manchester88

Suppose the U.S. has higher inflation than Japan. The U.S. is in the late expansion phase of the business cycle and Japan is in the initial recovery phase. Using only the PPP relationship for forecasting currency values and using the relationship between asset class returns and the business cycle, which asset should the manager invest in?

A) Japanese stocks.

B) Japanese bonds.

C) U.S. bonds.

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The PPP relationship states that countries with high inflation will see their currency depreciate, so the manager should invest in Japan. Within Japan, the investor should invest in stocks because stock prices have just started to rise and will continue to do so for some time. Bond yields will soon rise and their prices will fall as the economy expands.

manchester88

Which of the following statements least likely represents a scenario from an exogenous shock?

A) Political unrest in the Middle East leading to an unexpected decrease in oil production, increased oil prices, decreased consumer spending, increased unemployment, and a slowed economy.

B) A country defaults on its debt payments, thereby causing the country’s currency to lose value and forcing the central bank to take measures to stabilize the banking system and the economy.

C) OPEC not being able to agree on production levels leading to increased uncertainty in global markets and increased oil prices.

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Exogenous shocks usually lead to economic slowdowns, as in the case of an oil shock leading to higher prices, inflation, reduced consumer spending, increased unemployment, and a slowing economy. A reduction in oil prices could be caused by a weak global economy with weak demand for oil or an oversupply of oil in the global market. This would reduce the price of oil and boost the economy, potentially overheating it in which causes high inflation and increased interest rates that ultimately slow the economy down. In a financial crisis the result is usually characterized by banks becoming vulnerable and requiring action by the central bank to stabilize the banking system and economy by increasing liquidity and lowering interest rates.

manchester88

Which one of the following represents possibly the most difficult task the government faces in the event of an exogenous shock?

A) Rebuilding infrastructure after a natural disaster.

B) Preventing the shock from becoming a contagion and spreading to its own country.

C) Being able to lower interest rates in a deflationary environment.

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Banks are usually severely impacted by a financial crisis shock. In reaction the country’s central bank attempts to stabilize the banking system and the economy by injecting liquidity into the system by maintaining or lowering interest rates. It would be virtually impossible to lower interest rates further in an already low inflation, low interest rate, or deflationary environment. Although rebuilding after a major natural disaster could be difficult it would still be possible given enough resources. A country can prevent or minimize the impact of a contagion spreading to its own country due to a financial shock by having sound fiscal and monetary policies that will prevent the country from defaulting on its debt and prevent or minimize the impact of financial bubbles.

manchester88

Which of the following is most representative of an exogenous economic shock?

A) A hurricane hitting the Gulf of Mexico resulting in the shut-down of many oil wells and refineries and to higher oil prices.

B) Ongoing expansionary fiscal policy by the federal government leading to higher inflation and interest rates.

C) Anticipated loose monetary policy by a country’s central bank leading to inflation and to depreciation in the country’s currency.

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An exogenous shock is something that occurs outside the normal course of an economy, such as a natural disaster or unanticipated government policy. The shock is unanticipated and is not part of a trend as would be characterized by ongoing monetary or fiscal policy.