PROBLEM SETS 1. Expansionary (looser) monetary policy to lower interest rates wo

Question

PROBLEM SETS

1. Expansionary (looser) monetary policy to lower interest rates would stimulate both investment and expenditures on consumer durables. Expansionary fiscal policy (i.e., lower taxes, increased government spending, increased welfare transfers) would stimulate aggregate demand directly.

2. A top-down approach to security valuation begins with an analysis of the global and domestic economy. Analysts who follow a top-down approach then narrow their attention to an industry or sector likely to perform well, given the expected performance of the broader economy. Finally, the analysis focuses on specific companies within an industry or sector that has been identified as likely to perform well. A bottom-up approach typically emphasizes fundamental analysis of individual company stocks, and is largely based on the belief that undervalued stocks will perform well regardless of the prospects for the industry or the broader economy. The major advantage of the top-down approach is that it provides a structured approach to incorporating the impact of economic and financial variables, at every level, in to analysis of a company’s stock. One would expect, for example, that prospects for a particular industry are highly dependent on broader economic variables. Similarly, the performance of an individual company’s stock is likely to be greatly affected by the prospects for the industry in which the company operates.

3. Firms with greater sensitivity to business cycles are in industries that produce durable consumer goods or capital goods. Consumers of durable goods (e.g., automobiles, major appliances) are more likely to purchase these products during an economic expansion, but can often postpone purchases during a recession. Business purchases of capital goods (e.g., purchases of manufacturing equipment by firms that produce their own products) decline during a recession because demand for the firms’ end products declines during a recession.

4. a. The robotics process entails higher fixed costs and lower variable (labor) costs. Therefore, this firm will perform better in a boom and worse in a recession. For example, costs will rise less rapidly than revenue when sales volume expands during a boom. b. Because its profits are more sensitive to the business cycle, the robotics firm will have the higher beta.

5. a. Housing construction (cyclical but interest-rate sensitive): (iii) Healthy expansion b. Health care (a non-cyclical industry): (i) Deep recession c. Gold mining (counter-cyclical): (iv) Stagflation d. Steel production (cyclical industry) (ii) Superheated economy

6. a. General Autos. Pharmaceuticals are less of a discretionary purchase than automobiles.

b. Friendly Airlines. Travel expenditure is more sensitive to the business cycle than movie consumption.

7. The index of consumer expectations is a useful leading economic indicator because, if consumers are optimistic about the future, they will be more willing to spend money, especially on consumer durables, which will increase aggregate demand and stimulate the economy.

Explanation / Answer

(1) True

An expansionary monetary policy increases money supply & lowers interest rates, which boost consumption & investment. Expansionary fiscal policy directly increases aggregate demand.

(2) True.

A top down approach starts at macro level & goes to the micro level.

(3) True.

During a recession, non-necessity (luxury) goods' consumption decreases first, because people spend their available (lower) earnings on the necessities.

(4) (a) & (b) True.

A firm with high fixed costs will suffer during recession when its output is lower & cannot recover total costs.

Also, profits being more sensitive to business cycles, during boom profits rise more than average market profits & during recession, profits fall more rapidly than average market does. So Beta is high.

(5) Question is unclear. What is the question?

(6)

(a) False.

Unlike auto firms, pharma firms introduce their products (new drugs) after many years of research and development, therefore it can halt or postpone some discretionary expenses for some time if needed. But auto firm's product cycle is much shorter and putting away discretionary expenses make them lose their market share.

(b) True.

This is because of the cost of travel vis-a-vis cost of a movie ticket, which utilizes a low percentage of the total income. That's why, travel expense is more sensitive to business cycle (in all corporate companies, a downturn is always managed by cost cuts & the first cost cutting measure is to minimize travel).

(7) True.

A stronger consumer expectation index signals the producers to raise output in near term because, higher consumer confidence will boost aggregate demand & stimulate the economy.

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