NASAA Series 66 — All Questions

During a period of rising inflation, the Federal Reserve is MOST likely to:

• a.Raise interest rates to slow economic activity✓
• b.Take no action at all
• c.Cut interest rates to stimulate spending
• d.Guarantee bond prices

To combat rising inflation, the Federal Reserve typically tightens monetary policy by raising interest rates, which cools borrowing and spending. Higher rates tend to pressure bond and equity prices. This is a core macroeconomic relationship advisers must understand.

Gross domestic product (GDP) declining for two consecutive quarters is a common informal indicator of:

• a.A bull market
• b.Hyperinflation
• c.An economic expansion
• d.A recession✓

Two consecutive quarters of declining real GDP is a widely used informal signal of a recession, reflecting contracting economic output. Recessions typically bring rising unemployment and weaker corporate earnings. Advisers consider the business cycle when positioning portfolios.

The real rate of return is best described as:

• a.The return guaranteed by the government
• b.The nominal return before any adjustment
• c.The dividend yield only
• d.The nominal return adjusted for inflation✓

The real rate of return is the nominal return reduced by the inflation rate, reflecting the true increase in purchasing power. It matters because inflation erodes the value of investment gains. Advisers use it to set realistic long-term expectations.

A leading economic indicator is one that:

• a.Tends to change before the overall economy changes, helping to forecast direction✓
• b.Moves at the same time as the economy
• c.Has no predictive value
• d.Confirms trends after they have occurred

Leading indicators, such as building permits or stock prices, tend to shift ahead of the broader economy, offering forecasting value. Coincident indicators move with the economy, and lagging indicators confirm trends after the fact. Analysts use leading indicators to anticipate turning points.

If the yield curve is inverted, meaning short-term rates exceed long-term rates, this is often interpreted as:

• a.A potential signal of an approaching economic slowdown or recession✓
• b.Evidence of falling inflation only
• c.A guarantee of strong future growth
• d.Proof that bond prices cannot change

An inverted yield curve, where short-term yields exceed long-term yields, has historically been viewed as a possible warning of an economic slowdown or recession. It reflects expectations of future rate cuts amid weakening growth. Advisers monitor the curve as one of several signals, not a certainty.

The four phases of the business cycle, in order, are:

• a.Growth, maturity, decline, and renewal
• b.Inflation, deflation, stagflation, and recovery
• c.Expansion, peak, contraction, and trough✓
• d.Bull market, bear market, correction, and rally

The business cycle moves through expansion (growth), a peak, contraction (recession), and a trough before the next expansion begins. Recognizing the phase helps advisers position portfolios, since different sectors lead at different points. The cycle's timing and length are irregular, not fixed.

Fiscal policy refers to the use of:

• a.Bank reserve requirements controlling how much banks may lend
• b.Interest-rate targets and open-market operations set by the central bank
• c.Currency-exchange interventions to stabilize the currency
• d.Government spending and taxation to influence the economy✓

Fiscal policy is the use of government spending and taxation decisions — made by Congress and the President — to influence economic activity. It is distinct from monetary policy, which the Federal Reserve conducts through interest rates and the money supply. The two often work together to manage the economy.

Which of the following is a tool of the Federal Reserve's monetary policy?

• a.Open-market operations — buying and selling government securities✓
• b.Setting federal income tax rates for individuals and corporations
• c.Deciding federal spending on infrastructure and defense programs
• d.Establishing tariffs on imported goods to protect domestic industries

Open-market operations — the buying and selling of government securities — are the Fed's primary monetary-policy tool, alongside the discount rate and reserve requirements. Buying securities adds reserves and eases policy; selling drains reserves and tightens it. Taxes, spending, and tariffs are fiscal or trade matters, not monetary tools.

To stimulate a weak economy, the Federal Reserve would MOST likely:

• a.Sell Treasury securities in the open market to withdraw reserves
• b.Raise the interest rate it pays on reserve balances to encourage banks to hold them
• c.Buy government securities in the open market, adding reserves and lowering rates✓
• d.Increase the discount rate charged on loans to depository institutions

To ease policy and stimulate growth the Fed buys government securities in the open market, which adds reserves, lowers short-term rates and supports borrowing and spending. Selling securities, raising the interest rate on reserve balances and raising the discount rate would each tighten policy. The reserve-requirement option was dropped because the requirement has been 0% since March 2020.

The discount rate is the interest rate:

• a.The Federal Reserve charges member banks that borrow from it✓
• b.The U.S. Treasury pays on newly auctioned Treasury bills
• c.That banks charge their most creditworthy corporate borrowers for short-term needs
• d.That commercial banks charge one another for overnight loans of reserves

The discount rate is the interest rate the Federal Reserve charges member banks that borrow directly from it through the discount window. Lowering it encourages bank borrowing and eases credit; raising it does the opposite. It is separate from the federal funds rate, which is a bank-to-bank rate.

The federal funds rate is the rate at which:

• a.The Federal Reserve lends to banks at the discount window
• b.Banks lend to their most creditworthy corporate customers
• c.The government issues Treasury bonds
• d.Banks lend reserves to one another overnight✓

The federal funds rate is the interest rate banks charge one another for overnight loans of reserves held at the Fed. It is a key barometer of monetary policy and heavily influenced by open-market operations. It differs from the discount rate (a bank-to-Fed rate) and the prime rate (a bank-to-customer rate).

If the Federal Reserve lowers the reserve requirement, the MOST likely effect is that:

• a.Long-term Treasury bond prices will fall while yields also decline
• b.Banks will have less to lend, slowing economic growth
• c.Banks can lend more, expanding the money supply✓
• d.The federal budget deficit will shrink

Lowering the reserve requirement frees up a larger portion of deposits for lending, expanding banks' lending capacity and the money supply — an easing (expansionary) action. Raising the reserve requirement does the reverse. Reserve requirements are one of the Fed's three main monetary-policy tools.

The Consumer Price Index (CPI) is used primarily to measure:

• a.Wholesale inflation, by tracking prices received by domestic producers
• b.Economic growth, by totaling the value of all final goods produced in a year
• c.Inflation, by tracking the average change in the prices of a basket of consumer goods✓
• d.Consumer confidence, by surveying households about their spending plans

The Consumer Price Index measures inflation by tracking the average change over time in prices paid by consumers for a representative basket of goods and services; it is used to adjust wages, benefits and TIPS principal. Wholesale price tracking is the producer price index, total output is GDP, and household sentiment is a consumer confidence survey.

A fundamental analyst evaluating a stock would focus primarily on:

• a.Investor sentiment surveys and the relative-strength index
• b.Chart patterns, trading volume, and moving averages used to predict price moves
• c.The historical sequence of the stock's daily high, low, and closing prices on a chart
• d.The company's earnings, financial statements, and industry conditions✓

Fundamental analysis evaluates a company's intrinsic value using its earnings, financial statements, management, and industry and economic conditions to judge whether the stock is under- or overvalued. It contrasts with technical analysis, which studies price and volume patterns. Fundamental analysts ask what a company is worth.

A technical analyst primarily relies on:

• a.Estimates of future earnings growth and management quality
• b.Macroeconomic forecasts of gross domestic product, inflation, and interest rates
• c.A detailed review of the issuer's balance sheet, income statement, and cash flows
• d.Historical price and trading-volume patterns to forecast future movements✓

Technical analysis studies historical market data — chiefly price and volume patterns, trends, and chart formations — to forecast future price movements, rather than assessing a company's underlying value. It assumes that price action reflects all information and that trends tend to persist. It contrasts with fundamental analysis.

The fundamental balance-sheet equation states that a company's total assets equal:

• a.Its net income plus the dividends it paid
• b.Its annual revenue minus all expenses for the year
• c.The market value of its outstanding common and preferred shares
• d.Its liabilities plus shareholders' equity✓

The balance-sheet identity is Assets = Liabilities + Shareholders' Equity, meaning everything a company owns is financed either by debt or by owners' equity. Rearranged, equity equals assets minus liabilities. This equation underlies fundamental analysis of a firm's financial position.

A company's working capital is calculated as:

• a.Net income divided by common shares outstanding
• b.Current assets minus current liabilities✓
• c.Sales revenue minus the cost of goods sold
• d.Total assets minus total liabilities

Working capital equals current assets minus current liabilities and measures a firm's short-term liquidity — its ability to cover obligations due within a year. Positive working capital suggests adequate liquidity. It differs from total net worth (assets minus all liabilities) and from earnings measures.

Which of the following is generally classified as a coincident economic indicator?

• a.The average duration of unemployment, which peaks only after a recession has ended
• b.The average weekly hours worked in manufacturing
• c.Nonfarm payroll employment, which moves in step with the overall economy✓
• d.The number of new residential building permits issued each month

Coincident indicators, such as nonfarm payroll employment, industrial production, and personal income, move in step with the overall economy and confirm the current phase of the business cycle. Leading indicators (like building permits) change before the economy, and lagging indicators (like unemployment duration) change after it.

The average duration of unemployment is considered a lagging indicator because it:

• a.Changes months before the economy shifts direction
• b.Has no meaningful relationship to the business cycle
• c.Tends to change after the economy has already turned✓
• d.Moves at exactly the same time as overall economic output

A lagging indicator changes after the overall economy has already shifted direction, confirming a trend rather than predicting it. The average duration of unemployment typically keeps rising for a time even after a recession ends. Lagging indicators help verify that a turn in the cycle has genuinely occurred.

Stagflation describes an economic condition characterized by:

• a.Falling prices across the economy with rising employment
• b.A booming stock market that keeps climbing even as corporate earnings decline sharply
• c.Rapid economic growth with very low unemployment and stable consumer prices
• d.Stagnant growth and high unemployment together with rising inflation✓

Stagflation is the unusual combination of stagnant economic growth, high unemployment, and rising inflation occurring at the same time — as seen in the 1970s. It is difficult for policymakers because tools that fight inflation can worsen unemployment and vice versa. The term blends 'stagnation' and 'inflation.'

The prime rate is BEST described as:

• a.The rate at which banks lend reserves to one another overnight
• b.The rate banks charge their most creditworthy corporate customers✓
• c.The rate the Federal Reserve charges banks at its discount window
• d.The yield paid on newly issued short-term Treasury bills at auction

The prime rate is the interest rate commercial banks charge their most creditworthy (lowest-risk) corporate customers, and it serves as a benchmark for many consumer and business loans. It typically moves with the federal funds rate. It is distinct from the discount rate and the fed funds rate.

A strengthening U.S. dollar relative to foreign currencies generally:

• a.Makes imports cheaper for U.S. buyers but U.S. exports more expensive abroad✓
• b.Makes U.S. exports cheaper for foreign buyers and imports more expensive for U.S. buyers
• c.Raises the dollar value of overseas earnings that U.S. multinationals translate back into dollars
• d.Improves the U.S. trade balance by making domestic goods more attractive to foreign buyers

A stronger dollar buys more foreign currency, so imports get cheaper for U.S. buyers while U.S. goods cost foreign buyers more, which can hurt exporters and widen the trade deficit. Cheaper exports and costlier imports describe a weaker dollar. A stronger dollar also lowers, not raises, the dollar value of translated overseas earnings.

Gross domestic product (GDP) measures the total value of:

• a.The money supply circulating in the nation's financial system
• b.A country's exports minus its imports
• c.All financial assets, including stocks and bonds, owned by households and businesses
• d.All final goods and services produced within a country in a period✓

GDP is the total market value of all final goods and services produced within a country's borders during a specific period, and it is the broadest measure of economic output. Real GDP is adjusted for inflation. Two consecutive quarters of declining real GDP are a common informal marker of recession.

Keynesian economic theory generally holds that:

• a.Government spending can stimulate demand and help pull an economy out of a recession✓
• b.Free markets correct downturns on their own, so government should not intervene in the economy
• c.Cutting taxes and regulation for producers is the most effective way to revive output
• d.Steady growth in the money supply is the main determinant of output and price levels

Keynesian economics stresses aggregate demand and holds that government spending, especially deficit spending in a downturn, can stimulate demand and lift an economy out of recession. Laissez-faire thinking relies on markets to self-correct, supply-side thinking favors cutting taxes and regulation on producers, and monetarism focuses on controlling money-supply growth.

Monetarist economists, such as those following Milton Friedman, emphasize that:

• a.Deficit spending by government is the most reliable way to lift an economy out of recession
• b.Cutting marginal tax rates on producers is the main driver of long-term economic growth
• c.Controlling the growth of the money supply is the key to managing inflation and output✓
• d.Prices and wages adjust so quickly that government intervention is never needed or useful

Monetarists, led by Milton Friedman, argue that the money supply is the main driver of economic activity and inflation, so steady, controlled money-supply growth is the key to stability. Deficit spending as the cure for recession is the Keynesian view, tax-rate cuts on producers are the supply-side view, and fast-adjusting markets with no role for intervention is the classical view.

In theory, if the Federal Reserve lowers the reserve requirement ratio, the MOST likely effect is that:

• a.Inflation pressure eases, because banks keep more idle cash on hand
• b.Banks will have less to lend, slowing economic growth
• c.Banks can lend more, expanding the money supply✓
• d.The federal budget deficit will shrink as tax receipts rise

Lowering the reserve requirement ratio frees a larger share of deposits for lending, which expands banks' lending capacity and the money supply, an easing action. Raising the ratio does the reverse and would slow lending. Reserve requirements affect bank lending, not federal tax revenue or the budget deficit, and more lending adds to inflation pressure rather than easing it. In practice the Federal Reserve set the ratio to zero percent on March 26, 2020, so the tool is dormant today.Federal Reserve Regulation D, 12 CFR Part 204 (reserve requirements)

The Federal Reserve's trading desk sells a large block of Treasury securities to primary dealers. What is the most likely immediate effect on the banking system?

• a.Bank reserves fall, which tends to push the federal funds rate down
• b.Bank reserves rise, which tends to push the federal funds rate down
• c.Bank reserves stay unchanged, because only a discount-rate change moves reserves
• d.Bank reserves fall, which tends to push the federal funds rate higher✓

Dealers pay for the securities with reserves, so the sale drains reserves from the banking system, and scarcer reserves cost more to borrow overnight. Rising reserves with a lower rate describes a Fed purchase, not a sale. Open-market operations are the Fed's main day-to-day tool precisely because they change reserves directly, so unchanged reserves is wrong. Falling reserves cannot lower the rate, since less supply of a good raises its price.

Assume a 10% reserve requirement and no cash leakage. A bank receives a new $5,000 deposit. What is the maximum total deposits the banking system can support from it, counting the original deposit?

• a.$50,000, found by dividing the deposit by the 10% requirement✓
• b.$45,000, the loans the system creates beyond the original deposit
• c.$4,500, the most that the first bank itself can lend out initially
• d.$5,000, because deposits cannot grow beyond what was first deposited

The simple deposit multiplier is 1 / reserve requirement = 1 / 0.10 = 10, so $5,000 x 10 = $50,000 of total deposits, counting the original. The $45,000 figure is the new loans and deposits created beyond the original, not the total including it. $4,500 is only what the first bank can lend before the proceeds are redeposited. Treating the deposit as fixed ignores that loans are redeposited and re-lent. (The 10% requirement is a textbook assumption; the Fed has set reserve requirements to zero since March 2020.)

The money supply is $2 trillion and nominal GDP is $12 trillion. Using the equation of exchange (MV = PQ), what is the velocity of money?

• a.10, because nominal GDP less the money supply equals $10 trillion
• b.14, because the money supply plus nominal GDP equals $14 trillion
• c.6, because nominal GDP of $12 trillion divided by $2 trillion equals 6✓
• d.0.17, because the money supply divided by nominal GDP equals about 0.17

In MV = PQ, PQ is nominal GDP, so V = PQ / M = $12 trillion / $2 trillion = 6: each dollar changes hands six times a year on average. Inverting the fraction gives 0.17, which is the money supply as a share of GDP. Subtracting or adding the two figures mixes dollar amounts into a ratio and has no meaning as a turnover rate.

Nominal GDP grew 5.5% last year and the GDP price deflator rose 3.0%. Approximately how much did real GDP grow?

• a.About 2.5%, because real growth is nominal growth less inflation✓
• b.About 1.8%, because nominal growth is divided by inflation
• c.About 5.5%, because the deflator does not affect the growth rate
• d.About 8.5%, because inflation is added to nominal growth

Real GDP is nominal GDP stripped of price changes, so real growth is roughly 5.5% - 3.0% = 2.5%. Adding inflation would double count price increases. The deflator is exactly the adjustment that separates price changes from output changes, so it cannot be ignored. Dividing 5.5 by 3.0 yields about 1.8, but growth rates are subtracted, not divided.

The Producer Price Index (PPI) is most useful to an analyst as an early signal of what?

• a.Coming changes in unemployment, since producers adjust payrolls first
• b.Coming changes in real GDP, since producers' sales equal total output
• c.Coming changes in the federal funds rate, since the FOMC targets the PPI
• d.Coming changes in consumer prices, since producers often pass on input costs✓

The PPI measures prices received by domestic producers at the wholesale level, and rising producer costs often flow through to the CPI. Hiring decisions are tracked by payroll and jobless-claims data rather than by prices. Output is measured by GDP, not by an index of prices. The FOMC weighs many inputs, and no rule sets the policy rate mechanically from the PPI.

Inflation falls from 6% in one year to 3% the next, while prices continue to rise. This situation is best described as:

• a.Deflation, because the inflation rate declined during the year
• b.Stagflation, because prices rose while the inflation rate was still above 2%
• c.Disinflation, because the rate of price increase slowed but prices still rose✓
• d.Hyperinflation, because the earlier 6% rate was far above the long-run average

Disinflation is a decline in the inflation rate while the price level still increases. Deflation requires the price level itself to fall, which did not happen here. Stagflation pairs high inflation with stagnant output and high unemployment, and the facts say nothing about growth. Hyperinflation involves extremely rapid price increases, and 6% is nowhere near that.

Oil prices spike and manufacturers raise prices on finished goods to cover higher input costs, even though consumer demand has not increased. This is best described as:

• a.Cyclical disinflation
• b.Cost-push inflation✓
• c.Demand-pull inflation
• d.Structural deflation

Cost-push inflation arises when higher production costs, such as energy or wages, push up prices without a rise in demand. Demand-pull inflation requires spending to outrun supply, which the facts exclude. Deflation means falling prices, the opposite of what is happening. Disinflation is a slowing of inflation, not a supply-cost shock raising it.

According to the Phillips curve, what short-run relationship exists between unemployment and inflation?

• a.No link: inflation is determined only by the growth of the money supply
• b.An inverse trade-off: lower unemployment is associated with higher inflation✓
• c.A fixed link: each 1% fall in unemployment adds exactly 1% to inflation
• d.A direct link: higher unemployment is associated with higher inflation

The Phillips curve describes an inverse short-run relationship: tight labor markets raise wages and prices. A direct link describes stagflation, which the curve was criticized for failing to explain, not the curve itself. Monetarists emphasize money growth, but that is a rival view, not the Phillips relationship. The trade-off is not fixed at one-for-one and shifts with expectations.

An investor says long-term Treasury yields usually exceed short-term yields because investors demand extra compensation for tying up money and bearing more price risk. Which theory of the term structure is this?

• a.Pure expectations theory
• b.Liquidity preference theory✓
• c.Market segmentation theory
• d.Purchasing power parity

Liquidity preference theory says longer maturities carry a term premium, which tends to make the curve upward sloping. Pure expectations theory says long rates equal the average of expected future short rates, with no premium. Market segmentation says each maturity range has its own supply and demand and investors do not move between them. Purchasing power parity concerns exchange rates, not yields.

The one-year Treasury yields 4% and investors expect the one-year rate to be 6% a year from now. Under the pure expectations theory, the two-year yield is approximately:

• a.6%, the higher of the current and the expected one-year rate
• b.10%, the total of the current and the expected one-year rates
• c.4%, because only the current one-year rate is a known figure
• d.5%, the average of the current and the expected one-year rates✓

Pure expectations theory says a two-year rate equals the average of the current one-year rate and the expected one-year rate a year ahead: (4% + 6%) / 2 = 5%. The higher rate alone would ignore the first year. Summing the two rates gives a two-year total return, not an annualized yield. The theory is built on expectations, so the unobservable future rate is exactly what enters.

A country runs a persistent current account deficit. Which statement best describes how the deficit is financed?

• a.By net capital inflows, as foreigners buy its stocks, bonds, and property✓
• b.By central bank reserves that are never replaced, indefinitely
• c.By a matching trade surplus in services, which cancels the deficit
• d.By net capital outflows, as its residents buy assets abroad

The balance of payments must balance: a current account deficit is offset by a capital and financial account surplus, meaning foreigners are buying the country's assets or lending to it. Capital outflows would widen the gap, not fund it. A services surplus is already counted inside the current account figure. Reserves can cover a gap temporarily, but they run out, so they cannot finance a persistent deficit.

A U.S. investor owns Japanese stocks that have not changed in yen terms. If the yen weakens against the dollar, the investor's holding, measured in dollars, will most likely:

• a.Fall in value, because each yen then converts into fewer dollars✓
• b.Rise in value, because dividends are paid in the stronger currency
• c.Rise in value, because a weaker yen makes Japanese exports more competitive
• d.Stay the same, because the shares did not change in yen terms

Foreign holdings are translated back into dollars, so a yen that buys fewer dollars cuts the dollar value even if the yen price is flat. A weaker yen may help Japanese exporters over time, but the question asks about translation of an unchanged yen price. Unchanged yen value does not mean unchanged dollar value; that is currency risk. A yen dividend is also worth less when converted.

Purchasing power parity (PPP) predicts that, over the long run, the exchange rate between two currencies will adjust so that:

• a.The two countries must report identical inflation rates in each year
• b.The country with the larger economy and more exports holds the stronger currency
• c.Interest rates in the two countries converge after adjusting for risk
• d.A basket of goods costs the same in both countries once priced in one currency✓

PPP is the law-of-one-price idea applied to a basket of goods: currencies move until the basket costs the same everywhere. Equal interest rates are a different idea, interest rate parity. Economic size does not determine currency strength under PPP. PPP says currencies adjust to inflation differences; it does not require inflation rates to be equal.

Country X can make either cloth or wine, and gives up fewer units of wine per unit of cloth than Country Y does. Under the principle of comparative advantage, Country X should:

• a.Produce only the good in which it has an absolute cost advantage
• b.Specialize in cloth and trade for wine, even if Y is better at making both✓
• c.Specialize in wine, because it gives up less cloth for each unit of wine
• d.Produce both goods itself, because trade lowers domestic employment

Comparative advantage rests on opportunity cost: X gives up less wine to make cloth, so it should specialize in cloth, and both countries gain from trading even if one is more efficient at both. The wine option reverses the opportunity-cost comparison. Autarky forgoes the gains from trade, and the employment claim is not what the principle says. Absolute advantage is a different test and can point to the wrong specialization.

Economists describe 'crowding out' when government deficit spending financed by borrowing leads to:

• a.A stronger currency that lowers the cost of imports
• b.Higher taxes that raise household disposable income
• c.Higher interest rates that reduce private investment✓
• d.Lower interest rates that increase private investment

When the Treasury borrows heavily it competes for loanable funds, which can push interest rates up and discourage business borrowing and investment. Lower rates would encourage investment, the opposite effect. A stronger currency is a possible side effect through exchange rates, not the definition of crowding out. Higher taxes lower, not raise, disposable income.

If households spend 80% of each additional dollar of income, a sustained $100 billion increase in government spending could raise equilibrium output by up to approximately:

• a.$180 billion, since the multiplier is 1 + 0.80
• b.$125 billion, since the multiplier is 1 / 0.80
• c.$80 billion, since the multiplier is the 0.80 spending rate
• d.$500 billion, since the multiplier is 1 / (1 - 0.80) = 5✓

The simple spending multiplier is 1 / (1 - MPC) = 1 / 0.20 = 5, so $100 billion can raise output by $500 billion as income is re-spent. Adding 1 to the MPC gives 1.8, which has no basis in the model. Dividing by the MPC alone gives 1.25 and ignores the saved fraction that leaks out of each round. Using the MPC itself as the multiplier understates the compounding.

Supply-side economists argue that cutting marginal tax rates will mainly:

• a.Raise aggregate demand through larger government transfer payments
• b.Raise interest rates by increasing the supply of loanable funds
• c.Raise prices because higher after-tax wages are spent immediately
• d.Raise incentives to work, save, and invest, expanding productive capacity✓

Supply-side theory focuses on incentives for producers and workers, so lower marginal rates are argued to raise labor supply and investment and expand capacity. Transfer payments are a demand-side Keynesian tool, not what a tax cut delivers. More saving would increase loanable funds and push rates down rather than up. The inflationary spending channel is a demand-side argument.

Which asset is counted in the Federal Reserve's M2 money supply but not in M1?

• a.Checkable deposits at commercial banks and thrift institutions
• b.Large time deposits of $100,000 or more at commercial banks
• c.Small-denomination time deposits of less than $100,000 each✓
• d.Currency held by the public outside of bank vaults and the Fed

M2 equals M1 plus small time deposits (under $100,000) and retail money market fund balances. Currency and checkable deposits are core M1 components, so they are in both measures. Large time deposits of $100,000 or more are outside M2.

In an economy where households spend 80 cents of every additional dollar of income they receive, what is the simple spending multiplier?

• a.1.25, found by dividing 1 by the 0.80 spending share
• b.5, found by dividing 1 by (1 - 0.80)✓
• c.0.20, found by subtracting the spending share from 1
• d.4, found by dividing 0.80 by (1 - 0.80)

The simple multiplier = 1 / (1 - MPC) = 1 / 0.20 = 5, so each new dollar of spending ultimately raises income by about $5. Dividing 1 by the MPC gives 1.25, which ignores the repeated rounds of re-spending. Subtracting the MPC from 1 gives the saving share, which is the denominator and not the multiplier. Dividing the MPC by the saving share gives 4, which is the multiplier less the original dollar of spending.

During a recession, an investor wants stocks whose earnings are least sensitive to the business cycle. Which sector best fits that goal?

• a.Consumer discretionary, since spending on travel and autos stays strong
• b.Consumer staples, since households keep buying food and household basics✓
• c.Technology hardware, since firms accelerate equipment upgrades in downturns
• d.Industrials, since capital equipment orders rise when output falls

Defensive sectors such as consumer staples, utilities, and health care sell necessities whose demand holds up in downturns. Discretionary spending on travel and cars is cyclical and falls when incomes drop. Industrial orders and corporate hardware purchases are also postponed in recessions, not accelerated.

A stock trades at $60 per share. Its earnings over the last twelve months were $4 per share. What is its trailing price-to-earnings (P/E) ratio?

• a.15✓
• b.240
• c.56
• d.0.07

P/E equals price divided by earnings per share: $60 / $4 = 15. Multiplying price by earnings yields 240, which is not a ratio of price to earnings. The earnings yield, 4 / 60, is about 0.07, the inverse of the P/E. Subtracting earnings from price gives 56, a dollar difference with no valuation meaning.

A company reports net income of $12 million, pays $2 million in preferred dividends, and has a weighted average of 5 million common shares outstanding. What are its earnings per share?

• a.$1.60
• b.$2.00✓
• c.$2.40
• d.$2.80

EPS = (net income - preferred dividends) / weighted average common shares = ($12M - $2M) / 5M = $2.00. Dividing the full $12 million gives $2.40, which forgets that preferred holders are paid first. Adding the preferred dividend back gives $2.80, and subtracting it twice gives $1.60. Both move the adjustment in the wrong direction.

A company earned $4.00 per share and paid dividends of $1.00 per share. What are its dividend payout ratio and retention ratio?

• a.Payout 25% and retention 25%
• b.Payout 400% and retention 100%
• c.Payout 25% and retention 75%✓
• d.Payout 75% and retention 25%

Payout ratio = dividends / earnings = $1.00 / $4.00 = 25%, and the rest, 75%, is retained. Reversing the two numbers swaps the ratios. The two ratios must add to 100%, so 25% and 25% cannot both be right. Dividing earnings by dividends gives 4.0, not a payout percentage.

A company has net income of $8 million, total assets of $100 million, and shareholders' equity of $50 million. What is its return on equity (ROE)?

• a.16%✓
• b.8%
• c.50%
• d.6.25%

ROE = net income / shareholders' equity = $8M / $50M = 16%. Dividing by total assets gives 8%, which is return on assets. Equity as a share of assets is 50%, a capital-structure measure rather than a return. Dividing equity by net income gives 6.25 times, the inverse of the earnings ratio.