the public about the existence of a bubble, it usually gets too late to implement any corrective policies to deflate the bubble. Even if the bubble is identified in time, monetary policy is often observed to be a blunt instrument to sort the situation. In practice Interest rate changes may serve some purpose as a solution in a short run. Howsoever, changes in the interest rates actually tend to be worst off for the overall economic environment.

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